[JPRT, 111th Congress]
[From the U.S. Government Publishing Office]
CONGRESSIONAL OVERSIGHT PANEL
SPECIAL REPORT ON
REGULATORY REFORM *
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MODERNIZING THE AMERICAN FINANCIAL
REGULATORY SYSTEM:
RECOMMENDATIONS FOR IMPROVING
OVERSIGHT, PROTECTING CONSUMERS,
AND ENSURING STABILITY
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
February , 2009.--Ordered to be printed
* Submitted under Section 125(b)(2) of Title I of the Emergency
Economic Stabilization Act of 2008, Pub. L. No. 110-343
CONGRESSIONAL OVERSIGHT PANEL SPECIAL REPORT ON REGULATORY REFORM
CONGRESSIONAL OVERSIGHT PANEL
SPECIAL REPORT ON
REGULATORY REFORM *
__________
MODERNIZING THE AMERICAN FINANCIAL
REGULATORY SYSTEM:
RECOMMENDATIONS FOR IMPROVING
OVERSIGHT, PROTECTING CONSUMERS,
AND ENSURING STABILITY
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
February , 2009.--Ordered to be printed
* Submitted under Section 125(b)(2) of Title I of the Emergency
Economic Stabilization Act of 2008, Pub. L. No. 110-343
----------
U.S. GOVERNMENT PRINTING OFFICE
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Washington, DC 20402-0001
CONGRESSIONAL OVERSIGHT PANEL FOR ECONOMIC STABILIZATION
Panel Members
Elizabeth Warren, Chair
Sen. John Sununu
Rep. Jeb Hensarling
Richard H. Neiman
Damon Silvers
C O N T E N T S
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Page
I. Executive Summary................................................1
1. Lessons From the Past................................. 1
2. Shortcomings of the Present........................... 2
3. Recommendations for the Future........................ 3
II. Introduction.....................................................5
III. A Framework for Analyzing the Financial Regulatory System and Its
Effectiveness....................................................7
1. The Promise and Perils of Financial Markets........... 7
2. The Current State of the Regulatory System............ 8
Failure to Effectively Manage Risk................... 8
Failure to Require Sufficient Transparency........... 12
Failure to Ensure Fair Dealings...................... 15
3. The Central Importance of Regulatory Philosophy....... 18
IV. Critical Problems and Recommendations for Improvement...........21
1. Identify and Regulate Financial Institutions That Pose
Systemic Risk.......................................... 21
2. Limit Excessive Leverage in American Financial
Institutions........................................... 23
3. Modernize Supervision of Shadow Financial System...... 27
4. Create a New System for Federal and State Regulation
of Mortgages and other Consumer Credit Products........ 30
5. Create Executive Pay Structures That Discourage
Excessive Risk Taking.................................. 36
6. Reform the Credit Rating System....................... 40
7. Make Establishing a Global Financial Regulatory Floor
a U.S. Diplomatic Priority............................. 44
8. Plan for the Next Crisis.............................. 46
V. Issues Requiring Further Study..................................49
VI. Acknowledgments.................................................50
VII. About the Congressional Oversight Panel.........................51
VIII.Additional Views................................................52
Richard H. Neiman........................................ 52
Congressman Jeb Hensarling and former Senator John E.
Sununu................................................. 55
Appendix: Other Reports on Financial Regulatory Reform........... 95
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SPECIAL REPORT ON REGULATORY REFORM
_______
February , 2009.--Ordered to be printed
_______
I. EXECUTIVE SUMMARY
1. LESSONS FROM THE PAST
Financial crises are not new. As early as 1792, during the
presidency of George Washington, the nation suffered a severe
panic that froze credit and nearly brought the young economy to
its knees. Over the next 140 years, financial crises struck on
a regular basis--in 1797, 1819, 1837, 1857, 1873, 1893-96,
1907, and 1929-33--roughly every fifteen to twenty years.
But as the United States emerged from the Great Depression,
something remarkable happened: the crises stopped. New
financial regulation--including federal deposit insurance,
securities regulation, and banking supervision--effectively
protected the system from devastating outbreaks. Economic
growth returned, but recurrent financial crises did not. In
time, a financial crisis was seen as a ghost of the past.
After fifty years without a financial crisis--the longest
such stretch in the nation's history--financial firms and
policy makers began to see regulation as a barrier to efficient
functioning of the capital markets rather than a necessary
precondition for success.
This change in attitude had unfortunate consequences. As
financial markets grew and globalized, often with breathtaking
speed, the U.S. regulatory system could have benefited from
smart changes. But deregulation and the growth of unregulated,
parallel shadow markets were accompanied by the nearly
unrestricted marketing of increasingly complex consumer
financial products that multiplied risk at every stratum of the
economy, from the family level to the global level. The result
proved disastrous. The first warning followed deregulation of
the thrifts, when the country suffered the savings and loan
crisis in the 1980s. A second warning came in 1998 when a
crisis was only narrowly averted following the failure of a
large unregulated hedge fund. The near financial panic of 2002,
brought on by corporate accounting and governance failures,
sounded a third warning.
The United States now faces its worst financial crisis
since the Great Depression. It is critical that the lessons of
that crisis be studied to restore a proper balance between free
markets and the regulatory framework necessary to ensure the
operation of those markets to protect the economy, honest
market participants, and the public.
2. SHORTCOMINGS OF THE PRESENT
The current crisis should come as no surprise. The present
regulatory system has failed to effectively manage risk,
require sufficient transparency, and ensure fair dealings.
Financial markets are inherently volatile and prone to
extremes. The government has a critical role to play in helping
to manage both public and private risk. Without clear and
effective rules in place, productive financial activity can
degenerate into unproductive gambling, while sophisticated
financial transactions, as well as more ordinary consumer
credit transactions, can give way to swindles and fraud.
A well-regulated financial system serves a key public
purpose: if it has the power and if its leaders have the will
to use that power, it channels savings and investment into
productive economic activity and helps prevent financial
contagion. Like the management of any complex hazard, financial
regulation should not rely on a single magic bullet, but
instead should employ an array of related measures for managing
various elements of risk. The advent of the automobile brought
enormous benefits but also considerable risks to drivers,
passengers, and pedestrians. The solution was not to prohibit
driving, but rather to manage the risks through reasonable
speed limits, better road construction, safer sidewalks,
required safety devices (seatbelts, airbags, children's car
seats, antilock breaks), mandatory automobile insurance, and so
on. The same holds true in the financial sector.
In recent years, however, the regulatory system not only
failed to manage risk, it also failed to require disclosure of
risk through sufficient transparency. American financial
markets are profoundly dependent upon transparency. After all,
the fundamental risk/reward corollary depends on the ability of
market participants to have confidence in their ability to
accurately judge risk.
Markets have become opaque in multiple ways. Some markets,
such as hedge funds and credit default swaps, provide virtually
no information. Even so, disclosure alone does not always
provide genuine transparency. Market participants must have
useful, relevant information delivered in an appropriate,
timely manner. Recent market occurrences involving off-balance-
sheet entities and complex financial instruments reveal the
lack of transparency resulting from the wrong information
disclosed at the wrong time and in the wrong manner. Mortgage
documentation suffers from a similar problem, with reams of
paper thrust at borrowers at closing, far too late for any
borrower to make a well-informed decision. Just as markets and
financial products evolve, so too must efforts to provide
understanding through genuine transparency.
To compound the problem associated with uncontained and
opaque risks, the current regulatory framework has failed to
ensure fair dealings. Unfair dealing can be blatant, such as
outright deception or fraud, but unfairness can also be much
more subtle, as when parties are unfairly matched. Individuals
have limited time and expertise to master complex financial
dealings. If one party to a transaction has significantly more
resources, time, sophistication or experience, other parties
are at a fundamental disadvantage. The regulatory system should
take appropriate steps to level the playing field.
Unfair dealings affect not only the specific transaction
participants, but extend across entire markets, neighborhoods,
socioeconomic groups, and whole industries. Even when only a
limited number of families in one neighborhood have been the
direct victims of a predatory lender, the entire neighborhood
and even the larger community will suffer very real
consequences from the resulting foreclosures. As those
consequences spread, the entire financial system can be
affected as well. More importantly, unfairness, or even the
perception of unfairness, causes a loss of confidence in the
marketplace. It becomes all the more critical for regulators to
ensure fairness through meaningful disclosure, consumer
protection measures, stronger enforcement, and other measures.
Fair dealings provide credibility to businesses and
satisfaction to consumers.
In tailoring regulatory responses to these and other
problems, the goal should always be to strike a reasonable
balance between the costs of regulation and its benefits. Just
as speed limits are more stringent on busy city streets than on
open highways, financial regulation should be strictest where
the threats--especially the threats to other citizens--are
greatest, and it should be more moderate elsewhere.
3. RECOMMENDATIONS FOR THE FUTURE
Modern financial regulation can provide consumers and
investors with adequate information for making sound financial
decisions and can protect them from being misled or defrauded,
especially in complex financial transactions. Better regulation
can reduce conflicts of interest and help manage moral hazard,
particularly by limiting incentives for excessive risk taking
stemming from often implicit government guaranties. By limiting
risk taking in key parts of the financial sector, regulation
can reduce systemic threats to the broader financial system and
the economy as a whole. Ultimately, financial regulation
embodies good risk management, transparency, and fairness.
Had regulators given adequate attention to even one of the
three key areas of risk management, transparency and fairness,
we might have averted the worst aspects of the current crisis.
1. Risk management should have been addressed through
better oversight of systemic risks. If companies that are now
deemed ``too big to fail'' had been better regulated, either to
diminish their systemic impact or to curtail the risks they
took, then these companies could have been allowed to fail or
to reorganize without taxpayer bailouts. The creation of any
new implicit government guarantee of high-risk business
activities could have been avoided.
2. Transparency should have been addressed through better,
more accurate credit ratings. If companies issuing high-risk
credit instruments had not been able to obtain AAA ratings from
the private credit rating agencies, then pension funds,
financial institutions, state and local municipalities, and
others that relied on those ratings would not have been misled
into making dangerous investments.
3. Fairness should have been addressed through better
regulation of consumer financial products. If the excesses in
mortgage lending had been curbed by even the most minimal
consumer protection laws, the loans that were fed into the
mortgage backed securities would have been choked off at the
source, and there would have been no ``toxic assets'' to
threaten the global economy.
While the current crisis had many causes, it was not
unforeseeable. Correcting the mistakes that fueled this crisis
is within reach. The challenge now is to develop a new set of
rules for a new financial system.
The Panel has identified eight specific areas most urgently
in need of reform:
1. Identify and regulate financial institutions that
pose systemic risk.
2. Limit excessive leverage in American financial
institutions.
3. Increase supervision of the shadow financial
system.
4. Create a new system for federal and state
regulation of mortgages and other consumer credit
products.
5. Create executive pay structures that discourage
excessive risk taking.
6. Reform the credit rating system.
7. Make establishing a global financial regulatory
floor a U.S. diplomatic priority.
8. Plan for the next crisis.
While these are the most pressing reform recommendations,
many other issues merit further study, the results of which the
Panel will present in future reports. Despite the magnitude of
the task, the central message is clear: through modernized
regulation, we can dramatically reduce the risk of crises and
swindles while preserving the key benefits of a vibrant
financial system
Americans have paid dearly for this latest crisis. Lost
jobs, failed businesses, foreclosed homes, and sharply cut
retirement savings have touched people all across the county.
Now every citizen--even the most prudent--is called on to
assume trillions of dollars in liabilities spent to try to
repair a broken system. The costs of regulatory failure and the
urgency of regulatory reform could not be clearer.
II. INTRODUCTION
The financial crisis that began to take hold in 2007 has
exposed significant weaknesses in the nation's financial
architecture and in the regulatory system designed to ensure
its safety, stability, and performance. In fact, there can be
no avoiding the conclusion that our regulatory system has
failed.
The bursting of the housing bubble produced the first true
stress test of modern capital markets, their instruments, and
their participants. The first cracks were evident in the
subprime mortgage market and in the secondary market for
mortgage-related securities. From there, the crisis spread to
nearly every corner of the financial sector, both at home and
abroad, taking down some of the most venerable names in the
investment banking and insurance businesses and crippling
others, wreaking havoc in the credit markets, and brutalizing
equity markets worldwide.
As asset prices deflated, so too did the theory that had
increasingly guided American financial regulation over the
previous three decades--namely, that private markets and
private financial institutions could largely be trusted to
regulate themselves. The crisis suggested otherwise,
particularly since several of the least regulated parts of the
system were among the first to run into trouble. As former
Federal Reserve Chairman Alan Greenspan acknowledged in
testimony before the House Committee on Oversight and
Government Reform in October 2008, ``Those of us who have
looked to the self-interest of lending institutions to protect
shareholders' equity, myself included, are in a state of
shocked disbelief.'' \1\
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\1\ See Edmund L. Andrews, Greenspan Concedes Error on Regulation,
New York Times (Oct. 24, 2008). See also House Committee on Oversight
and Government Reform, Testimony of Alan Greenspan, The Financial
Crisis and the Role of Federal Regulators, 110th Cong., at 2 (Oct. 23,
2008) (online at oversight.house.gov/documents/20081023100438.pdf).
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The financial meltdown necessitates a thorough review of
our regulatory infrastructure, the behavior of regulators and
their agencies, and the regulatory philosophy that informed
their decisions. At the same time, we must be careful to avoid
the trap of looking solely backward--preparing to fight the
last war. Although the crisis has exposed many deficiencies,
there are likely others that have yet to be uncovered. What is
more, the vast federal response to the crisis--including
unprecedented rescues of crippled businesses and a
proliferation of government guaranties--threatens to distort
private incentives in the future, further eroding the caution
of financial creditors and making the job of regulatory
oversight all the more essential.
Realizing that far-reaching reform will be needed in the
wake of the crisis, Congress directed the Congressional
Oversight Panel (hereinafter ``the Panel'') to submit a special
report on regulatory reform,
analyzing the current state of the regulatory system
and its effectiveness at overseeing the participants in
the financial system and protecting consumers, and
providing recommendations for improvement, including
recommendations regarding whether any participants in
the financial markets that are currently outside the
regulatory system should become subject to the
regulatory system, the rationale underlying such
recommendation, and whether there are any gaps in
existing consumer protections.\2\
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\2\ Emergency Economic Stabilization Act of 2008, Pub. L. No. 110-
343, at Sec. 125(b)(2).
Toward this end, part III of this report presents a broad
framework for analyzing the effectiveness of financial
regulation, focusing on three critical failures of the current
system: (1) inadequate private and public risk management, (2)
insufficient transparency and information, and (3) a lack of
protection against deception and unfair dealing. These key
failures of the regulatory system have manifested themselves in
a plethora of more specific problems, ranging from excessively
leveraged financial institutions to opaque financial
instruments falling outside the scope of the jurisdiction of
any regulatory agency. While this report cannot tackle every
one of these problems, part IV focuses on eight areas of the
current financial regulatory system that are in need of
improvement, offering the Panel's recommendations for each as
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follows:
1. Identify and regulate financial institutions that
pose systemic risk.
2. Limit excessive leverage in American financial
institutions.
3. Modernize supervision of the shadow financial
system.
4. Create a new system for federal and state
regulation of mortgages and other consumer credit
products.
5. Create executive pay structures that discourage
excessive risk taking.
6. Reform the credit rating system.
7. Make establishing a global financial regulatory
floor a U.S. diplomatic priority.
8. Plan for the next crisis.
Finally, part V of this report points to some additional
challenges in need of attention over the longer term, several
of which will be addressed in future reports of the Panel. An
appendix comprising summaries of other recent reports regarding
reform of the regulatory system is found at the end of the
report.
This report is motivated by the knowledge that millions of
Americans suffer when the financial regulatory system and the
capital markets fail. The financial meltdown has many causes
but one overwhelming result: a great increase in unexpected
hardships and financial challenges for American citizens. The
unemployment rate is rising sharply every month, a growing
number of Americans are facing the prospect of losing their
homes, retirees are worried about how to afford even basic
necessities, and families are anxious about paying for college
and securing a decent start in adult life. The goal of the
regulatory reforms presented in this report is not to endorse a
particular economic theory or merely to guide the country
through the current crisis. The goal is instead to establish a
sturdy regulatory system that will facilitate the growth of
financial markets and will protect the lives of current and
future generations of Americans.
III. A FRAMEWORK FOR ANALYZING THE FINANCIAL REGULATORY SYSTEM AND ITS
EFFECTIVENESS
1. THE PROMISE AND PERILS OF FINANCIAL MARKETS
Households, firms, and government agencies all rely on the
financial system for saving and raising capital, settling
payments, and managing risk. A dynamic financial system
facilitates the mobilization of resources for large projects
and the transfer of resources across time and space and
provides critical information in the form of price signals that
help to coordinate dispersed economic activity. A healthy
financial system, one that allows for the efficient allocation
of capital and risk, is indispensable to any successful
economy.
Unfortunately, financial systems are also prone to
instability and abuse. Until the dawn of modern financial
regulation in the 1930s and early 1940s, financial panics were
a regular--and often debilitating--feature of American life.
The United States suffered significant financial crises in
1792, 1819, 1837-39, 1857, 1873, 1893-95, 1907, and 1929-33.
After the Great Depression and the introduction of federal
deposit insurance and federal banking and securities
regulation, the next significant banking crisis did not strike
for more than forty years. This period of relative stability--
by far the longest in the nation's history--persisted until the
mid-1980s, with the onset of the savings and loan crisis;
dealing with that crisis cost American taxpayers directly some
$132 billion.\3\ The country also suffered a group of bank
failures that produced the need to recapitalize the FDIC's
initial Bank Insurance Fund in the early 1990s; suffered a
stock market crash in 1987; witnessed a wave of foreign
currency crises (and associated instability) in 1994-95 and
1997-98; saw the collapse of Long Term Capital Management
(LCTM) hedge fund in 1998; and faced the collapse of the tech
bubble in 2001. Financial crisis has now struck again, with the
subprime-induced financial turmoil of 2007-09.
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\3\ On the period of relative financial stability (``the great
pause''), see David Moss, An Ounce of Prevention: The Power of Sound
Risk Management in Stabilizing the American Financial System (2009).
See also Federal Deposit Insurance Corporation, History of the
Eighties--Lessons for the Future, Volume I: An Examination of the
Banking Crises of the 1980s and Early 1990s, at 187 (online at
www.fdic.gov/bank/historical/history/167_188.pdf).
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Although every crisis is distinctive in its particulars,
the commonalities across crises are often more striking than
the differences. As the financial historian Robert Wright
explains: ``All major panics follow the same basic outline:
asset bubble, massive leverage (borrowing to buy the rising
asset), bursting bubble (asset price declines rapidly),
defaults on loans, asymmetric information and uncertainty,
reduced lending, declining economic activity, unemployment,
more defaults.'' \4\
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\4\ See Andrea Young, What Economic Historians Think About the
Meltdown, History News Network (Oct. 20, 2008) (online at hnn.us/
articles/55851.html).
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Nor are financial panics the only cause for concern.
Financial markets have also long exhibited a vulnerability to
manipulation, swindles, and fraud, including William Duer's
notorious attempt to corner the market for United States
government bonds in 1791-92, the ``wildcat'' life insurance
companies of the early nineteenth century (which took premiums
from customers but disappeared before paying any claims), the
infamous pyramiding scheme of Charles Ponzi in 1920, and the
highly suspect practices of New York's National City Bank and
its chairman, Charles Mitchell, in the run-up to the Great
Crash of 1929. The apparent massive Ponzi scheme of Bernard
Madoff that has recently unraveled in 2008 is only the latest
in a long series of such financial scandals.
Even apart from the most spectacular financial crises and
crimes, the failure of any individual financial institution--
all by itself--can have devastating consequences for the
investors and clients who rely on it.\5\ The collapse of a
bank, insurance company, or pension fund can prove particularly
damaging, disrupting longstanding financial relationships and
potentially destroying the safety nets that many Americans have
spent years carefully building.
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\5\ In fact, because of the salutary effects of existing
regulations, not all failures of financial institutions create the same
level of damage. For instance, the government has insured consumer
deposits in financial institutions since the New Deal in recognition of
the dangers of a loss of depositor confidence. Consequently, it is no
longer the risk of shareholder losses that cause fear of systemic
crisis, but rather the risk of financial institutions defaulting on
fixed obligations.
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The good news is that many of these financial risks can be
significantly attenuated through sound regulation. Well-
designed regulation has the potential to enhance both financial
safety and economic performance, and it has done so in the
past. To be sure, the risks of capital market crises cannot be
eliminated altogether, just as the risk of automobile accidents
will never entirely disappear, despite rigorous safety
standards.
2. THE CURRENT STATE OF THE REGULATORY SYSTEM
The purpose of financial regulation is to make financial
markets work better and to ensure that they serve the interests
of all Americans. There are many important (and sometimes
competing) goals of financial regulation, ranging from safety
and stability to innovation and growth. In order to achieve
these goals, an effective regulatory system must manage risk,
facilitate transparency, and promote fair dealings among market
actors. The current system has failed on all three counts.
Failure to effectively manage risk
As the current financial meltdown makes clear, private
financial markets do not always manage risk effectively on
their own. In fact, to a large extent, the current crisis can
be understood as the product of a profound failure in private
risk management, combined with an equally profound failure in
public risk management, particularly at the federal level.
Failure of private risk management. The risk-management
lapses in the private sector are by now obvious. In the
subprime market, brokers and originators often devoted
relatively little attention to risk assessment, exhibiting a
willingness to issue extraordinarily risky mortgages (for high
fees) so long as the mortgages could be sold quickly on the
secondary market.\6\ Securitizers on Wall Street and elsewhere
proved hungry for these high-interest-rate loans, because they
could earn large fees for bundling them, dividing the payments
into tranches, and selling the resulting securities to
investors. These securities proved attractive, even to
relatively risk-averse investors, because the credit rating
agencies (who were paid by the issuers) awarded their triple-A
seal of approval to the vast majority of the securities in any
given issue. The credit rating agencies concluded--wrongly, it
turns out--that virtually all of the risk of a subprime
mortgage-backed securitization was concentrated in its lowest
tranches (e.g., the bottom 15 to 25 percent) and that the
remainder was exceedingly safe. Nor did the process end there,
since lower-tranche securities (e.g., those with a BBB rating
or below) could be aggregated into so-called collateralized
debt obligations (CDOs) and re-tranched, creating whole new
sets of AAA and AA securities. Only when the housing market
turned down and delinquencies and foreclosures started to rise,
beginning in 2006-07, did the issuers, investors, and rating
agencies finally recognize how severely they had underestimated
the key risks involved.\7\
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\6\ These mortgages included so-called 2-28s (which were scheduled
to reset to a sharply higher interest rate after two years) and option-
arms (which allowed customers essentially to set their own payments in
an initial period, followed by ballooning payments after that). Whether
or not borrowers could reasonably be expected to repay--based on their
earning capacity--was no longer always a decisive criterion for
lending, particularly against the backdrop of rising home prices. Said
one broker of an elderly client who had lost his home as a result of an
unaffordable loan, ``It's clear he was living beyond his means, and he
might not be able to afford this loan. But legally, we don't have a
responsibility to tell him this probably isn't going to work out. It's
not our obligation to tell them how they should live their lives.'' See
Charles Duhigg, When Shielding Money Clashes with Elders' Free Will,
New York Times (Dec. 24, 2007).
\7\ Credit card and automobile loans are also securitized and sold
in various formats. It remains to be seen whether an increased rate of
default on those loans (which can be expected as the economic slowdown
deepens) will generate a second wave of severe capital market
disruptions.
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Had these excesses been limited to the subprime market, it
is unlikely that the initial turmoil could have sparked a full-
blown financial crisis. Unfortunately, the broader financial
system was in no position to absorb the losses because a great
many of the leading financial firms were themselves heavily
leveraged (especially by incurring a large proportion of short-
term debt) and contingent liabilities (including many tied back
to the housing market). Such leverage had greatly magnified
returns in good times, but proved devastating once key assets
began to drop in value. Higher-leverage necessarily meant
higher risk. As it became clear that not only AAA-rated
mortgage-backed securities but also AAA-rated financial
institutions were at risk, trust all but disappeared in the
marketplace, leaving even potentially solvent financial
institutions vulnerable to runs by their creditors, who were
rattled and increasingly operating on a hair trigger.\8\
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\8\ See section III.2.
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In a sense, no one should have been surprised by the
turmoil. Unregulated and weakly regulated financial markets
have historically shown a tendency toward excessive risk taking
and instability. The reasons for this are worth reviewing.
To begin with, financial actors do not always bear the full
consequences of their decisions and therefore are liable to
take (or impose) more risk than would otherwise seem
reasonable. For example, financial institutions generally
invest other people's money and often enjoy asymmetric
compensation incentives, which reward them for gains without
penalizing them for losses. Even more troubling, the failure of
a large financial firm can have systemic consequences,
potentially triggering a cascade of losses, which means that
risk taking by the firm can impose costs far beyond its own
shareholders, creditors, and counterparties. The freezing up of
the credit markets in 2008-09, because even healthy banks are
afraid to lend, is an especially serious example of this
phenomenon.
A closely related problem is that of contagion or panic, in
which fear drives a sudden surge in demand for safety and
liquidity. A traditional bank run by depositors is one
expression of contagion, but other types of creditors can also
create a ``run'' on a financial institution and potentially
weaken or destroy it; for example, short-term lenders can
refuse to roll over existing loans to the institution, and
market actors may refuse to continue to deal with it. In fact,
whole markets can succumb to panic selling under certain
circumstances. In all of these cases, the fearful depositors,
creditors, and investors who suddenly decide to liquidate their
positions may be imposing costs on others, since the first to
run will generally get their money out whereas the last to do
so typically will not. More broadly, poorly managed financial
institutions impose costs on well-managed ones, because of the
threat of contagion.
Yet another problem endemic to financial markets is that
individual borrowers and investors may not always be ideally
positioned to evaluate complex risks. How can any of us be sure
that a particular financial agreement or product is safe?
Ideally, we carefully read the contract or prospectus. But
given limits on time and expertise (including the expense of
expert advice), even a relatively careful consumer or investor
is liable to make mistakes--and potentially large ones--from
time to time. Virtually all of us, moreover, rely on various
kinds of shortcuts in assessing risks in daily life--intuition,
seeking nonexpert outside advice, a trusting attitude toward
authority, and so on. Although such an approach may normally
work well, it sometimes fails and is particularly subject to
manipulation--for example, by aggressive (or even predatory)
lenders. Such problems were an important contributor to the
excesses and eventual implosion of subprime mortgage lending.
In addition, particularly in recent years, it appears that even
many of the most sophisticated investors--and perhaps even the
credit rating agencies themselves--had trouble assessing the
risks associated with a wide array of new and complex financial
instruments. Complexity itself may therefore have contributed
to the binge of risk taking that overtook the United States
financial system in recent years.
Failure of public risk management. Ideally, state and
federal regulators should have intervened to control the worst
financial excesses and abuses long before the crisis took hold.
Almost everyone now recognizes that the government serves as
the nation's ultimate risk manager--as the lender, insurer, and
spender of last resort--in times of crisis. But effective
public risk management is critical in normal times as well,
both to protect consumers and investors and to help prevent
crises from developing in the first place.\9\
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\9\ On the government's role as a risk manager, see David Moss,
When All Else Fails: Government as the Ultimate Risk Manager (2002).
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A good example involves bank regulation. Americans have
faced recurrent banking crises as well as frequent bank
suspensions and failures for much of the nation's history. The
problem appeared to ease after the creation of the Federal
Reserve in 1914 but then returned with a vengeance in 1930-33,
when a spiraling panic nearly consumed the entire American
banking system. All of this changed after the introduction of
federal deposit insurance in June of 1933. Bank runs virtually
disappeared, and bank failures fell sharply. Critics worried
that the existence of federal insurance would encourage
excessive risk taking (moral hazard), because depositors would
no longer have to worry about the soundness of their banks and
instead would be attracted by the higher interest rates that
riskier banks offered. The authors of the 1933 legislation
prepared for this threat, authorizing not only public deposit
insurance but also intelligent bank regulation designed to
ensure the safety and soundness of insured banks. The end
result was an effective system of new consumer protections, a
remarkable reduction in systemic risk, and a notable increase
in public confidence in the financial system. By all
indications, well-designed government risk management helped
strengthen the market and prevent subsequent crises.\10\ (See
figure below: Bank Failures, 1864-2000).
---------------------------------------------------------------------------
\10\ In fact, significant bank failures did not reappear until
after the start of bank deregulation in the early 1980s. Bank
deregulation is often said to have started with the Depository
Institutions Deregulation and Monetary Control Act of 1980, Pub. L. No.
96-221, and the Depository Institutions Act of 1982, Pub. L. No. 97-
320.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
In our own time, appropriate regulatory measures might have
proved similarly salutary. Reasonable controls on overly risky
consumer and corporate lending and effective limits on the
leverage of major (systemic) financial institutions might have
been enough, by themselves, to prevent the worst aspects of the
collapse. Greater regulatory attention in numerous other areas,
from money market funds and credit rating agencies to credit
default swaps, might also have made a positive difference.
However, key policymakers, particularly at the federal level,
often chose not to expand this critical risk-management role--
to cover new and emerging risks--when they had the chance.
Looking forward, the need for meaningful regulatory reform
has now become particularly urgent--not only to correct past
mistakes, but also to limit the likelihood and the impact of
future crises and to control the moral hazard that is likely to
flow from the recent profusion of federal bailouts and
guaranties. If creditors, employees, and even shareholders of
major financial institutions conclude that the federal
government is likely to step in again in case of trouble
(because of the systemic significance of their institutions),
they may become even more lax about monitoring risk, leading to
even greater excesses in the future. For this reason, the
recent federal actions in support of the nation's largest
financial institutions, involving more than $10 trillion in new
federal guaranties, make effective regulation after the crisis
even more vital. The example set in 1933--of pairing explicit
public insurance with an effective regulatory mechanism for
monitoring and controlling moral hazard--must not be forgotten.
In fact, the need to control the moral hazard created by the
current financial rescue may be the most important reason of
all for strengthening financial regulation in the months and
years ahead.
Failure to require sufficient transparency
While allowing financial institutions to take on too much
risk, federal and state regulators at the same time have
permitted these actors to provide too little information to
protect investors and enable markets to function honestly and
efficiently. Because financial information often represents a
public good, it may not be adequately provided in the
marketplace without government encouragement or mandate.
Investors without access to basic financial reporting face
serious information asymmetries, potentially raising the cost
of capital and compromising the efficient allocation of
financial resources.\11\ Truthful disclosures are also
essential to protect investors. Essential disclosure and
reporting requirements may therefore enhance efficiency by
reducing these informational asymmetries. The broad
availability of financial information also promises to boost
public confidence in financial markets. As former Securities
and Exchange Commission (SEC) Chairman Arthur Levitt has
observed, ``the success of capital is directly dependent on the
quality of accounting and disclosure systems. Disclosure
systems that are founded on high-quality standards give
investors confidence in the credibility of financial
reporting--and without investor confidence, markets cannot
thrive.'' \12\
---------------------------------------------------------------------------
\11\ Modern economic research has shown that markets can only
function efficiently--that Adam Smith's ``invisible hand'' only works
to the extent that the information processed by the markets is accurate
and complete. See Joseph E. Stiglitz, Globalization and Its Discontents
(2002) at ch. 3, n. 2 and accompanying text. On information asymmetry
and the cost of capital, see Douglas Diamond and Robert Verrecchia,
Disclosure, Liquidity, and the Cost of Capital, Journal of Finance, at
1325-1359 (Sept. 1991). See also S. P. Kothari, The Role of Financial
Reporting in Reducing Financial Risks in the Market, in Building and
Infrastructure for Financial Stability, at 89-102 (Eric. S. Rosengren
and John S. Jordan eds., June 2000).
\12\ See id. at 91.
---------------------------------------------------------------------------
From the time they were introduced at the federal level in
the early 1930s, disclosure and reporting requirements have
constituted a defining feature of American securities
regulation (and of American financial regulation more
generally). President Franklin Roosevelt himself explained in
April 1933 that although the federal government should never be
seen as endorsing or promoting a private security, there was
``an obligation upon us to insist that every issue of new
securities to be sold in interstate commerce be accompanied by
full publicity and information and that no essentially
important element attending the issue shall be concealed from
the buying public.'' \13\
---------------------------------------------------------------------------
\13\ See James M. Landis, The Legislative History of the Securities
Act of 1933, George Washington Law Review, at 30 (1959).
---------------------------------------------------------------------------
Historically, embedding a flexible approach to jurisdiction
has made for strong, effective regulatory agencies. When the
SEC was founded, during the Depression, Congress armed the
commission with statutory authority based upon an extremely
broad view of what constituted a security and gave it wide
latitude in determining what disclosures were necessary from
those who sought to sell securities to the public. There was a
similar breadth of coverage and flexibility in substantive
approach in the Investment Advisors Act and the Investment
Company Act, which together governed money managers. These
broad grants of jurisdiction led to the SEC's having regulatory
authority over most capital-market transactions outside the
banking and insurance systems until the end of the 1970s.
However, the financial markets have outpaced even the
broadest grants of regulatory authority. Starting in the 1980s,
skilled market operators began to exploit what had previously
seemed to be merely insignificant loopholes in this system--
exceptions that had always existed in the regulation of
investment management. The increasing importance of
institutional intermediaries in the capital markets exacerbated
this tendency. By the 1990s, the growth of over-the-counter
derivative markets had created unregulated parallel capital-
market products. This trend has continued in recent years, with
the SEC allowing the founding of publicly traded hedge-fund and
private-equity management firms that do not have to register as
investment companies.
Over subsequent years, the reach of the SEC and its
reporting requirements were gradually expanded. Securities
traded over the counter, for example, were brought into the
fold beginning in 1964. The SEC targeted ``selective
disclosure'' in 2000 with Regulation Fair Disclosure (Reg FD),
a new weapon in the ongoing fight against insider activities.
Two years later, Congress passed the Sarbanes-Oxley Act, which
aimed to bolster the independence of the accounting industry
and required top corporate executives to personally certify key
financial statements.\14\
---------------------------------------------------------------------------
\14\ See Chris Yenkey, Transparency, Democracy, and the SEC: 70
Years of Securities Market Regulation, in Transparency in a New Global
Order: Unveiling Organizational Visions (Christina Garsten and Monica
Lindh de Montoya eds., 2007).
---------------------------------------------------------------------------
By the time the crisis struck in 2007-08, however, one of
the most common words used to describe the American financial
system was ``opaque.'' Hedge funds, which squeeze into an
exemption in the Investment Company Act of 1940, face almost no
registration or reporting requirements; moreover, a modest
attempt by the SEC to change this situation was struck down in
federal court in 2006. Similarly, over-the-counter markets for
credit default swaps and other derivative instruments remain
largely unregulated and, say critics, constitute virtually the
polar opposite of open and transparent exchange. (According to
news reports, an attempt by Brooksley Born, the former
chairperson of the Commodity Futures Trading Commission, to
regulate OTC-traded derivatives in 1997-98, was blocked by Fed
Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and
others, allegedly on the grounds that such regulation could
precipitate a financial crisis. In any event, Congress in 2000
prohibited regulation of most derivatives.) \15\ In addition,
the proliferation of off-balance-sheet entities (conduits,
structured investment vehicles [SIVs], etc.) and the rapid
growth of highly complex financial instruments (such as CDOs)
further undermined clarity and understanding in the
marketplace. The financial consultant Henry Kaufman maintains
that leading financial institutions actively ``pushed legal
structures that made many aspects of the financial markets
opaque.'' \16\ Moreover, starting in 1994, with the Central
Bank of Denver decision,\17\ the courts have severely limited
the ability of investors to police transparency failures
involving financial institutions working with public companies.
This failure was extended in the Supreme Court's Stoneridge
decision,\18\ closing off liability to investors even in cases
in which financial institutions were participants in a
fraudulent scheme.
---------------------------------------------------------------------------
\15\ Peter S. Goodman, The Reckoning: Taking Hard New Look at a
Greenspan Legacy, New York Times (Oct. 8, 2008).
\16\ Henry Kaufman, How the Credit Crisis Will Change the Way
America Does Business: Huge Financial Companies Will Grow at the
Expense of Borrowers and Investors, Wall Street Journal (Dec. 6, 2008).
\17\ Central Bank of Denver, N.A. v. First Interstate Bank of
Denver, N.A., 511 U.S. 164 (1994).
\18\ Stoneridge Investment Partners, LLC v. Scientific-Atlanta,
Inc., 128 S. Ct. 761 (2008). See also Congressional Oversight Panel,
Testimony of Joel Seligman, Reforming America's Financial Regulatory
Structure, at 5 (Jan. 14, 2009) (online at cop.senate.gov/documents/
testimony-011409-seligman.pdf).
---------------------------------------------------------------------------
There are of course legitimate questions about how far
policymakers should go in requiring disclosure--where the line
should be drawn between public and proprietary information. But
particularly given the breakdown that has now occurred, it is
difficult to escape the conclusion that America's financial
markets have veered far from the goal of transparency,
fundamentally compromising the health and vitality of the
financial sector and, ultimately, the whole economy.
Why our regulatory system failed to expand the zone of
transparency in the face of far-reaching financial innovation
is a question that merits careful attention. At least part of
the answer, once again, appears to be that key regulators
preferred not to expand the regulatory system to address these
challenges, or simply believed that such expansion was
unnecessary. In 2002, for example, Federal Reserve Chairman
Alan Greenspan explained his view on ``the issue of regulation
and disclosure in the over-the-counter derivatives market''
this way:
By design, this market, presumed to involve dealings
among sophisticated professionals, has been largely
exempt from government regulation. In part, this
exemption reflects the view that professionals do not
require the investor protections commonly afforded to
markets in which retail investors participate. But
regulation is not only unnecessary in these markets, it
is potentially damaging, because regulation presupposes
disclosure and forced disclosure of proprietary
information can undercut innovations in financial
markets just as it would in real estate markets.\19\
---------------------------------------------------------------------------
\19\ The Federal Reserve Board, Remarks by Chairman Alan Greenspan
before the Society of Business Economists, London, U.K. (Sept. 25,
2002) (online at www.federalreserve.gov/BoardDocs/Speeches/2002/
200209252/default.htm).
Subsequent developments--including the effective failure
(and rescue) of American International Group, Inc. (AIG), as a
result of massive exposure in the credit default swaps market--
raise serious questions about this hands-off view. The abuses
in the mortgage markets, and especially in the subprime
mortgage market, are a good example, but so are abuses
throughout the range of consumer credit products. The challenge
now is to develop a plan not only to bring much-needed sunlight
into the most opaque corners of the financial system but to
ensure appropriate regulatory adaptation to new financial
innovation in the future.
Failure to ensure fair dealings
The current regulatory system has not only allowed for
excessive risk and an insufficient degree of transparency, but
it has also failed to prevent the emergence of unfair dealings
between actors. Overt lies are dishonest, of course, and lying
may trigger legal liability. But fair dealing involves more
than refraining from outright lying. Deception and
misdirection, are the antithesis of fair dealing. When the
legal system permits deception and misdirection it undermines
consensual agreements between parties, the very foundation of a
market economy designed to serve all individuals.
Deceptive or misleading dealings can occur in any setting,
but they are most likely to occur when the players are
mismatched. When one player is sophisticated, has ample
resources, and works regularly in the field while the other is
a nonspecialist with limited resources and little experience,
the potential for deception is at its highest. A credit card
contract, for example, may be a relatively simple,
straightforward agreement from which both issuer and customer
may benefit. Or it may be a thirty-plus page document that is
virtually incomprehensible to the customer. In the latter case,
the issuer who can hire a team of lawyers to draft the most
favorable language may carefully measure every nuance of the
transaction, while the customer who has little time or
sufficient expertise to read--much less negotiate--such a
contract is far less likely to appreciate the risks associated
with the deal.
Similarly, in the subprime mortgage market prospective
borrowers were often led to believe that a scheduled interest-
rate reset would never affect them because they had been told
that they could ``always'' refinance the property at a lower
rate before the reset took effect. Similarly, studies show that
payday loan customers, while generally aware of finance
charges, are often unaware of annual percentage rates.\20\ In
one survey, of those who took on tax refund anticipation loans,
approximately half of all respondents were not aware of the
substantial fees charged by the lender.\21\ One authority on
consumer credit has catalogued a long list of ``tricks and
traps,'' particularly in the credit card market, designed to
``catch consumers who stumble or mistake those traps for
treasure and find themselves caught in a snare from which they
cannot escape.'' \22\ While each of these contracts may meet
the letter of the law, deals that are structured so that one
side repeatedly does not understand the terms do not meet the
definition of fair dealing.
---------------------------------------------------------------------------
\20\ See NFI, Gregory Elliehausen, Consumers' Use of High-Price
Credit Products: Do They Know What They Are Doing?, at 29 (2006)
(Working Paper No. 2006-WP-02); Credit Research Center, Georgetown
University, Gregory Elliehausen and Edward C. Lawrence, Payday Advance
Credit in America: An Analysis of Customer Demand, at 2 (2001) (online
at www.cfsa.net/downloads/analysis_customer_demand.pdf).
\21\ See Elliehausen, supra note 20, at 31.
\22\ Senate Committee on Banking, Housing and Urban Affairs of the
United States Senate, Testimony of Elizabeth Warren, Examining the
Billing, Marketing, and Disclosure Practices of the Credit Card
Industry, and Their Impact on Consumers, 110th Cong., at 1 (Jan. 25,
2007) (online at banking.senate.gov/public/_files/warren.pdf). The list
of tricks and traps includes ``universal default, default rates of
interest, late fees, over-limit fees, fees for payment by telephone,
repeated changes in the dates bills are due, changes in the locations
to which bills should be mailed, making it hard to find the total
amount due on the bill, moving bill-reception centers to lengthen the
time it takes a bill to arrive by mail, misleading customers about
grace periods, and double cycle billing.'' Id. at 3.
---------------------------------------------------------------------------
The available evidence suggests that the costs of deceptive
financial products are high, quickly climbing into the billions
of dollars annually.\23\ But the problem is not limited to
monetary loss--many people are stripped not only of their
wealth, but also of their confidence in the financial
marketplace. They come to regard all financial products with
suspicion, including those on fair terms and those that could
be beneficial to them.
---------------------------------------------------------------------------
\23\ Oren Bar-Gill and Elizabeth Warren, Making Credit Safer,
University of Pennsylvania Law Review (Nov. 2008) (summarizing studies
showing the high costs of consumer errors on checking accounts, credit
cards, payday loans and refund anticipation loans).
---------------------------------------------------------------------------
As the recent crisis has shown, the effects of deceptive
contracts can have wide ripple effects. For example, deceptive
mortgages have led to lender foreclosures on residential
housing--foreclosures that cost taxpayers money and threaten
the economic stability of already imperiled neighborhoods.\24\
A recent housing report observed: ``Foreclosures are costly--
not only to homeowners, but also to a wide variety of
stakeholders, including mortgage servicers, local governments
and neighboring homeowners . . . up to $80,000 for all
stakeholders combined.'' \25\ Lenders can lose as well,
forfeiting as much as $50,000 per foreclosure, which translates
to roughly $25 billion in total foreclosure-related losses in
2003.\26\ A city can lose up to $19,227 per house abandoned in
foreclosure in lost property taxes, unpaid utility bills,
property upkeep, sewage, and maintenance.\27\ Many foreclosure-
related costs fall on taxpayers, who ultimately must shoulder
the bill for services provided by their local governments.
---------------------------------------------------------------------------
\24\ See Joint Economic Committee, Sheltering Neighborhoods from
the Subprime Foreclosure Storm, at 15-16 (Apr. 2007) (online at
jec.senate.gov/index.cfm?FuseAction= Files.View&FileStore_id=8c3884e5-
2641-4228-af85-b61f8a677c28) (hereinafter ``JEC Report''). See also
Nelson D. Schwartz, Can the Mortgage Crisis Swallow a Town?, New York
Times (Sept. 2, 2007) (online at www.nytimes.com/2007/09/02/business/
yourmoney/02village.html); U.S. Department of the Treasury, Remarks by
Secretary Henry M. Paulson, Jr. on Current Housing and Mortgage Market
Developments at Georgetown University Law Center (Oct. 16, 2007)
(online at www.treasury.gov/press/releases/hp612.htm) (``Foreclosures
are costly and painful for homeowners. They are also costly for
mortgage servicers and investors. They can have spillover effects into
property values throughout a neighborhood, creating a downward cycle we
must work to avoid.'').
\25\ JEC Report, supra note 24, at 17. See also Dan Immergluck and
Geoff Smith, The External Costs of Foreclosure: The Impact of Single-
Family Mortgage Foreclosures on Property Values, Housing Policy Debate,
at 69-72 (2006) (finding that a single-family home foreclosure causes a
decrease in values of homes within an eighth of a mile--or one city
block--by an average of 0.9 percent, or approximately $1,870 when the
average home sale price is $164,599, and 1.44 percent in low- and
moderate-income communities, or about $1,600 when the average home sale
price is $111,002).
\26\ See, e.g., Desiree Hatcher, Foreclosure Alternatives: A Case
for Preserving Homeownership, Profitwise News and Views, at 2 (Feb.
2006) (online at www.chicagofed.org/community_development/files/
02_2006_foreclosure_alt.pdf).
\27\ See JEC Report, supra note 24, at 15.
---------------------------------------------------------------------------
The burdens of credit-market imperfections are not spread
evenly across economic, educational, or racial groups. The
wealthy tend to be insulated from many credit traps, while the
vulnerability of the working class and middle-class increases.
For those closer to the economic margins, a single economic
mistake--a credit card with an interest rate that unexpectedly
escalates to 29.99 percent or misplaced trust in a broker who
recommends a high-priced mortgage--can trigger a downward
economic spiral from which no recovery is possible. There is
ample evidence that African Americans and Hispanics have been
targets for certain deceptive products, much to their injury
and to the injury of a country that prizes equality of
opportunity for all its citizens.\28\
---------------------------------------------------------------------------
\28\ See, e.g., Consumer Federation of America, Allan J. Fishbein
and Patrick Woodall, Exotic or Toxic? An Examination of the Non-
Traditional Mortgage Market for Consumers and Lenders, at 24 (May 2006)
(online at www.consumerfed.org/pdfs/Exotic_Toxic_
Mortgage_Report0506.pdf); U.S. Department of Housing and Urban
Development and U.S. Department of the Treasury, Curbing Predatory Home
Mortgage Lending, at 35 (2000) (online at www.huduser.org/publications/
hsgfin/curbing.html); Center for Community Change, Bradford Calvin,
Risk or Race? Racial Disparities and the Subprime Refinance Market, at
6-8 (May 2002) (online at butera-andrews.com/legislative-updates/
directory/Background-Reports/
Center%20for%20Community%20Change%20Report.pdf); Paul Calem, Kevin
Gillen and Susan Wachter, The Neighborhood Distribution of Subprime
Mortgage Lending, Journal of Real Estate Finance and Economics, at 401-
404 (Dec. 2004). Another study, based on the Federal Reserve data,
found that ``African-American and Latino borrowers are at greater risk
of receiving higher-rate loans than white borrowers, even after
controlling for legitimate risk factors.'' Center for Responsible
Lending, Debbie Gruenstein Bocian, Keith S. Ernst and Wei Li, Unfair
Lending: The Effect of Race and Ethnicity on the Price of Subprime
Mortgages, at 3 (May 31, 2006) (online at www.responsiblelending.org/
pdfs/rr011exec-Unfair_Lending-0506.pdf). A third study by the Survey
Research Center at the University of Michigan found that black
homeowners are significantly more likely to have prepayment penalties
or balloon payments attached to their mortgages than nonblack
homeowners, even after controlling for age, income, gender, and
creditworthiness. Michael S. Barr, Jane K. Dokko, and Benjamin J. Keys,
Who Gets Lost in the Subprime Mortgage Fallout? Homeowners in Low- and
Moderate-Income Neighborhoods (Apr. 2008) (online at ssrn.com/
abstract=1121215). And a fourth study, by Susan Woodward, found that
black borrowers pay an additional $415 in mortgage fees and Latino
borrowers pay an additional $365 in mortgage fees. Urban Institute,
Susan Woodward, A Study of Closing Costs for FHA Mortgages, at ix
(2008).
---------------------------------------------------------------------------
When businesses sell deceptive products, they not only
injure their customers but also injure their competitors, who
are forced to adopt similar practices or face losing their
markets. The result is a downward spiral, a race to the bottom
in which those who offer the most slyly deceptive products
enjoy the greatest profits while entire industries and markets
are corrupted and cease to provide efficient and mutually
beneficial transactions. The same phenomenon operates on a more
macroeconomic level: some investment banks that may have had
initial doubts about packing subprime loans were drawn into a
downward spiral, abandoning their standards of investment
quality in a race for the same profits that other firms
appeared to be making.
Assuring fair dealing is not the same as assuring that no
one makes a mistake. Buyers and sellers of financial services
can miscalculate. They can fail to save, take unwise gambles,
or simply buy too much. Personal responsibility will always
play a critical role in dealing with financial products, just
as personal responsibility remains essential to the responsible
use of any physical product. Fair dealing assures only that
deception and misdirection will not bring a person to ruin,
while it leaves room to maximize the opportunities for people
to chart their own economic futures, free to succeed and free
to fail.
The government can play a unique role in assuring that
repeat dealings in circumstances of substantial imbalances of
power and knowledge are nonetheless fair dealings. Regulation
can assure a more level playing field, one in which the terms
of an agreement, for example, are clear and easily understood.
When terms are clear, individuals are more likely to compare
options, which in turn drives far greater market efficiency.
More importantly, when terms are clear, individuals are better
able to assess investment risks and are thus empowered to make
decisions that are more beneficial for themselves.
By limiting the opportunities for deception and allowing
for the necessary trust to develop between interconnected
parties, regulation can enhance the vitality of financial
markets. Historically, new regulation has often served this
role. For example, as the money manager Martin Whitman has
observed, far from stifling the markets, the new regulations of
the Investment Company Act of 1940 enabled the targeted
industry to flourish:
It ill behooves any successful money manager in the
mutual fund industry to condemn the very strict
regulation embodied in the Investment Company Act of
1940. Without strict regulation, I doubt that our
industry could have grown as it has grown, and also be
as prosperous as it is for money managers. Because of
the existence of strict regulation, the outside
investor knows that money managers can be trusted.
Without that trust, the industry likely would not have
grown the way it has grown.\29\
---------------------------------------------------------------------------
\29\ Letter from Third Avenue Funds Chairman of the Board Martin J.
Whitman to Shareholders, at 6 (Oct. 31, 2005) (online at
www.thirdavenuefunds.com/ta/documents/sl/shareholderletters-05Q4.pdf).
Markets built on fair dealing produce benefits for all
Americans on both sides of the transactions.
3. THE CENTRAL IMPORTANCE OF REGULATORY PHILOSOPHY
The magnitude of the current financial crisis makes clear
that America's system of financial regulation has failed. As a
result, there is now growing interest in reforming the
essential structure of financial regulation in the United
States. (See the appendix for a summary of other recent reports
on regulatory reform.) Critics highlight the inherent problems
of vesting regulatory authority in a large number of separate
agencies at both the state and federal levels, each responsible
for isolated elements of a vast financial architecture.
Although this complex regulatory system benefits from
competition across governmental bodies, it also suffers from
the problem of ``regulatory arbitrage'' (a situation in which
regulated firms play regulators off against one another) as
well as numerous gaps in coverage.
Structural and organizational problems are certainly
important, and are taken up in section III, below. But at root,
the regulatory failure that gave rise to the current crisis was
one of philosophy more than structure. In too many cases,
regulators had the tools but failed to use them. And where
tools were missing, regulators too often failed to ask for the
necessary authority to develop what was needed.
Markets are powerful and robust institutions, and a healthy
respect for free market activity has served this nation well
since its founding. At the same time, the best tradition in
American policy has always been pragmatic. History has
consistently shown that markets cannot be counted upon to
regulate themselves or to function efficiently in the absence
of regulation. While the price mechanism calibrates supply and
demand, it cannot prevent bank runs, abusive lending or Ponzi
schemes without regulation. The current financial meltdown
proves these points in an especially severe way.
Excesses and abuse are all too common in a system without
regulation. Government thus has a vital role to play. As
President Lincoln once wrote: ``The legitimate object of
government, is to do for a community of people, whatever they
need to have done, but can not do, at all, or can not, so well
do, for themselves--in their separate, and individual
capacities.'' \30\
---------------------------------------------------------------------------
\30\ Abraham Lincoln, Speeches and Writings, 1832-1858: Speeches,
Letters, and Miscellaneous Writings, at 301 (Don Edward Fehrenbacher
ed., 1989).
---------------------------------------------------------------------------
Lincoln's vision of government goes beyond correcting
abuses to improving the welfare of ``a community of people.''
Regulators must never lose sight of the fact that the well-
being of Americans is their goal, and that the welfare of the
people has never been best served by extreme political
ideologies. Franklin Roosevelt perhaps put it best: the
question, he said, is ``whether individual men and women will
have to serve some system of government or economics, or
whether a system of government and economics exists to serve
individual men and women.'' \31\ Not only is this pragmatic
approach democratic, asking regulation and the market to serve
the American people, but it also places the American people at
the foundation of the economy. If Americans are secure and
flourishing, the financial system will be secure and
flourishing as well. If Americans are in crisis or face
considerable risks, so too will the financial system. Success
is defined by the quality of life Americans have, not by the
impersonal metrics of any theory of government or economics.
---------------------------------------------------------------------------
\31\ Franklin Roosevelt, Remarks to the Commonwealth Club (Sept.
23, 1932) (online at www.americanrhetoric.com/speeches/
fdrcommonwealth.htm).
---------------------------------------------------------------------------
Well-conceived financial regulation has the potential not
only to safeguard markets against excesses and abuse but also
to strengthen markets as foundations of innovation and growth.
Creativity and innovation are too often channeled into
circumventing regulation and exploiting loopholes. Smart
financial regulations can redirect creative energy from these
unproductive endeavors to innovations that increase efficiency
and address the tangible risks people face.\32\ As discussed
above, the decades following the New Deal regulatory reforms
were the longest period without a serious finanial crisis in
the nation's history; they were also a period of unusually high
average real economic growth.
---------------------------------------------------------------------------
\32\ Congressional Oversight Panel, Testimony of Joseph E.
Stiglitz, Reforming America's Financial Regulatory Structure, at 3
(Jan. 14, 2009) (online at cop.senate.gov/documents/testimony-011409-
stiglitz.pdf).
---------------------------------------------------------------------------
In April 2008, former Federal Reserve Chairman Paul Volcker
commented on these developments in a speech to the Economic
Club of New York:
[T]oday's financial crisis is the culmination, as I
count them, of at least five serious breakdowns of
systemic significance in the past twenty-five years--on
the average one every five years. Warning enough that
something rather basic is amiss.
Over that time, we have moved from a commercial bank-
centered, highly regulated financial system, to an
enormously more complicated and highly engineered
system. Today, much of the financial intermediation
takes place in markets beyond effective official
oversight and supervision, all enveloped in unknown
trillions of derivative instruments. It has been a
highly profitable business, with finance accounting
recently for 35 to 40 percent of all corporate profits.
It is hard to argue that the new system has brought
exceptional benefits to the economy generally. Economic
growth and productivity in the last twenty-five years
has been comparable to that of the 1950s and '60s, but
in the earlier years the prosperity was more widely
shared.
The sheer complexity, opaqueness, and systemic risks
embedded in the new markets--complexities and risks
little understood even by most of those with management
responsibilities--has enormously complicated both
official and private responses to this current mother
of all crises. . . .
Simply stated, the bright new financial system--for
all its talented participants, for all its rich
rewards--has failed the test of the market place. . . .
In sum, it all adds up to a clarion call for an
effective response.\33\
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\33\ Paul A. Volcker, Address to the Economic Club of New York, at
1-2 (Apr. 8, 2008) (online at econclubny.org/files/
Transcript_Volcker_April_2008.pdf). In his address, Volcker recalled
the financial troubles of New York City in 1975--that having been the
last time he addressed the Economic Club of New York (then as President
of the Federal Reserve Bank of New York). Volcker noted in his 2008
address, ``Until the New York crisis, the country had been free from
any sense of financial crisis for more than forty years.'' Id. at 1.
As Volcker himself went on to observe, there is no going
back to the ``heavily regulated, bank dominated, nationally
insulated markets'' of the past.\34\ At the same time, given
the enormity of the current crisis and the evident failure of
financial markets to regulate themselves, it is imperative that
Congress take up the challenge of fashioning appropriate
regulation for the twenty-first century--to stabilize and
strengthen the nation's financial markets in the face of
extraordinary innovation and globalization. For this to work,
we must first remind ourselves that government has a vital role
to play, not in replacing financial markets or overwhelming
them with rules, but in bolstering financial markets through
judicious regulation. Rooted in the principles of sound risk
management, transparency, and fairness, new financial
regulation can succeed, and must succeed.
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\34\ Id. at 3.
IV. CRITICAL PROBLEMS AND RECOMMENDATIONS FOR IMPROVEMENT
The sweeping nature of the current financial crisis points
to the need for a thorough review of financial regulation and,
ultimately, for significant regulatory reform. As discussed in
part III, financial regulation is particularly necessary to
manage risk, facilitate transparency, and ensure fair dealings.
The current system has failed on all counts, and as a result,
numerous discrete problems have emerged. This report focuses on
the following most critical of these problems:
1. Systemic risk is often not identified or regulated
until crisis is imminent.
2. Many financial institutions carry dangerous
amounts of leverage.
3. The unregulated ``shadow financial system'' is a
source of significant systemic risk.
4. Ineffective regulation of mortgages and other
consumer credit products produces unfair, and often
abusive, treatment of consumers, but also creates risks
for lending institutions and the financial system.
5. Executive pay packages incentivize excessive risk.
6. The credit rating system is ineffective and
plagued with conflicts of interest.
7. The globalization of financial markets encourages
countries to compete to attract foreign capital by
offering increasingly permissive regulatory laws that
increase market risk.
8. Participants, observers, and regulators neither
predicted nor developed contingency plans to address
the current crisis.
This section addresses each problem in turn, and provides
recommendations for improvement.
1. IDENTIFY AND REGULATE FINANCIAL INSTITUTIONS THAT POSE SYSTEMIC RISK
Problem with current system: Systemic risk is often not
identified or regulated until crisis is imminent
Today, there is no regulator with the authority to
determine which financial institutions or products pose a
systemic risk to the broader economy. In 2008, Bear Stearns,
Fannie Mae, Freddie Mac, AIG, and Citigroup all appear to have
been deemed too big--or, more precisely, too deeply embedded in
the financial system--to fail. The decisions to rescue these
institutions were often made in an ad hoc fashion by regulators
with no clear mandate to act nor the proper range of financial
tools with which to act.
This is the wrong approach. Systemic risk needs to be
managed before moments of crisis, by regulators who have clear
authority and the proper tools. Once a crisis has arisen,
financial regulation has already failed. The underlying problem
can no longer be prevented, it can only be managed, often at
the cost of extraordinary expenditures of taxpayer dollars.
Action item: Mandate that a new or existing agency or an
interagency task force regulate systemic risk within the
financial system on an ongoing basis
A much better approach would be to identify the degree of
systemic risk posed by financial institutions, products, and
markets in advance--that is, in normal times--and to regulate
them accordingly. Providing proper oversight of such
institutions would help to prevent a crisis from striking in
the first place, and it would put public officials in a much
better position to deal with the consequences should a crisis
occur.\35\
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\35\ See Moss, supra note 3.
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To make this possible, Congress and the President should
designate a body charged with identifying the degree of
systemic risk posed by financial institutions, products, and
markets. This body could be an existing agency, such as the
Board of Governors of the Federal Reserve System, a new agency,
or a coordinating body of existing regulators.\36\
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\36\ Vesting that authority in an existing agency, such as the
Board of Governors of the Federal Reserve, would require attention to
the issues of transparency and accountability that the Panel will
consider further when it looks at regulator structure.
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The need for a body to identify and regulate institutions
with systemic significance is a necessary response to two clear
lessons of the current financial crisis: (1) systemic risk is
caused by institutions that are not currently covered or
adequately covered by the financial services regulatory system;
and (2) in a crisis the federal government may feel compelled
to stabilize systemically significant institutions. However, no
regulatory body currently has the power to identify and
regulate systemically significant nonbank institutions.
Consequently, Congress should authorize legitimate, coherent
governmental powers and processes for doing so.
The systemic regulator should have the authority to require
reporting of relevant information from all institutions that
may be systemically significant or engaged in systemically
significant activities. It should have a process for working
with the regulatory bodies charged with the day-to-day
oversight of the financial system. Finally, it should have
clear authority and the proper tools for addressing a systemic
crisis.
The regulator should operate according to the philosophy
that systemic risk is a product of the interaction of
institutions and products with market conditions. Thus, the
regulator would oversee structures described in the next two
action items that address a continuum of systemic risk by
increasing capital and insurance requirements as financial
institutions grow. This approach seeks to maximize the
incentives for private parties to manage risk while recognizing
and acting upon the fact that as financial institutions grow
they become more ``systemically significant.''
Finally, creating a systemic risk regulator is not a
substitute for ongoing regulation of our capital markets,
focused on safety and soundness, transparency, and
accountability. The agencies charged with those missions must
be strengthened while we at the same time address the problem
of systemic risk.
Action item: Impose heightened regulatory requirements for
systemically significant institutions to reduce the risk of
financial crisis
Precisely because of the potential threat they pose to the
broader financial system, systemically significant institutions
should face enhanced prudential regulation to limit excessive
risk taking and help ensure their safety. Such regulation might
include relatively stringent capital and liquidity
requirements, most likely on a countercyclical basis; an
overall maximum leverage ratio (on the whole institution and
potentially also on individual subsidiaries); well-defined
limits on contingent liabilities and off-balance-sheet
activity; and perhaps also caps on the proportion of short-term
debt on the institution's balance sheet. The systemic regulator
should consider the desirability of capping any taxpayer
guarantee and whether to require systemically significant firms
to purchase federal capital insurance under which the bank, in
return for a premium payment, would receive a certain amount of
capital in specified situations.\37\
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\37\ See Moss, supra note 3.
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Whether such enhanced oversight for systemically
significant institutions should be provided by a new systemic
regulator or by existing regulatory agencies is a question that
requires further study and deliberation.
Action item: Establish a receivership and liquidation process
for systemically significant nonbank institutions that is
similar to the system for banks
The current bankruptcy regime under the Bankruptcy Code
does not work well for systemically significant nonbanks
institutions. Recent experience with the failure of Bear
Stearns & Co. and Lehman Brothers Inc. has indicated that there
are gaps in the system for handling the receivership or
liquidation of systemically significant financial institutions
that are not banks or broker-dealers and are therefore subject
to the Bankruptcy Code. Two problems are evident: (1) Because
the federal bankruptcy system was not designed for a large,
systemically significant financial institution, financial
regulators may feel the need to prop up the ailing institution
in order to avoid a messy and potentially destructive
bankruptcy process, and (2) the Bankruptcy Code's provisions
for distribution of the assets of a bankrupt financial
institution do not take into account the systemic
considerations that regulators are obligated to consider.
The Panel recommends that systemically significant nonbank
financial institutions be made subject to a banklike
receivership and liquidation scheme. We note that the
bankruptcy regime under the Federal Deposit Insurance Act has
generally worked well.
2. LIMIT EXCESSIVE LEVERAGE IN AMERICAN FINANCIAL INSTITUTIONS
Problem with current system: Excessive leverage carries
substantial risks for financial institutions
Leverage within prudent limits is a valuable financial
tool. But excessive leverage in the financial sector is
dangerous and can pose a significant risk to the financial
system. In fact, it is now widely believed that overleveraging
(i.e., relying on an increasingly steep ratio of borrowing to
capital) at key financial institutions helped to convert the
initial subprime turmoil in 2007 into a full-blown financial
crisis in 2008.
Recent estimates suggest that just prior to the crisis,
investment banks and securities firms, hedge funds, depository
institutions, and the government-sponsored mortgage enterprises
(primarily Fannie Mae and Freddie Mac) held assets worth nearly
$23 trillion on a base of $1.9 trillion in capital, yielding an
overall average leverage ratio of approximately 12:1. We must,
however, consider this figure carefully, because average
leverage varied widely for different types of financial
institutions. The most heavily leveraged, as a class, were
broker-dealers and hedge funds, with an average leverage ratio
of 27:1; government sponsored enterprises were next, with an
average ratio of 23.5:1.35. Commercial banks were toward the
low end, with an average ratio of 9.8:1, and savings banks have
the lowest average ratio at 8.7:1.
Financial institutions pursue leverage for numerous
reasons. All bank lending, for example, is leveraged, because a
certain amount of capital is permitted to support a much larger
volume of loans. And the leverage of financial institutions is
generally procyclical, meaning that it tends to increase when
asset prices are rising (when leverage seems safer) and tends
to decline when they are falling (when leverage seems more
dangerous).\38\
---------------------------------------------------------------------------
\38\ Tobias Adrian and Hyun Song Shin, Liquidity, Monetary Policy,
and Financial Cycles, Current Issues in Economics and Finance, at 1-7
(Jan./Feb. 2008). Some have argued that high leverage--especially
short-term debt--may have a positive governance impact by imposing
tough discipline on the management of financial institutions. K.
Kashyap, Raghuram G. Rajan, and Jeremy Stein, Rethinking Capital
Regulation (Aug. 2008) (online at www.kc.frb.org/publicat/sympos/2008/
KashyapRajanStein.08.08.08.pdf) (paper prepared for Federal Reserve
Bank of Kansas City symposium on ``Maintaining Stability in a Changing
Financial System'' in Jackson Hole, Wyoming). Given the experiences of
the last year, however, this theory requires a good deal more research.
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For an institution with high debt and a relatively small
base of capital, returns on equity are greatly magnified.
Unfortunately, high leverage can also prove destabilizing
because it effectively magnifies losses as well as gains. If a
firm with $10 billion in assets is leveraged 10:1, then a loss
of just 3 percent ($300 million) on total assets translates
into a 30 percent decline in capital (from $1 billion to $700
million), raising the bank's leverage ratio to nearly 14:1. The
challenge is obviously far more extreme for a firm with
leverage of 30:1, as was typical for leading investment banks
prior to the crisis. Here, a 3 percent ($300 million) loss on
total assets translates into a 90-percent decline in capital
(from $333 million to $33 million) and a new leverage ratio of
nearly 300:1. To get back to leverage of 30:1, that firm would
either have to raise $300 million in new equity (to bring
capital back to its original level) or collapse its balance
sheet, selling more than 95 percent ($9.37 billion) of its
assets and paying off an equivalent amount of debt.\39\
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\39\ This illustration was inspired by: Brandeis University
Rosenberg Institute of Global Finance and University of Chicago
Initiative on Global Markets, David Greenlaw, et al., Leveraged Losses:
Lessons from the Mortgage Market Meltdown (2008) (U.S. Monetary Forum
Report No. 2) (online at research.chicagogsb.edu/igm/docs/
USMPF_FINAL_Print.pdf); David Scharfstein, Why Is the Crisis a Crisis
(Dec. 2, 2008) (slide presentation prepared for Colloquium on the
Global Economic Crisis, Harvard Business School).
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Although raising $300 million in new equity would seem
vastly preferable to selling $9.37 billion in assets, the
problem is that financial institutions with depleted capital
often find it difficult to raise new equity, particularly in
times of general financial distress. If sufficient new capital
is not available and the weakened firms are ultimately forced
to dispose of assets under firesale conditions, this can
depress asset prices further, generating additional losses
across the financial system (particularly in the context of
mark-to-market accounting). In the extreme, these sales can set
off a vicious downward spiral of forced selling, falling
prices, rising losses and, in turn, more forced selling.
Action item: Adopt one or more regulatory options to strengthen
risk-based capital and curtail leverage
The goal of enhanced capital requirements is to limit
excessive risk taking during boom times and reducing the need
for dangerous ``fire sales'' during downturns. Several common
criteria must be met by proposals for enhanced capital
requirements. Above all, any such proposals must operate in a
way that does not restrict prudent leverage or produce other
unintended consequences. Moreover, they must recognize that
proper risk adjustment can prove particularly vexing: the
appropriateness of a leverage ratio depends on the safety of
the assets the leverage supports, both directly and in the
context of the business as a whole. Determining that safety
level is anything but easy, as the current crisis shows.
Finally, any proposal must recognize that no one solution will
fit the entire financial sector (or perhaps even all
institutions of one type within the financial sector).
A number of valuable ideas have been proposed as ways to
strengthen capital and curtail excessive leverage, including
the following:
Objectives-based capital requirements. Under this approach,
capital requirements should be applied not simply according to
the type of institution (commercial bank, broker-dealer, hedge
fund, etc.) but on the basis of regulatory objectives (for
example, guard against systemic risk, etc.). For example,
required capital ratios could be made to increase progressively
with the size of the firm's balance sheet, so that larger
financial institutions face a lower limit on leverage than
smaller ones (on the assumption that larger firms have greater
systemic implications and ultimately become ``too big to
fail''). Required capital ratios could also be made to vary
with other variables that regulators determine to be salient,
such as the proportion of short-term debt on an institution's
balance sheet or the identity of the holders of its
liabilities.
Leverage requirements. Beyond risk-based capital
requirements, there is also a strong argument for unweighted
capital requirements, to control overall leverage. Stephen
Morris and Hyun Song Shin suggest that these ``leverage
requirements'' are necessary to limit systemic risk, by
reducing the need for dangerous asset fire sales in a
downturn.\40\ FDIC Chairperson Sheila Bair has been
particularly insistent on this point, declaring in 2006, for
example, that ``the leverage ratio--a simple tangible capital
to assets measure--is a critically important component of our
regulatory capital regime.'' \41\ It should be noted that the
current crisis may be exacerbated because leverage ratios are
not a common feature of banking regulation in Europe; any
approach to curtailing leverage in a globalized financial
system must implement such standards on a global basis.
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\40\ Brookings Institute, Stephen Morris and Hyun Song Shin,
Financial Regulation in a System Context, at 21-26 (2008) (online at
www.brookings.edu/economics/bpea//media/Files/Programs/ES/BPEA/
2008_fall_bpea_papers/2008_fall_bpea_morris_shin.pdf). See also id. at
23 (``Instead of risks on the asset side of the balance sheet, the
focus is on the liabilities side of balance sheets, and the potential
spillover effects that result when financial institutions withdraw
funding from each other. Thus, it is raw assets, rather than risk-
weighted assets that matter.'').
\41\ Federal Deposit Insurance Corporation, Remarks by Sheila C.
Bair, Chairman before the Conference on International Financial
Instability: Cross-Border Banking and National Regulation, Federal
Reserve Bank of Chicago and the International Association of Deposit
Insurers (Oct. 5, 2006) (online at www.fdic.gov/news/news/speeches/
archives/2006/chairman/spoct0606.html).
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Countercyclical capital requirements. To help financial
institutions prepare for the proverbial rainy day and manage
effectively in a downturn, it has been proposed that capital
(and provisioning) requirements be made countercyclical--that
is, more stringent when asset prices are rising and less
stringent when they are falling. Since the procyclicality of
financial institution leverage likely intensifies the ups and
downs in asset markets, countercyclical capital requirements
could serve as a valuable automatic stabilizer, effectively
leaning against the wind. One approach could involve a
framework that raises capital adequacy requirements by a ratio
linked to the growth of the value of bank's assets in order to
tighten lending and build up reserves when times are good.
Spain's apparently favorable experience with ``dynamic
provisioning'' in its banking regulation serves as a model for
many related proposals.\42\ Joseph Stiglitz takes the idea one
step further, suggesting that a ``simple regulation would have
prevented a large fraction of the crises around the world--
speed limits restricting the rate at which banks can expand,
say, their portfolio of loans. Very rapid rates of expansion
are typically a sign of inadequate screening.'' \43\ Similarly,
because rapid increases in leverage appear to precede periods
of financial turmoil, capital requirements could be tailored to
discourage particularly quick buildups of leverage.
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\42\ See, e.g., Spanish Steps: A Simple Way of Curbing Banks'
Greed, Economist (May 15, 2008) (online at www.economist.com/
specialreports/displaystory.cfm?story_id=11325484).
\43\ House Financial Services Committee, Testimony of Joseph
Stiglitz, The Future of Financial Services Regulation, 110th Cong.
(Oct, 21, 2008) (online at financialservices.house.gov/hearing110/
stiglitz102108.pdf). Stiglitz also notes that there are ``several
alternatives to speed limits imposed on the rate of expansion of
assets: increased capital requirements, increased provisioning
requirements, and/or increased premia on deposit insurance for banks
that increase their lending (lending in any particular category) at an
excessive rate can provide incentives to discourage such risky
behavior.'' Id.
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Liquidity requirements. To further address the problem of
financial firms being forced to sell illiquid assets into a
falling market, some commentators have proposed that regulators
could impose liquidity requirements in addition to capital
requirements, so that financial firms would have to hold a
certain proportion of liquid assets as well as a liquidity
buffer that could be used in a crisis. Armed with sufficient
supply of liquid assets (such as treasury bills), firms could
safely sell these assets in a downturn without placing downward
pressure on the prices of less liquid assets, which would
contribute to systemic risk.\44\
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\44\ Liquidity requirements can mitigate contagion, and can play a
similar role to capital buffers in curtailing systemic failure. In some
cases, liquidity may be more effective than capital buffers in
forestalling systemic effects. When asset prices are extremely
volatile, for example during periods of major financial distress, even
a large capital buffer may be insufficient to prevent contagion, since
the price impact of selling into a falling market would be very high.
Liquidity requirements can mitigate the spillover to other market
participants generated by the price impact of selling into a falling
market. Moreover, because financial institutions do not recognise the
indirect benefits of adequate liquidity holdings on other network
members (and more generally on system resilience), their liquidity
choices will be suboptimal. As a result, liquidity and capital
requirements need to be imposed externally, in relation to a bank's
contribution to systemic risk.
Bank of England, Rodrigo Cifuentes, Gianluigi Ferrucci, and Hyun
Song Shin, Liquidity Risk and Contagion (2005) (Working Paper No. 264)
(online at www.bankofengland.co.uk/publications/workingpapers/
wp264.pdf).
U.S. bank regulators monitor a bank's liquidity as part of their
Uniform Financial Institutions Ratings (CAMELS) System. See, e.g.,
Board of Governors of the Federal Reserve System, Commercial Bank
Examination Manual, Sec. 2020.1.
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These and other proposals will need to be thoughtfully
reviewed, bearing in mind that leverage is not a consistent
phenomenon, but rather varies across financial institutions,
regulatory structures, and different types of leveraged
situations. The current crisis provides two lessons to inform
this review. First, options to curtail excessive leverage must
proceed as a top priority and an integral part of the
restructuring of the regulation of American financial
institutions. Second, reforms in this area must reflect the
primary lesson of the crisis: that no asset types, however
labeled, and no transaction patterns, however familiar, are
inherently stable.
3. MODERNIZE SUPERVISION OF SHADOW FINANCIAL SYSTEM
Problem with current system: The unregulated ``shadow financial
system'' is a source of significant systemic risk
Since 1990, certain large markets and market intermediary
institutions have developed outside the jurisdiction of
financial market regulators. Collectively, these markets and
market actors have become known as the shadow financial
system.\45\ The key components of the shadow financial system
are unregulated financial instruments such as over-the-counter
(OTC) derivatives, off-balance-sheet entities such as conduits
and SIVs,\46\ and nonbank institutions such as hedge funds and
private equity funds. While the shadow financial system must be
brought within any plan for systemic risk management, that
alone would be insufficient. Routine disclosure-based capital-
market regulation and routine safety-and-soundness regulation
of financial institutions will not function effectively unless
regulators have jurisdiction over the shadow financial system
and are able to enforce common standards of transparency,
accountability, and adequate capital reserves.
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\45\ See, e.g., Bill Gross, Beware Our Shadow Banking System,
Fortune (Nov. 28, 2007) (online at money.cnn.com/2007/11/27/news/
newsmakers/gross_banking.fortune); Nouriel Roubini, The Shadow Banking
System is Unraveling, Financial Times (Sept. 21, 2008) (online at
www.ft.com/cms/s/0/622acc9e-87fl-11dd-b114-0000779fd18c.html).
\46\ Off-balance sheet entities are a significant part of the
shadow financial system, and are addressed in part in our earlier
recommendations on leverage, and in part should be the subject of a
more extended technical inquiry into reforming Financial Accounting
Standard 140.
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As a result of the growth of the shadow financial system,
it is nearly impossible for regulators or the public to
understand the real dynamics of either bank credit markets or
public capital markets. This became painfully clear during the
collapse of Bear Stearns and the subsequent bankruptcy of
Lehman Brothers, and the collapse of AIG. In the case of Bear
Stearns, key regulators expressed the view that as a result of
that firm's extensive dealing with hedge funds and in the
derivatives markets, the systemic threat posed by a disorderly
bankruptcy could prove quite severe, though difficult to
predict with any certainty.\47\ Six months later, Lehman
Brothers was allowed to file for protection under Chapter 11,
the only major financial firm to be allowed to do so in the
United States during the financial crisis. Lehman's bankruptcy
resulted in substantial systemwide disruption, particularly as
a result of credit default swap obligations triggered by
Lehman's default on its debt obligations. The unregulated
nature of several financial markets involved in this crisis
contributed to the inability of regulators to understand the
unfolding problems and act responsively.
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\47\ In a speech on August 22, 2008, Federal Reserve Chairman Ben
Bernanke spoke frankly about the potential for a Bear Stearns failure
to echo throughout the financial system: ``Although not an
extraordinarily large company by many metrics, Bear Stearns was deeply
involved in a number of critical markets, including (as I have noted)
markets for short-term secured funding as well as those for over-the-
counter (OTC) derivatives. One of our concerns was that the
infrastructures of those markets and the risk- and liquidity-management
practices of market participants would not be adequate to deal in an
orderly way with the collapse of a major counterparty. With financial
conditions already quite fragile, the sudden, unanticipated failure of
Bear Stearns would have led to a sharp unwinding of positions in those
markets that could have severely shaken the confidence of market
participants. The company's failure could also have cast doubt on the
financial conditions of some of Bear Stearns's many counterparties or
of companies with similar businesses and funding practices, impairing
the ability of those firms to meet their funding needs or to carry out
normal transactions. As more firms lost access to funding, the vicious
circle of forced selling, increased volatility, and higher haircuts and
margin calls that was already well advanced at the time would likely
have intensified. The broader economy could hardly have remained immune
from such severe financial disruptions.''
Board of Governors of the Federal Reserve System, Chairman Ben S.
Bernanke Remarks on Reducing Systemic Risk before the Federal Reserve
Bank of Kansas City's Annual Economic Symposium (Aug. 22, 2008) (online
at www.federalreserve.gov/newsevents/speech/bernanke20080822a.htm).
Action item: Ensure consistency of regulation for instruments
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currently operating in the shadow financial system
Extending the reach of financial regulation to cover the
shadow financial system is necessary in order to accurately
measure and manage risk across the markets. A consistent
regulatory regime will also reduce the ability of market
players to escape regulation by using complex financial
instruments and to secure higher yields by masking risk through
information asymmetries.
The Panel urges Congress to consider shifting the focus of
existing regulation toward a functional approach. While the
details would need to be worked out by empowered regulators,
the principle is simple: hedge funds and private equity funds
are money managers and should be regulated according to the
same principles that govern the regulation of money managers
generally. At a minimum, Congress must grant the SEC the clear
authority to require hedge fund advisors to register as
investment advisors under the Investment Advisors Act. If they
venture into writing insurance contracts or providing credit to
others, hedge funds' activities in these areas need to be
regulated according to the principles governing insurance or
lending. An over-the-counter derivative can be almost any kind
of contract synthesizing almost any kind of economic act--such
instruments need to be regulated according to what they do, not
what they are called.
While further study is needed, proposals for regulating
more consistently instruments currently in the shadow financial
system include: applying capital requirements to firms engaged
in making credit or insurance commitments through derivatives;
requiring transparency around derivatives contracts tied to
publicly traded securities; and holding hedge funds and private
equity funds to a single, well-understood federal standard of
fiduciary duty as other money managers are. However, regulating
the shadow markets does not necessarily mean treating a hedge
fund in the same manner as a mutual fund, or a credit default
swap between institutions in the same manner as an insurance
policy sold to retail consumers. Functional regulation can mean
applying the same principles and not necessarily producing
identical regulatory outcomes.
Action item: Increase transparency in OTC derivatives markets
The Panel also recommends implementing new measures to
improve transparency in the shadow financial system. Lack of
transparency in the shadow financial system contributed to
failures of risk management and difficulty in pricing assets
and assessing the health of financial institutions.
Transparency can be enhanced in several ways; several options
are presented below:
Regulated clearinghouses. A clearinghouse is an entity that
provides clearance and settlement services with respect to
financial products. It acts as a central counterparty with
respect to trades that it clears. When the original parties to
the trade introduce it to the clearinghouse for clearing, the
original trade is replaced by two new trades in which the
clearinghouse becomes the buyer to the original seller and the
seller to the original buyer.
Proposals for clearinghouses generally involve the
clearinghouse itself taking on credit risk. Such credit risk
raises the issue of how to provide adequate capital in case of
a default. One method for doing so involves taking the
``margin'' to secure performance of each trade. Another method
involves daily marks-to-market to reduce risk arising from
price fluctuations in the value of the contract. Others have
proposed guaranty funds, in which each of the clearing members
of the clearinghouse puts up a deposit to cover its future
liabilities. Most central counterparty proposals also involve
``mutualization of risk,'' in which the guaranty fund deposits
of all clearing members may be used to cover a default by one
member if the defaulting member's margin payments and guaranty
fund contribution are insufficient to cover the loss. Finally,
a clearinghouse may have the right to call for further
contributions from members to cover any losses.
In addition to regulators risk management principles, a
clearinghouse structure may also involve inspection by federal
officials for the purposes of detecting and punishing
fraudulent activity and public reporting of prices, volumes and
open interest.\48\
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\48\ See President's Working Group on Financial Markets, Policy
Objectives for the OTC Derivatives Market (Nov. 14, 2008) (online at
www.treas.gov/press/releases/reports/policyobjectives.pdf).
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Exchange-traded derivatives. As an alternative to
clearinghouses, regulators can require that all standardized--
and standardizable--OTC derivatives contracts be traded on
regulated derivatives markets. These markets would be governed
by the same standards that guide designated contract markets
under the Commodity Exchange Act (CEA). CEA-governed exchanges
must fully disclose the terms of the contracts traded and rules
governing trading, and must also publicly report prices,
volumes and open interest. The exchange would maintain detailed
records to be inspected by federal regulators and would be
empowered with the ability to deter, detect, and punish
fraudulent activity. Intermediaries participating in the
exchange would face registration, reporting, and capital
adequacy requirements as well. Finally, the exchanges could
still make use of clearinghouses to minimize counterparty risk.
Public reporting requirements. SEC Chairman Christopher Cox
has proposed requiring CDS market participants to adhere to a
public disclosure regime that would allow regulators to monitor
market risk and potential market abuse. Cox's proposals
include: (1) public reports of OTC transactions to improve
transparency and pricing, and (2) reporting to the SEC
derivatives positions that affect public securities.\49\
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\49\ Christopher Cox, Swapping Secrecy for Transparency, New York
Times (Oct. 18, 2008) (online at www.nytimes.com/2008/10/19/opinion/
19cox.html).
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4. CREATE A NEW SYSTEM FOR FEDERAL AND STATE REGULATION OF MORTGAGES
AND OTHER CONSUMER CREDIT PRODUCTS
Problem with current system: Ineffective regulation of
mortgages and other consumer credit products has produced
unfair, and often abusive, treatment of consumers, which
destabilizes both families and the financial institutions that
trade in those products
For decades, default rates on traditional home mortgages
were low; profits to mortgage lenders were steady. Millions of
Americans used mortgages to enable them to buy homes and retain
homes. Over time, however, a number of mortgage lenders and
brokers began offering higher-priced, higher-profit--and higher
risk--mortgages to millions of families.\50\ Unlike the low-
risk ``prime'' mortgages of the 1940s through the 1990s, the
new ``subprime'' offered much bigger payouts for lenders and,
ultimately, for the investors to whom the lenders sold these
mortgages, but they also created higher costs and greater risks
for consumers. For example, a family buying a $175,000 home
with a subprime loan with an effective interest rate of 15.6
percent would pay an extra $420,000 during the 30-year life of
the mortgage--that is, over and above the payments due on a
prime 6.5 percent mortgage. While investors were attracted to
the bigger returns associated with these subprime mortgages,
many overlooked the much bigger risks of default that have now
become glaringly apparent.
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\50\ See Federal Reserve Board, Christopher J. Mayer, Karen M.
Pence, and Shane M. Sherlund, The Rise in Mortgage Defaults, at 2
(2008) (Finance and Economics Discussion Series No. 2008-59) (online at
www.federalreserve.gov/Pubs/feds/2008/200859/200859pap.pdf)
(``According to data from the Mortgage Bankers Association, the share
of mortgage loans that were `seriously delinquent' (90 days or more
past due or in the process of foreclosure) averaged 1.7 percent from
1979 to 2006 . . . But by the second quarter of 2008, the share of
seriously delinquent mortgages had surged to 4.5 percent.''). For
detailed historical data on prime and subprime mortgages, see Mortgage
Bankers Association, National Delinquency Survey (online at
www.mbaa.org/ResearchandForecasts/productsandsurveys/
nationaldelinquencysurvey.htm).
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The new subprime mortgages were marked by exotic, and often
predatory, new features, such as two year teaser rates that
permitted marketing of mortgages to individuals who could not
have qualified for credit at the enormous required rate
increase in year three, or so-called ``liars'' or ``no-doc''
loans based on false paperwork about a borrower's financial
situation. Terms such as these virtually guaranteed that the
mortgages would default, and families would lose their homes,
unless the real estate price inflation continued. These
mortgages were especially cruel for new, especially lower-
income, home buyers. The data show, however, that a substantial
number of middle-income families (and even some upper-income
families) with low default risk signed up for subprime loans
that were far more expensive than the prime mortgages for which
they qualified.
The complexity of subprime mortgage products made
understanding the costs associated with an offered mortgage,
let alone comparing several mortgage products, almost
impossible. The high proportion of people with good credit
scores who ended up with high-cost mortgages raises the specter
that some portion of these consumers were not fully cognizant
of the fact that they could have borrowed for much less.\51\
This conclusion is further corroborated by studies showing that
subprime mortgage prices cannot be fully explained by borrower-
specific and loan-specific risk factors.\52\ These difficulties
were further exacerbated by sharp selling practices and delayed
disclosure of relevant documents. Buyers were steered to
overpriced mortgages by brokers or other agents who represented
themselves as acting in the borrower's best interests, but who
were taking commissions from subprime lenders to steer them to
riskier mortgages.\53\ In other cases, lenders would not make
relevant documents available until the closing date. In all of
these respects, the mortgage market simply failed consumers.
---------------------------------------------------------------------------
\51\ In 2002, for example, researchers at Citibank concluded that
at least 40 percent of those who were sold high interest rate, subprime
mortgages would have qualified for prime-rate loans. Lew Sichelman,
Community Group Claims CitiFinancial Still Predatory, Origination News,
at 25 (Jan. 2002) (reporting on new claims of CitiFinancial's predatory
practices after settlements with state and federal regulators). Freddie
Mac and Fannie Mae estimate that between 35 percent and 50 percent of
borrowers in the subprime market could qualify for prime market loans.
See James H. Carr & Lopa Kolluri, Predatory Lending: An Overview, in
Fannie Mae Foundation, Financial Services in Distressed Communities:
Issues and Answers, at 31, 37 (2001). See also Lauren E. Willis,
Decisionmaking and the Limits of Disclosure: The Problem of Predatory
Lending: Price, Maryland Law Review, at 730 (2006). A study by the
Department of Housing and Urban Development of all mortgage lenders
revealed that 23.6 percent of middle-income families (and 16.4 percent
of upper-income families) who refinanced a home mortgage ended up with
a high-fee, high-interest subprime mortgage. U.S. Department of Housing
and Urban Development, Randall M. Scheessele, Black and White
Disparities in Subprime Mortgage Refinance Lending, at 28 (2002)
(Working Paper No. HF-014) (online at www.huduser.org/Publications/pdf/
workpapr14.pdf). A study conducted for the Wall Street Journal showed
that from 2000 to 2006, 55 percent of subprime mortgages went to
borrowers with credit scores that would have qualified them for lower-
cost prime mortgages. Rick Brooks and Ruth Simon, Subprime Debacle
Traps Even the Very Credit Worthy; As Housing Boomed, Industry Push
Loans to a Broader Market, Wall Street Journal (Dec. 3, 2007) (study by
First American Loan Performance for the Journal). By 2006, that
proportion had increased to 61 percent. Id. None of these studies is
definitive on the question of overpricing because they focus
exclusively on FICO scores, which are critical to loan pricing but are
not the only factor to be considered in credit risk assessment.
However, they suggest significant market problems.
\52\ Joint Center for Housing Studies, Harvard University, Ren S.
Essene and William Apgar, Understanding Mortgage Market Behavior:
Creating Good Mortgage Options for All Americans, at 2 (2007) (online
at www.jchs.harvard.edu/publications/finance/mm07-1_mortgage_market
_behavior.pdf) (quoting Fishbein and Woodall, supra note 28, at 24);
Howard Lax, et al., Subprime Lending: An Investigation of Economic
Efficiency, Housing Policy Debate, at 533 (2004).
\53\ See, e.g., Howell E. Jackson and Jeremy Berry, Kickbacks or
Compensation: The Case of Yield Spread Premiums (Jan. 2002) (online at
www.law.harvard.edu/faculty/hjackson/pdfs/january_draft.pdf). In some
neighborhoods these brokers went door-to-door, acting as ``bird dogs''
for lenders, looking for unsuspecting homeowners who might be tempted
by the promise of extra cash. Other families were broadsided by extra
fees and hidden costs that didn't show up until it was too late to go
to another lender. One industry expert described the phenomenon: ``Mrs.
Jones negotiates an 8% loan and the paperwork comes in at 10%. And the
loan officer or the broker says, `Don't worry, I'll take care of that,
just sign here.' '' Dennis Hevesi, A Wider Loan Pool Draws More Sharks,
New York Times (Mar. 24, 2002).
---------------------------------------------------------------------------
Although mortgage documents include a raft of legally-
required disclosures, those disclosures are a long way from a
meaningful understanding of the loan transaction--and a much
longer distance from supporting competitive markets. Many of
the same points can be made for credit cards and other consumer
financial products. In all of these cases consumers have little
access to the key information they need to make responsible
decisions. The result is a market in which people fail to
assess risks properly, over-pay, and get into financial
trouble. As the current crisis shows, these effects are not
confined to those who buy the credit products. The high risk
that consumers could not pay back their loans was multiplied by
the bundling and re-bundling of millions of the loans into
asset-backed securities. That rebundling, in turn, spread the
risk further, to the investment portfolios of other financial
institutions, pension funds, state and local governments, and
other investors for whom such risk was not appropriate.
Ultimately, the widespread marketing of high-cost, high-risk
consumer products has contributed to the destabilizing of the
entire economy.
If, for example, a home buyer had been required to
demonstrate an ability to pay the long-term mortgage rate
rather than the teaser rate, home owners--and the country--
would have been spared the specter of millions of foreclosures
when payment resets made the monthly payment unaffordable.
Moreover it would have been impossible to offer flawed
investment products based on such mortgages.
State regulators have a long history as the first-line of
protection for consumers. For example, states first sounded the
alarm against predatory lending and brought landmark
enforcement actions against some of the biggest subprime
lenders, including Household, Beneficial Finance, AmeriQuest,
and Delta Funding. But states are sometimes pressured to offer
no more consumer protection than is offered on the federal
level so that financial firms do not leave their state
regulator for a more favorable regulatory environment (taking
the fee revenues they provide with them).\54\ Moreover, the
same competition for business that exists at the state level
also exists at the federal level. Federal regulators face the
possibility of losing business both to state regulators or to
other federal regulatory agencies. At the federal level, this
problem is exacerbated by direct financial considerations. The
budgets of the OCC and OTS, for example, are derived from the
number and size of the financial institutions they regulate,
which means that a bank's threat to leave a regulator has
meaningful consequences.\55\ As Professor Arthur Wilmarth has
testified, ``Virtually the entire [Office of the Comptroller of
the Currency] budget is funded by national bank fees, and the
biggest national banks pay the highest assessment rates. . . .
The OCC's unimpressive enforcement record is, unfortunately,
consistent with its strong budgetary incentive in maintaining
the loyalty of leading national banks.'' \56\
---------------------------------------------------------------------------
\54\ In any of these situations, of course, the state from which
the financial institution switches its charter is deprived of
substantial revenue, and the new chartering jurisdiction gains
substantial revenue.
\55\ Michael Schroeder, Bank Regulator Cleans House, Wall Street
Journal (Aug. 19, 2005) (``Bank consolidation has created competition
among regulators. The OCC has been a winner in wooing banks to choose
it as their regulator, helping to keep its coffers flush. Bank fees
finance its $519 million annual budget, not taxpayer money.'').
\56\ See, e.g., Senate Committee on Banking, Housing, and Urban
Affairs, Testimony of Arthur E. Wilmarth, Jr., Review of the National
Bank Preemption Rules, 108th Cong. (Apr. 7, 2004) (online at
banking.senate.gov/public/_files/wilmarth.pdf); Christopher L.
Peterson, Federalism and Predatory Lending: Unmasking the Deregulatory
Agenda, Temple Law Review, at 70-74, 77-84 (2005).
---------------------------------------------------------------------------
This has caused much of the regulatory scheme to come
unraveled. State usury laws have eroded; according to recent
research, at least 35 states have amended their usury laws to
make it legal to charge annual interest rates exceeding 300
percent in connection with consumer credit products.\57\ Many
states were apparently also unwilling to deal with subprime
mortgages. In 2006, fully half-52 percent--of subprime
mortgages originated with companies that were subject only to
state regulation.\58\ And now, as the mortgage crisis deepens,
the National Association of Attorneys General has a highly
visible working group on foreclosures, but only about half of
the states participate.
---------------------------------------------------------------------------
\57\ Christopher L. Peterson, Usury Laws, Payday Loans and
Statutory Sleight of Hand: Salience Distortion in American Credit
Pricing Limits, Minnesota Law Review, at 1139 (2008).
\58\ Greg Ip and Damian Palleta, Regulators Scrutinized in Mortgage
Meltdown, Wall Street Journal (Mar. 27, 2007).
---------------------------------------------------------------------------
In addition, the authority of the states to deal with
consumer protection for credit products has been sharply
limited by interpretations in federal law. First, the Supreme
Court has ruled that the usury laws of a national bank's state
of incorporation controlled its activities nationwide. The
decision naturally produced the pressures for repeal of state
usury protections noted above. Second, the Office of the
Comptroller of the Currency and federal courts have interpreted
the National Banking Act to pre-empt action by state regulators
to apply state consumer protection laws to national banks or to
operating subsidiaries of national banks; virtually all of the
nation's large banks--and most of those receiving federal
assistance under the TARP--are national banks. The OCC's action
was prompted by the attempt of Georgia to apply its Fair
Lending Act to all banks within its jurisdiction. Yet, despite
promises to Congress and the states, federal regulators have
made the problem worse by failing to provide any significant
supervision or regulation of their own.\59\
---------------------------------------------------------------------------
\59\ See, e.g., Watters v. Wachovia Bank, 550 U.S. 1 (2007). See
also Elizabeth R. Schiltz, The Amazing, Elastic, Ever-Expanding
Exportation Doctrine and Its Effect on Predatory Lending Regulation,
Minnesota Law Review (2004); Cathy Lesser Mansfield, The Road to
Subprime ``HEL'' Was Paved with Good Congressional Intentions: Usury
Deregulation and the Subprime Home Equity Market, South Carolina Law
Review (2000).
Action item: Eliminate federal pre-emption of application of
---------------------------------------------------------------------------
state consumer protection laws to national banks
Preemption affects states' consumer protection initiatives
in three main respects:
1. Standards: The ability of states to set consumer
protection laws and the scope of coverage for those laws.
2. Visitation: The ability of states to examine financial
institutions for compliance with consumer protection laws.
3. Enforcement: The ability of states to impose penalties
for violations of consumer protection laws.
Visitation and enforcement are closely connected but
distinct.
Given the critical role of state consumer protection,
Congress should amend the National Banking Act to provide
clearly that state consumer protection laws can apply to
national banks and to reverse the holding that the usury laws
of a national bank's state of incorporation govern that bank's
operation through the nation.
Action item: Create a single federal regulator for consumer
credit products
The need for a uniform federal law to create a meaningful
baseline of protections is clear. It is essential that one
regulatory agency have the responsibility and accountability
for drafting, implementing, and overseeing effective consumer
credit product protection rules. Without a uniform set of
minimum standards, regulatory arbitrage among state--and
federal--regulators will continue, and no regulator or agency
will have the authority and responsibility to protect
consumers.
The new federal regulator must be responsible for
establishing minimum standards for disclosure and transparency,
reviewing consumer credit products (in a manner set by statute)
in light of those standards to eliminate unfair practices, and
promoting practices that encourage the responsible use of
credit. This regulator should assure that consumers are not
misled by the terms of the sales pitches for credit products
and that they have the information needed to make informed and
thoughtful purchasing decisions. The statement of purposes of
the legislation creating the new agency, and the standards
governing its actions, would include the need to balance
consumer protection with the legitimate need of financial
institutions to create fair products and maintain the flow of
credit to the national economy.
Creation of a single federal regulator would produce a
single, national floor for consumer financial products. Some
state regulators might conclude that their citizens require
better protection, and they might put other constraints on the
institutions that want to do business in their states. This
proposal leaves them free to do so. The regulatory agency
simply assures that all Americans, regardless of where they
live, can count on basic protection. Regulations that apply to
all products of a certain kind--e.g., mortgages, credit cards,
payday loans--without any exceptions are far more comprehensive
than those based on the kind of institution that issued them--
federally chartered, state charted, thrift, bank, etc. Because
such baselines are inescapable, the impact of regulatory
arbitrage is sharply undercut. A financial institution cannot
escape the restrictions on mortgage disclosures, for example,
by reincorporating from a federal bank to a state bank. Any
issuer of home mortgages must meet the minimum federal
standards.
One option is to make the new federal regulator an
independent agency within the financial regulatory community.
This approach would have several advantages. A single regulator
would have the opportunity to develop significant expertise in
consumer products. Consumer protection would be a priority
rather than one issue among many competing with a myriad of
other regulatory priorities that have consistently commanded
more attention in financial institution regulatory agencies. An
agency devoted to consumer protection can make it a first
priority to understand the functioning of financial products in
the consumer marketplace. Expertise can also be concentrated
from around the country. A single group of regulators can
develop greater expertise to ensure that products are
comprehensible to customers and that they are protected from
unfair business practices. Such expertise can also be
transferred from one product to another. As financial products
become more functionally intertwined--for example, home equity
lines of credit that operate like credit cards--an agency can
develop the needed cross-expertise and more nuanced rules.
Another option is to place the new regulator within the
Federal Reserve Board. The Board is the umbrella supervisor of
bank holding companies, and it directly supervises state-
chartered banks that choose to become members of the Federal
Reserve System. It was given specific authority to deal with
deceptive mortgages more than forty years ago.\60\ Congress
voted repeatedly to expand the Board's power to provide
stronger consumer protection.\61\
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\60\ Truth in Lending Act (TILA), Pub. L. No. 90-321 (1968), at
Sec. 105(a) (codified as amended at 15 U.S.C. Sec. 1601 et seq.) (``The
Board shall prescribe regulations to carry out the purposes of this
title.''). The Federal Reserve Board implements TILA through its
Regulation Z. 12 C.F.R. pt. 226. See also Home Ownership and Equity
Protection Act of 1994 (HOEPA), Pub. L. No. 103-325 (codified at 15
U.S.C. Sec. 1639) (amending TILA).
\61\ Congress has amended TILA to improve consumer credit
protection. See, e.g., Fair Credit and Charge Card Disclosure Act of
1988, Pub. L. No. 100-583 (codified at 15 U.S.C. Sec. 1637). In 1994,
Congress amended TILA again to address predatory lending in the
mortgage market. HOEPA, supra note 60.
---------------------------------------------------------------------------
Placing the new regulator within the Board would keep
safety and soundness and consumer protection responsibilities
together, on the ground that each responsibility, if properly
implemented, could complement and re-enforce the other.
Choosing that option, however, would require changes to the
Federal Reserve Act to make consumer protection one of the
Fed's primary responsibilities, on a par with bank supervision.
It would also depend on a new understanding and attitude by the
Board toward its execution of its consumer protection mission.
Federal Reserve Chairman Ben Bernanke has acknowledged that
although the powers of the Fed to deal with mortgage abuses
were ``broad,'' \62\ the Board has for years been slow to
act,\63\ and the actions it took were inadequate.\64\ Its power
under TILA and HOEPA to issue regulations binding upon all
mortgage lenders gave it the capacity to halt the lending
practices that inflated the housing bubble and that led
millions of home owners toward eventual foreclosure, but the
Fed failed to do so.
---------------------------------------------------------------------------
\62\ In 2007, Chairman Bernanke said the Board would ``consider
whether other lending practices meet the legal definition of unfair and
deceptive and thus should be prohibited under HOEPA.'' Board of
Governors of the Federal Reserve System, Chairman Ben S. Bernanke
Remarks on The Subprime Mortgage Market before the Federal Reserve Bank
of Chicago's 43rd Annual Conference on Bank Structure and Competition
(May 17, 2007) (online at www.federalreserve.gov/newsevents/speech/
bernanke20070517a.htm). In 2008, recognizing that its authority under
HOEPA is ``broad,'' the Board strengthened Regulation Z. 73 Fed. Reg.
44,522 (July 30, 2008).
\63\ It was not until the end of 2001, after the volume of subprime
loans had increased nearly 400 percent, that the Board restricted more
abusive practices and broadened the scope of mortgages covered by
HOEPA. See 66 Fed. Reg. 65,604, 65,605 (Dec. 20, 2001).
\64\ The Fed updated Regulation Z in response to HOEPA in March
1995. 60 Fed. Reg. 15,463. It also amended Regulation C, ``Home
Mortgage Disclosure,'' in 2002. 67 Fed. Reg. 7222. Nonetheless, neither
regulation was strong enough to head off the mortgage abuses that
continued to accelerate through 2008.
---------------------------------------------------------------------------
Similarly, in areas such as credit card regulation, only
when Congress threatened to take away powers, did the Fed
finally act.\65\ Barney Frank, Chairman of the House Financial
Services Committee, explained that the failure of the Fed to
act was longstanding: ``When Chairman Bernanke testified before
us a few weeks ago . . . he said something I hadn't heard in my
28 years in this body, a Chairman of the Federal Reserve Board
uttering the words, `consumer protection.' It had not happened
since 1981.'' \66\
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\65\ See, e.g., Jane Birnbaum, Credit Card Overhauls Seem Likely,
New York Times (July 5, 2008) (``Representative Barney Frank, Democrat
of Massachusetts and chairman of the House Financial Services
Committee, said the Federal Reserve acted last fall after the House
approved legislation that would have transferred some of the Fed's
regulatory power to other agencies. `At that point, I said use it or
lose it,' Mr. Frank recalled. `And subsequent to that, the Fed began
using its authority, and is now proposing rules similar to those in our
credit card bill.' '')
\66\ House Financial Services Committee, Subcommittee on Financial
Institutions and Consumer Credit, Statement of Chairman Barney Frank,
The Credit Cardholders' Bill of Rights: Providing New Protections for
Consumers, 110th Cong. 5-6 (2008).
---------------------------------------------------------------------------
Currently, the staffing, the budgets, the expertise and the
primary responsibilities of the Fed necessarily reflect the
critical functions it performs: setting monetary policy and
controlling the money supply, consolidated supervision of bank
holding companies and the financial institutions those holding
companies own to assure the safety and soundness of those
groups, supervision of state-chartered member-banks in
coordination with state regulators, and oversight of the
federal reserve banks. Under this option the Fed would be
required to accept consumer protection as a responsibility that
is the equal of its other responsibilities, staff and budget
for that function and, makes its operations in the area
transparent. These responsibilities should be subject to
specific oversight by a designated Board member.
Wherever it is placed, the success of the new regulator
would depend in part on a statutory outline of the manner in
which it would be related to the various financial institution
regulatory agencies, and how those agencies would relate to one
another, in dealing with consumer credit products. The agencies
that are responsible for assuring the safety and soundness of
the financial institutions would be able to pursue those goals
without interference. The point of the single regulatory
authority would be only to assure that both financial
institutions and non-financial institutions that issue consumer
credit products must play on a level field, all meeting the
minimum standards established by the federal agency. No one
issuer could gain advantage by moving to a different regulator.
5. CREATE EXECUTIVE PAY STRUCTURES THAT DISCOURAGE EXCESSIVE RISK
TAKING
Problem with current system: Executive pay packages incentivize
excessive risk
Executive pay is a key issue in modernizing the financial
regulatory system. However, the common focus on the themes of
inequality and ``pay for performance'' misses the unnecessary
risk that many compensation schemes introduce into the
financial sector. Altering the incentives that encourage this
risk through the tax code, regulation, and corporate governance
reform will help mitigate systemic risk in future crises.
Executive compensation has been one of the most
controversial issues in American business since the late 1980s.
In response to criticism that executives' and shareholders'
interests did not sufficiently align,\67\ executive
compensation packages began to contain more and more stock
options, to the point where options now represent the lion's
share of a high-ranking executive's pay.\68\
---------------------------------------------------------------------------
\67\ Steven Balsam, An Introduction to Executive Compensation, at
161 (2002).
\68\ According to academic literature, between 1992 and 2002, the
inflation-adjusted value of employee options granted by firms in the
S&P 500 increased from an average of $22 million per company to $141
million per company, rising as high as $238 million per company in
2000. One academic study we referenced showed that, whereas in 1992
share options accounted for only 24 percent of the average pay package
for these CEOs, by 2002 options comprised approximately half of the
typical CEO's total compensation. The practice of granting option
awards has not been limited to the top echelon of company executives.
The percentage of option grants to all employees has grown steadily as
well, if not at the same pace as the very top-most strata of corporate
executives.
Senate Committee on Homeland Security and Governmental Affairs,
Permanent Subcommittee on Investigations, Testimony of John W. White,
Concerning Tax and Accounting Issues Related to Employee Stock Option
Compensation, 110th Cong. (June 5, 2007) (online at idea.sec.gov/news/
testimony/2007/ts060507jww.htm) (internal citations omitted).
---------------------------------------------------------------------------
Much criticism of executive pay has had its origins in the
increase in the ratio of the pay of public company executives
to average worker pay, from 42:1 in 1982 to over 400:1 in the
early years of this decade.\69\ Recent executive pay scandals,
such as those associated with the backdating of stock options,
have centered on efforts by executives to disconnect pay from
performance without informing investors.\70\ Numerous accounts
of executive pay in the context of the financial crisis of
2007-08 have focused on large severance packages, often
described as once again disconnecting pay from performance.\71\
---------------------------------------------------------------------------
\69\ Jeanne Sahadi, CEO Pay: Sky High Gets Even Higher,
CNNMoney.com (Aug. 30, 2005) (online at money.cnn.com/2005/08/26/news/
economy/ceo_pay).
\70\ See, e.g., U.S. Securities Exchange Commission, SEC Charges
Former Apple General Counsel for Illegal Stock Option Backdating (Apr.
24, 2007) (online at www.sec.gov/news/press/2007/2007-70.htm).
\71\ The most prominent example is that of Angelo Mozilo, the
former Chief Executive Officer of Countrywide Financial Corporation.
Countrywide was rescued from bankruptcy by being acquired by Bank of
America, which is now itself seeking additional financial assistance
from the TARP. Mozilo realized more than $400 million in compensation
from 2001 to 2007, most of it in the form of stock related compensation
that he received and cashed out during the period. Executive
Incentives, Wall Street Journal (Nov. 20, 2008) (online at
online.wsj.com/public/resources/documents/st_ceos_20081111.html).
Similarly, three of Merrill Lynch's top executives realized a combined
$200 million in bonuses shortly before Bank of America absorbed that
firm. Andrew Clark, Banking Crisis: Merrill Lynch Top Brass Set to
Share $200m, The Guardian (Sept. 17, 2008) (online at
www.guardian.co.uk/business/2008/sep/17/merrilllynch.
executivesalaries).
---------------------------------------------------------------------------
However, even before the current crises, many criticized
such incentive plans for encouraging excessive focus on the
short term at the expense of consideration of the risks
involved.\72\ This short-term focus led to unsustainable stock
buyback programs, accounting manipulations, risky trading and
investment strategies, or other unsustainable business
practices that merely yield short-term positive financial
reports.
---------------------------------------------------------------------------
\72\ CFA Centre for Financial Market Integrity and the Business
Roundtable Institute for Corporate Ethics, Breaking the Short-Term
Cycle: Discussion and Recommendations on How Corporate Leaders, Asset
Managers, Investors, and Analysts Can Refocus on Long-Term Value, at 9-
10 (2006) (online at www.darden.virginia.edu/corporate-ethics/pdf/
Short-termism_Report.pdf).
---------------------------------------------------------------------------
Executive pay should be designed, regulated, and taxed to
incentivize financial executives to prioritize long-term
objectives, and to avoid both undertaking excessive,
unnecessary risk and socializing losses with the help of the
federal taxpayer.
Action item: Create tax incentives to encourage long-term-
oriented pay packages
Financial firm packages typically have a number of features
that introduce short-term biases in business decision making.
Most equity-linked compensation is either in the form of
performance bonuses, typically awarded on an annual basis, and
options on restricted stock, typically awarded in the form of
grants with three-year vesting periods, and no restrictions on
sale after vesting. These structures, together with the typical
five-years-or-less tenure of public company CEOs, often lead to
a focus on investment horizons of less than three years.\73\
---------------------------------------------------------------------------
\73\ Id.
---------------------------------------------------------------------------
Altering the tax treatment of executive compensation
packages in the interests of encouraging stability, lessening
risks, and orienting finance executives toward long-term goals
represents a relatively simple step toward solving the
incentive problem. Such a change could result from revising
applicable tax rates, changing the treatment of compensation as
income versus capital gains, or other relatively simple
measures.
Action item: Encourage financial regulators to guard against
asymmetric pay packages in financial institutions, such as
options combined with large severance packages
Asymmetric links between compensation and risk create
incentives for executives to pursue potentially systemically
threatening high-risk-high-reward strategies without sufficient
regard for the downside potential. Encouraging regulators to
spot and discourage compensation packages that excessively
insulate executives from losses will help resolve this
asymmetry and promote stability.
Stock options create incentives that are tied to stock
price, but the overall compensation package's asymmetric link
to stock price actually helps encourage more dramatic risk
taking. As the price of the underlying stock declines, the
option holders become less sensitive to further declines in
value of the underlying stock, and more interested in the
possibility of achieving dramatic gains, regardless of the risk
of further losses.\74\
---------------------------------------------------------------------------
\74\ Lucian Bebchuk and Jesse Fried, Pay Without Performance: The
Unfulfilled Promise of Executive Compensation, 139 (2004).
---------------------------------------------------------------------------
A number of common features of executive pay practice that
further protect executives against downside risk exacerbate
this asymmetry problem. Among these features are the prevalence
of option repricing when the underlying company stock falls
below the option strike price for sustained periods of time and
large severance packages paid to failed executives.
While asymmetries in executive compensation are potentially
harmful in the context of any company, they create particular
difficulties in the context of regulated financial
institutions. Most regulated financial institutions are the
beneficiaries of explicit or implicit guarantees. The FDIC
insurance system is an explicit guarantee to some depositors,
which in the current crisis has been extended to all bank debt.
The current Treasury and Federal Reserve rescues of Fannie Mae,
Freddie Mac, and AIG, and the recent TARP actions in relation
to Citigroup and Bank of America--and perhaps all nine major
TARP recipient banks--all raise issues of implicit guarantees.
These guarantees provide regulators with an opportunity to
ensure that problematically asymmetrical compensation plans do
not reappear in these institutions.
Action item: Regulators should consider requiring executive pay
contracts to provide for clawbacks of bonus compensation for
executives of failing institutions
Financial system regulators should consider revoking bonus
compensation for executives of failing institutions that
require federal intervention. Whether the federal government
promises to support the institution before a crisis develops,
as with Fannie Mae and Freddie Mac, or after, as with TARP
recipients, the prospect of losing bonus compensation could
deter risky practices that make the federal rescue more
probable.
The cases of the Fannie Mae and Freddie Mac seem
particularly relevant. In both companies, executive pay in the
course of the 1990s moved from a model focused on corporate
stability to a model focused on stock price maximization
through asymmetric, short-term incentives.\75\ It appears that
this change fed pressures to increase margins in ways that were
only possible by engaging in riskier investment practices.\76\
This approach to executive pay is inconsistent with federal
guarantees of solvency; inevitably, if it is not abandoned,
taxpayers will end up paying for imprudent risk taking by
improperly incentivized executives.
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\75\ Federal Reserve Bank of St. Louis, William R. Emmons and
Gregory E. Sierra, Executive Compensation at Fannie Mae and Freddie Mac
(Oct. 26, 2004) (Working Paper No. 2004-06) (online at papers.ssrn.com/
sol3/papers.cfm?abstract_id=678404).
\76\ Id.
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As the financial crisis has developed, there has been a
fair amount of discussion of clawbacks of executive pay. The
Sarbanes-Oxley Act of 2002 required clawbacks of executive pay
awarded as a result of fraudulent financial statements.\77\
Similar clawback provisions could help restore symmetry and a
longer-term perspective to executive compensation systems. As
such, regulators should consider adding them to the tools at
their disposal.
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\77\ Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, at Sec. 304.
Action item: Encourage corporate governance structures with
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stronger board and long-term investor oversight of pay packages
The Associated Press recently reported that ``even where
banks cut back on pay, some executives were left with seven- or
eight-figure compensation that most people can only dream
about. Richard D. Fairbank, the chairman of Capital One
Financial Corp., took a $1 million hit in compensation after
his company had a disappointing year, but still got $17 million
in stock options. The McLean, Va.-based company received $3.56
billion in bailout money on Nov. 14.'' \78\
---------------------------------------------------------------------------
\78\ Frank Bass and Rita Beamish, Study: $1.6B of Bailout Funds
Given to Bank Execs, Associated Press (Dec. 21, 2008).
---------------------------------------------------------------------------
Corporate governance regulations should strengthen the role
of boards and long-term shareholders in the executive pay
process with the goal of encouraging executive pay practices
that align executives' interests with the long-term performance
of the businesses they manage.
The twin problems of asymmetric and short-term-focused
executive pay have been the subject of a number of reform
efforts by business groups. Such reform recommendations have
come from the Conference Board, in its report on the origins of
the financial crisis,\79\ and from the Aspen Institute's
Principles for Long Term Value Creation,\80\ endorsed by the
U.S. Chamber of Commerce and the Business Roundtable, as well
as by the Council of Institutional Investors and the AFL-CIO.
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\79\ Conference Board, Linda Barrington, Ellen S. Hexter, and
Charles Mitchell, CEO Challenge 2008: Top 10 Challenges--Financial
Crisis Edition (Nov. 2008) (online at www.conference-board.org/
publications/describe.cfm?id=1569).
\80\ Aspen Institute, Long-Term Value Creation: Guiding Principles
for Corporations and Investors (2008).
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Financial regulators should encourage these efforts
wherever possible and provide assistance wherever practicable.
6. REFORM THE CREDIT RATING SYSTEM
Problem with current system: The credit rating system is
ineffective and plagued with conflicts of interest
The major credit rating agencies played an important--and
perhaps decisive--role in enabling (and validating) much of the
behavior and decision making that now appears to have put the
broader financial system at risk. In the subprime-related
market specifically, high ratings for structured financial
products--especially mortgage-backed securities (MBS),
collateralized debt obligations (CDO), and CDOs that invested
in other CDOs (frequently referred to as CDO-squared, or
CDO\2\)--were essential for ensuring broad demand for these
products. High ratings not only instilled confidence in
potentially risk-averse investors, but also helped satisfy
investors' regulatory requirements, which were often explicitly
linked to ratings from the major credit rating agencies. By
2006, Moody's business in rating structured financial products
accounted for 44 percent of its revenues, as compared to 32
percent from its traditional corporate-bond rating
business.\81\ It has also been reported that ``roughly 60
percent of all global structured products were AAA-rated, in
contrast to less than 1 percent of corporate issues.'' \82\
Financial firms, from Fannie Mae to AIG, also benefited greatly
from having high credit ratings of their own--especially AAA--
allowing them not only to borrow at low rates on the short-term
markets to finance longer-term (and higher yielding)
investments but also to sell guaranties of various sorts,
effectively ``renting out'' their credit rating.
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\81\ Harvard Business School, Joshua D. Coval, Jakib Jurek, and
Erik Stafford, The Economics of Structured Finance, at 4 (2008)
(Working Paper No. 09-060) (online at papers.ssrn.com/sol3/
papers.cfm?abstract_id=1287363).
\82\ Id.
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Numerous explanations have been offered for credit rating
agencies' apparent mistakes, including conflicts of interest,
misuse of complex models, and their quasi-public status as
nationally recognized statistical rating organizations
(NRSROs).
Regarding conflicts of interests, worrisome is the rating
agencies' practice of charging issuers for their ratings, a
practice that began at Fitch and Moody's in 1970 and at
Standard & Poor's a few years later.\83\ Although the practice
of collecting payments from issuers has long provoked
criticism, market observers often downplayed these concerns,
suggesting that ``the agencies have an overriding incentive to
maintain a reputation for high-quality, accurate ratings.''
\84\ Others, however, claim that the ``issuer pays'' model
biases ratings upward and also encourages ``ratings shopping''
by issuers, which in turn provokes a race to the bottom on the
part of the rating agencies, each willing to lower quality
standards to drum up more business.\85\
---------------------------------------------------------------------------
\83\ Richard Cantor and Frank Packer, The Credit Rating Industry,
FRBNY Quarterly Review, at 4 (Summer-Fall 1994). See also Claire Hill,
Regulating the Rating Agencies, Washington University Law Quarterly, at
50 (2004).
\84\ Cantor and Packer, supra note 81, at 4.
\85\ House Committee on Oversight and Government Reform, Testimony
of Jerome S. Fons, Credit Rating Agencies and the Financial Crisis,
110th Cong., at 3 (Oct. 22, 2008) (online at oversight.house.gov/
documents/20081022102726.pdf).
---------------------------------------------------------------------------
Beyond the ratings themselves, credit rating agencies also
charge issuers for advice, including pre-rating assessments (in
which issuers learn what ratings will likely be under various
hypothetical scenarios) and risk-management consulting. In some
cases, credit rating agency analysts subsequently go to work
for the companies they had been rating.\86\ This revolving-door
practice creates not only the potential for conflicts of
interest but also for gaming of the system, since former
employees of the rating agencies presumably know how best to
exploit weaknesses in the agencies' risk assessment models.
---------------------------------------------------------------------------
\86\ John P. Hunt, Credit Rating Agencies and the `Worldwide Credit
Crisis': The Limits of Reputation, the Insufficiency of Reform, and a
Proposal for Improvement, Columbia Business Law Review, at 32-33 (2009)
(papers.ssrn.com/sol3/papers.cfm?abstract_id=1267625).
---------------------------------------------------------------------------
Many critics charge that it was the models themselves--and
overreliance on them--that got the credit rating agencies into
trouble in recent years, particularly in assigning ratings to
structured financial products. ``Instead of focusing on actual
diligence of the risks involved, demanding additional issuer
disclosures, or scrutinizing collateral appraisers'
assessments,'' writes one skeptic, ``rating agencies primarily
relied on mathematical models that estimated the loss
distribution and simulated the cash flows of RMBS [residential
mortgage backed securities] and CDOs using historical data.''
\87\
---------------------------------------------------------------------------
\87\ Jeffrey David Manns, Rating Risk after the Subprime Mortgage
Crisis: A User Fee Approach for Rating Agency Accountability, North
Carolina Law Review (forthcoming), at 32-33 (papers.ssrn.com/sol3/
papers.cfm?abstract_id=1199622) (accessed Jan. 4, 2009).
---------------------------------------------------------------------------
Many of the models involved excessively rosy assumptions
about the quality of the underlying mortgages, ignoring the
fact that these mortgages (especially subprime mortgages) were
far riskier than ever before and were in fact becoming steadily
riskier year by year.\88\ Credit rating agency modeling of
mortgage-related securities may also have involved mistaken
assumptions about the independence of the underlying
mortgages--including the assumption that defaults would not be
highly correlated across a broad bundle of mortgages or
mortgage-related securities.\89\ By extension, many of the
rating agencies' models may also have involved overly
optimistic assumptions about the direction of housing prices
(that is, that they would not fall by much, if at all). When
asked on a conference call in March 2007 about how a 1 to 2
percent decline in home prices over an extended period of time
would affect Fitch's modeling of certain subprime-related
securities, a Fitch representative conceded, ``The models would
break down completely.'' \90\
---------------------------------------------------------------------------
\88\ U.S. Securities and Exchange Commission Office of Compliance
Inspections and Examinations, Summary Report of Issues Identified in
the Commission Staff's Examinations of Select Credit Rating Agencies,
at 33 (July 2008) (online at www.sec.gov/news/studies/2008/
craexamination070808.pdf) (hereinafter ``Summary Report'') (``In
addition to the recent growth in subprime origination, there has also
been a growth in the risk factors associated with subprime mortgages.
Studies indicate that the percentage of subprime loans with less-than-
full documentation, high combined loan to total value (CLTVs), and
second liens grew substantially between 1999 and 2006. Notably, while
2/28 adjustable rate mortgages comprised just 31 percent of subprime
mortgages in 1999, they comprised almost 69 percent of subprime loans
in 2006. Further, 40-year mortgages were virtually non-existent prior
to 2005, but they made up almost 27 percent of the subprime loans in
2006. These data provide evidence that the majority of subprime
origination occurred within the last five years, and the loans
containing very high risk combinations are even more recent.''). The
SEC report also documented that, at one major credit rating agency,
``the average percentage of subprime RMBS in the collateral pools of
CDOs it rated grew from 43.3 percent in 2003 to 71.3 percent in 2006.''
Id. at 7. Given these dramatic changes in the mortgage market, basing
models on historical mortgage data may have proved particularly
problematic.
\89\ Indeed, a significant degree of independence was essential,
since ``CDOs rely on the power of diversification to achieve credit
enhancement.'' Coval, et al., supra note 81, at 10.
\90\ See id. at 23.
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Yet another problem plaguing the rating agencies' models
was the practice of embedded structuring by issuers, according
to which CDOs would themselves become inputs into new CDOs
(CDO2). ``With multiple rounds of structuring,''
three finance professors explain, ``even minute errors at the
level of the underlying securities, which would be insufficient
to alter the security's rating, can dramatically alter the
ratings of the structured finance securities.'' \91\
---------------------------------------------------------------------------
\91\ Id. at 10.
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Of particular concern from a regulatory standpoint is the
extent to which state and federal (and even global) financial
regulations are linked to private credit ratings--and, in fact,
to ratings issued by just a handful of specially designated
credit rating agencies, the NRSROs). To the extent that leading
credit rating agencies enjoy a protected status and virtually
guaranteed demand as a result of their regulatory significance,
they may face diminished incentives to maintain the quality of
their ratings.
The SEC has recently undertaken a number of reforms aimed
at the operations of the NRSROs pursuant to the passage of the
Credit Rating Agency Reform Act of 2006 (the Rating Agency
Act),\92\ which granted the SEC authority to implement
registration, recordkeeping, financial reporting, and oversight
rules with respect to registered credit rating agencies. Before
this grant of authority to the SEC, NRSROs were essentially
unregulated. Pursuant to its new regulatory authority, the SEC
has registered ten firms; \93\ instituted examinations of
NRSROs' practices; \94\ and proposed rules designed to enhance
accountability, transparency, and competition.\95\ The Rating
Agency Act and the SEC's recent regulatory activity are
positive developments. However, since 2006 the financial crisis
has revealed the extent of the harmful consequences of the
deep-seated conflicts of interest and distorted incentives
associated with the credit ratings firms. With the knowledge
that the contours of reform of credit rating agency regulation
must take into account the SEC's actions, we propose the
following recommendations.
---------------------------------------------------------------------------
\92\ Credit Rating Agency Reform Act of 2006, Pub. L. No. 109-291.
\93\ U.S. Securities Exchange Commission, Nationally Recognized
Statistical Rating Organizations (online at www.sec.gov/divisions/
marketreg/ratingagency.htm) (accessed Jan. 26, 2008) (hereinafter ``SEC
NRSRO Web site''). These ten include the old line firms Moody's,
Standard & Poor's, and Fitch. Id.
\94\ Senate Committee on Banking, Housing, and Urban Affairs,
Testimony of Christopher Cox, Turmoil in U.S. Credit Markets: The Role
of the Credit Rating Agencies, 110th Cong. (Apr. 22, 2008) (online at
www.sec.gov/news/testimony/2008/ts042208cc.htm).
\95\ SEC NRSRO Web site, supra note 93.
Action item: Adopt one or more regulatory options to address
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conflicts of interest and incentives
To address conflicts of interest, the SEC or a new
regulatory body (see below) could impose limits on the
proportion of revenues of rating agencies that are derived from
issuers, though there is disagreement about whether alternative
revenue sources would prove sufficient.\96\ Alternatively, for
each rating, issuers could be required to pay into a pool, from
which a rating agency would be chosen at random.\97\ Here, the
challenge would be to maintain the quality of ratings after
severing the link between pay and performance. One could also
imagine the introduction of grace periods in which credit
rating analysts could not take jobs with their clients. While
this too would limit conflicts of interest, it might also
interfere with the recruiting of high-quality credit analysts
at the rating agencies.
---------------------------------------------------------------------------
\96\ House Committee on Oversight and Government Reform, Testimony
of Sean J. Egan, Credit Rating Agencies and the Financial Crisis, 110th
Cong., at 9 (Oct. 22, 2008) (online at oversight.house.gov/documents/
20081022102906.pdf).
\97\ David G. Raboy, Concept Paper on Credit Rating Agency
Incentives (Jan. 9, 2009) (unpublished working paper on file with the
Panel).
---------------------------------------------------------------------------
To improve incentives, the SEC or some other regulatory
body should further encourage additional competition by
progressively expanding the ranks of the NRSROs.\98\ Other
options would include additional disclosure requirements or
prohibitions on rating agencies' use of nonpublic
information.\99\ Since rating agencies currently face little if
any legal liability for malfeasance in the production of
ratings, a number of experts have proposed strategies for
imposing liability on credit rating agencies to ensure
appropriate accountability.\100\ Although such reforms might
well prove helpful, they would be unlikely to solve the
underlying problem by themselves.
---------------------------------------------------------------------------
\98\ Hill, supra note 83, at 86-87.
\99\ Egan, supra note 96, at 8.
\100\ Senate Committee on Banking, Housing, and Urban Affairs,
Testimony of Frank Partnoy, Assessing the Current Oversight and
Operation of Credit Rating Agencies, 109th Cong., at 5 (Mar. 7, 2006)
(online at banking.senate.gov/public/_files/partnoy.pdf).
Action item: Reform the quasi-public role of NRSROs and
---------------------------------------------------------------------------
consider creating a Credit Rating Review Board
Perhaps the most pressing issue of all from a regulatory
standpoint is the NRSRO designation itself. Particularly given
all of the concerns that have been raised about the credit
rating agencies and their poor performance leading up to the
current crisis, state and federal policymakers will need to
reassess whether they can continue to rely on these private
ratings as a pillar of public financial regulation.\101\ In
fact, it may be time to consider the possibility of
eliminating, or at least dramatically scaling back, the NRSRO
designation and replacing it with something else.\102\
---------------------------------------------------------------------------
\101\ A recent SEC report acknowledged, ``The rating agencies'
performance in rating these structured finance products raised
questions about the accuracy of their credit ratings generally as well
as the integrity of the ratings process as a whole.'' Summary Report,
supra note 88, at 2).
\102\ Frank Partnoy has suggested linking regulation instead to
market-based measures of risk, such as credit spreads or the prices of
credit default swaps. Partnoy, supra note 100, at 80-81.
---------------------------------------------------------------------------
One option would be to create a public entity--a Credit
Rating Review Board--that would have to sign off on any rating
before it took on regulatory significance. Even if an asset was
rated as investment grade by a credit rating agency, it could
still not be added to a bank or pension fund portfolio, for
example, unless the rating was also approved by the review
board. Ideally, the board would be given direction by lawmakers
to favor simpler (plain vanilla) instruments with relatively
long track records. New and untested instruments might not make
the cut. Of course, such new instruments could still be
actively bought and sold in the private marketplace. Only
regulated transactions that currently require ratings would be
affected. Two key advantages of this approach are that it would
permit a dramatic opening of the market for private credit
ratings and at the same time discontinue the unsuccessful
outsourcing of vital regulatory monitoring.
Another, substantially different, option for the design of
such a Credit Rating Review Board would be to model the board
in part on the Public Company Accounting Oversight Board
(PCAOB), a not-for-profit corporation that was created by the
Sarbanes-Oxley Act to oversee the auditors of public
companies.\103\ Under this model, the Credit Rating Review
Board would not rate instruments ex ante, but instead audit
ratings after the fact, perhaps on an annual basis, to ensure
that rating agencies are sufficiently disclosing their rating
methodologies, the ratings agencies' methodologies are sound,
and the rating agencies are adhering to their methodologies.
Depending on the course of the SEC's rulemaking, the Credit
Rating Review Board could coordinate with or assume some of the
SEC's authority to regulate conflicts of interest and inspect,
investigate, and discipline NRSROs.
---------------------------------------------------------------------------
\103\ See Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, at
Sec. Sec. 101-109.
---------------------------------------------------------------------------
7. MAKE ESTABLISHING A GLOBAL FINANCIAL REGULATORY FLOOR A U.S.
DIPLOMATIC PRIORITY
Problem with current system: The globalization of financial
markets encourages countries to compete to attract foreign
capital by offering increasingly permissive regulatory laws
that increase market risk
The rapid globalization of financial markets in recent
decades has created a new set of problems for national
regulators and exposed market participants to an additional
element of risk. Capital is able to flow freely across
international borders, while regulatory controls are bound to
domestic jurisdictions. Private actors, therefore, have the
benefit of seeking out regulatory climates that best
accommodate their financial objectives. Countries, in turn, bid
for capital flows by adjusting their tax and regulatory
schemes, as well as their legal infrastructure and employment
laws. While New York and London tout their preeminence as
financial capitals, Tokyo, Hong Kong, Singapore, Bahrain, and
Doha, Qatar have all become financial hubs. At the same time,
certain offshore tax havens, such as the Cayman Islands, the
Bahamas, and the Channel Islands have developed local
industries catering to the financial services needs of
foreigners. Often, the sole comparative advantage offered by
these locations is the opportunity to profit from ``regulatory
arbitrage.'' The consequence is a global race to the bottom
whereby deregulation is pursued to the detriment of market
stability.
Meanwhile, global markets have become increasingly
interconnected. From 1990 to 2000, the total dollar amount of
crossborder securities holdings where non-U.S. investors held
U.S. securities, or vice versa, grew from approximately $1.5
trillion to approximately $6.9 trillion.\104\ Today, U.S.
issuers raise debt and equity funding in local markets all over
the world. Conversely, foreign issuers who previously looked to
the liquidity of the United States capital markets now find
equally liquid pools of capital in Europe and Asia.
---------------------------------------------------------------------------
\104\ Securities Industry Association, Securities Industry Fact
Book, at 80 (2002) (online at www.sifma.org/research/statistics/other/
2002Fact_Book.pdf).
---------------------------------------------------------------------------
When financial turmoil strikes issuers or borrowers in one
country, it is equally likely to have adverse consequences
beyond national borders. The subprime mortgage crisis of 2008
caused widespread havoc outside the United States, beginning
with a small thrift in England and sweeping over the world. At
the same time the United States government initiated its $700
billion bailout plan, the United Kingdom established a facility
to make additional capital available to eight of its largest
banks and building societies, the governments of France,
Belgium, Luxembourg and the Netherlands made large capital
infusions to bail out major banks operating in those countries,
and the government of Iceland was forced to take over the three
largest banks there.\105\ Stock markets worldwide plunged.
Investors large and small suffered.
---------------------------------------------------------------------------
\105\ Steven Erlanger and Katrin Bennhold, Governments on Both
Sides of the Atlantic Push to Get Banks to Lend, New York Times (Nov.
6, 2008).
---------------------------------------------------------------------------
The abiding lesson is that booms and busts can no longer be
restricted to their country of origin. Nations must embark on
aggressive diplomatic efforts to address the collective risks
posed by today's globalized financial markets.
Action item: Build alliances with foreign partners to create a
global financial regulatory floor
Given the ease with which money moves across international
borders, it is difficult for one country to adopt a system to
provide adequate regulation of the capital markets, as well as
adequate consumer protection, unless all major participants in
the global economy have agreed to coordinated action
beforehand. Otherwise, regulatory arbitrage and the resulting
race to the bottom are inevitable. To assure the stability of
the markets, it is therefore imperative for U.S. financial
market regulators, as well as the State Department, to work
together to encourage greater harmonization of regulatory
standards, as well as broad adoption of a floor of recognized
``prudent regulatory measures.''
Better coordination of regulation and surveillance, while
difficult to achieve, will result in better-regulated entities
that are less likely to cause damages to global markets and
other market participants. It is also likely to result in more
efficient and less costly regulation for regulated entities.
Action item: Actively participate in international
organizations that are designed to strengthen communication and
cooperation among national regulators
Financial services regulators have created a number of
organizations to share ideas and information regarding
financial services entities and markets. These include the
Basel Committee on Bank Supervision (BCBS), the Senior
Supervisors Group (SSG), and the International Organization of
Securities Commissions (IOSCO). The SSG, for one, meets
regularly to discuss supervisory matters and to issue
recommendations for better supervision.\106\
---------------------------------------------------------------------------
\106\ Senior Supervisors Group, Observations on Risk Management
Practices in the Recent Market Turbulence (Mar. 6, 2008) (online at
www.newyorkfed.org/newsevents/news/banking/2008/
ssg_risk_mgt_doc_final.pdf).
---------------------------------------------------------------------------
The SSG also periodically sponsor ``colleges of
supervisors,'' in which supervisors from several countries that
have jurisdiction over part of the operations of a globally
active financial services firm will convene to discuss issues
regarding regulation of the firm. Established linkages between
regulators with different perspectives on a particular entity
facilitate information-sharing that enables all supervisors to
better understand the risks facing the entity. These
relationships also ensure better coordination during times of
stress. These efforts should be expanded to include
consideration of systemically important financial institutions,
in order to develop a better understanding of the risk profiles
of such institutions and to improve their ability to intervene
where the risk profile increases to potentially destabilizing
levels.
8. PLAN FOR THE NEXT CRISIS
Problem with current system: Participants, observers, and
regulators neither predicted nor developed contingency plans to
address the current crisis
Despite calls for caution from some quarters, very few
observers predicted the severity of the current collapse in the
housing, debt, and equity markets, or the massive decline in
economic activity. Those commentators who most vocally raised
doubts about the sustainability of housing prices, the pace of
derivatives growth, or lax regulation were largely dismissed as
fearmongers, or as simply ``not getting it.'' \107\
---------------------------------------------------------------------------
\107\ See, e.g., Meet Dr. Doom, IMF Survey, at 308 (Oct. 16, 2006)
(online at www.imf.org/EXTERNAL/PUBS/FT/SURVEY/2006/101606.pdf).
---------------------------------------------------------------------------
Traditional measures of financial and economic exposure,
such as bank capitalization, troubled loans, stock prices, and
money supply growth, indicated only moderate exposure to a
sharp asset price collapse and a severe recession.\108\ Yet
there was a compelling case for concern based on a closer
examination of the multiple layers of leverage invested in
housing assets and their derivatives.\109\ More broadly,
stagnant household productivity, the pace of financial product
innovation and the increased leverage on Wall Street might all
have set off alarm bells.\110\
---------------------------------------------------------------------------
\108\ See, e.g., id.
\109\ Government Accountability Office, Financial Regulation: A
Framework for Crafting and Assessing Proposals to Modernize the
Outdated U.S. Financial Regulatory System, at 16-23 (2009) (online at
www.gao.gov/new.items/d09216.pdf) (discussing overleveraging and
financial interconnectedness as contributing to a risky financial
environment immediately preceding the current crisis).
\110\ Id.
---------------------------------------------------------------------------
Indeed, some analysts see systemic collapses as inherently
more likely in complex, interdependent systems such as our
modern financial environment.\111\ While most destructive
outcomes are deemed to be so unlikely, based on historical
comparisons, that they are not worth considering, recent
analysis indicates on the contrary that complex systems produce
these ``outlier'' results on a counterintuitively regular
basis.\112\
---------------------------------------------------------------------------
\111\ Id. at 18-19.
\112\ See, e.g., Nassim Nicholas Taleb, The Black Swan: The Impact
of the Highly Improbable (2007); Daniel G. Goldstein and Nassim
Nicholas Taleb, We Don't Quite Know What We Are Talking About When We
Talk About Volatility (Mar. 28, 2007) (online at ssrn.com/
abstract=970480).
---------------------------------------------------------------------------
Current institutions are not likely to fare better in the
future. Governments, industry, Wall Street, and academia
typically employ economists with similar training and
backgrounds to create their forecasts, leading to procyclical
optimism and convergence of economic forecasts. In particular,
economists have a truly dismal record in predicting the onset
of recessions and asset crashes.\113\ Given the risk of a
similar collapse in the future and the lack of formal processes
in business or government requiring that the truly dismal
scenarios be assessed, the current system will likely face
similar risks not long after the present crisis is resolved.
---------------------------------------------------------------------------
\113\ Even where outside advisory groups have been set up to
counsel the Government regularly on economic issues, as the Conseil
d'Analyse Economique (CAE) does in France, there is a marked similarity
of backgrounds among their membership. Conseil d'Analyse Economique,
Membres du Conseil (online at www.cae.premier-ministre.gouv.fr)
(accessed Jan. 26, 2009). This may help explain why these bodies did
not produce even minority viewpoints warning of the current financial
crash; CAE did not produce a report on the subprime mortgage crisis
until September, 2008. Conseil d'Analyse Economique, Rapports du
Conseil d'analyse economique (online at www.cae.premier-
ministre.gouv.fr) (accessed Jan. 26, 2009).
Action item: Create Financial Risk Council of outside experts
to report to Congress and regulators on possible looming
---------------------------------------------------------------------------
challenges
To promote better planning, financial experts should be
aiming to identify the problems of the future, much as the
military does. To this end, the Panel recommends establishing a
Financial Risk Council featuring a truly diverse group of
opinions, a formal mechanism whereby the concerns, both
individual and collective, of this group will be regularly
brought to the attention of Congress and financial regulators,
with a focus on precisely those low-likelihood, huge-magnitude
developments that consensus opinion will dismiss.
The council should consider all potential domestic and
foreign threats to the stability of the U.S. financial systems.
These sources of threat should include, but not be limited to:
(1) Economic shocks and recessions; (2) asset booms and busts;
(3) fiscal, trade, foreign exchange, and monetary imbalances;
(4) infrastructure failures, natural disaster, and epidemics;
(5) institutional mismanagement; (6) crime, fraud; and
terrorism; (7) legislative and regulatory failure; and (8)
failed product and process innovation.
Strong, independent thinking among the membership of the
Council will be critical: Every effort should be made to avoid
an optimistic consensus that there are no major threats
looming. To that end, Council members should represent a
diverse array of stakeholders, with a record of speaking their
minds.
The council would be required to publish regular reports to
Congress and to select among various techniques for identifying
threats. These approaches might include:
1. Wargaming: Teams represent various market, government,
regulatory, and subversive constituents. A control team sets up
the initial environment and introduces destabilizing changes.
The teams respond in real time and the control group feeds the
impacts of their decisions into the environment. Subsequent to
the wargame, there is an examination of outcomes, the level of
constituent preparedness, and the quality of the risk
management processes.
2. Strategic scenario analysis: An analytic team works
backward from worst-case financial crisis outcomes to identify
the potential triggering factors and preventative or mitigating
solutions. This approach prevents the ``it couldn't happen''
mindset.
3. Nonlinear modeling/``black swan'' sensitivity analysis:
An analytic team assumes previously unseen levels for key
variables in order to destabilize financial models and observes
break points and systemic failures.
A Financial Risk Council composed of strong, divergent
voices should avoid overly optimistic consensus and
conventional wisdom, keeping Congress appropriately concerned
and energized about known and unknown risks in a complex,
highly interactive environment.
V. ISSUES REQUIRING FURTHER STUDY
There are several important questions regarding financial
regulatory reform that are beyond the scope of this Report, and
will require further attention.
First, the Panel has identified three highly technical
issues relating to the financial regulatory system, and
recommends that the relevant regulatory agencies take up
specialized review of these questions. These are:
1. Accounting rules: Further study is required to identify
needed reforms of the current accounting rules, particularly
with connection to systemic risk. Among the issues that should
be considered are mark-to-market accounting, mark-to-model
accounting, fair-value accounting, issues of procyclicality,
accounting for contingent liabilities, and off-balance-sheet
items.
2. Securitization: Further study is required to consider
the logic and limits of securitization, and reform options such
as requiring issuers to retain a portion of offering, phased
compensation based on loan or pool performance, and other
requirements.
3. Short-selling: In light of recent imposed limits,
regulation of short-selling should be further studied and long-
term policies should be developed.
Second, the Panel plans to address regulatory architecture
more thoroughly in a subsequent report, including the issues of
co-regulation, universal banking, regulatory capture, the
revolving door problem, bankruptcy and receivership issues
involving financial institutions, and the division of
regulatory responsibilities.
VI. ACKNOWLEDGMENTS
The Panel owes a debt of gratitude to many people who
helped produce this report. Our deepest thanks go to Professor
David Moss of Harvard Business School, who played a key role in
conceptualizing and drafting the report. He was ably assisted
by Melanie Wachtell, who worked long hours both to direct the
underlying research efforts and to help pull the final draft
together. The Panel is also grateful to Christopher Caines for
his meticulous and thoughtful editing of this report. We
express our thanks to Professor Arthur Wilmarth, Professor
Patricia McCoy, Professor Ronald Mann, Professor Julio
Rotemberg, Professor David Scharfstein, and Dr. Robert Litan,
all of whom read portions of the draft and made helpful
comments. Ganesh Sitaraman and Jonathan Lackow offered
important drafting assistance. Thanks are also due to Abbye
Atkinson, Brett Arnold, Cole Bolton, Marc Farris, Arthur
Kimball-Stanley, Gregory Lablanc, Eric Nguyen, Adam Pollet,
Walter Rahmey, Chris Theodoridis, Patrick Tierney, and Chieh-
Ting Yeh, who contributed careful and detailed research to this
undertaking.
The Panel also gratefully acknowledges the assistance of
Christine Sgarlata Chung, assistant clinical professor of law
and director of the Securities Arbitration Clinic at Albany Law
School, and David P. McCaffrey, distinguished teaching
professor at Albany-SUNY, the co-directors of the Center for
Financial Market Regulation, in preparing the summaries of
prior reports on regulatory reform contained in the appendix
and the longer summaries of those reports that may be found on
the Panel's Web site, cop.senate.gov.
The Panel is also grateful to the following individuals who
generously provided their time and expertise to the preparation
of this report: Tobias Adrian, Professor Edward Balleisen, Dean
Baker, Brandon Becker, Pervenche Beres, Professor Bruce
Carruthers, Professor Lord Eatwell, Douglas Engmann, former
Senator Phil Gramm, Professor Michael Greenberger, Professor
Joseph Grundfest, Michael Jamroz, Robert Kelly, Professor Naomi
Lamoreaux, Professor Stan Liebowitz, Professor Andrew Lo, David
Raboy, Professor Hal Scott, L.W. Seidman, Professor Jay
Westbrook, Professor Luigi Zingales, Professor Todd Zywicki,
and the Squam Lake Working Group on Financial Regulation
(including Martin Baily, Andrew Bernard, John Campbell, John
Cochrane, Doug Diamond, Darrell Duffie, Ken French, Anil
Kashyap, Rick Mishkin, Raghu Rajan, David Scharfstein, Matt
Slaughter, Bob Shiller, Hyun Song Shin, Jeremy Stein, and Rene
Stulz). The Panel thanks the following institutions and
organizations for their contributions: Business Roundtable
(including John Castellani and Tom Lehner), the Chicago Board
Options Exchange, the Financial Industry Regulatory Authority,
the Council of Institutional Investors (including Anne Yerger,
Amy Borrus, and Jeff Mahoney), the Consumer Federation of
America (and Barbara Roper), the International Swaps and
Derivatives Association (and Robert Pickel), and the National
Consumer Law Center (including Lauren Saunders and Margot
Saunders). The Panel also benefited from the guidance of David
Einhorn, Sarah Kelsey, Arthur Levitt, Alex Pollock, Professor
Robert Merton, and Lawrence Uhlick.
VII. ABOUT THE CONGRESSIONAL OVERSIGHT PANEL
In response to the escalating crisis, on October 3, 2008,
Congress provided the U.S. Department of the Treasury with the
authority to spend $700 billion to stabilize the U.S. economy,
preserve home ownership, and promote economic growth. Congress
created the Office of Financial Stabilization (OFS) within
Treasury to implement a Troubled Asset Relief Program (TARP).
At the same time, Congress created the Congressional Oversight
Panel to ``review the current state of financial markets and
the regulatory system.'' The Panel is empowered to hold
hearings, review official data, and write reports on actions
taken by Treasury and financial institutions and their effect
on the economy. Through regular reports, the Panel must oversee
Treasury's actions, assess the impact of spending to stabilize
the economy, evaluate market transparency, ensure effective
foreclosure mitigation efforts, and guarantee that Treasury's
actions are in the best interests of the American people. In
addition, Congress has instructed the Panel to produce a
special report on regulatory reform that will analyze ``the
current state of the regulatory system and its effectiveness at
overseeing the participants in the financial system and
protecting consumers.''
On November 14, 2008, Senate Majority Leader Harry Reid and
the Speaker of the House Nancy Pelosi appointed Richard H.
Neiman, Superintendent of Banks for the State of New York,
Damon Silvers, Associate General Counsel of the American
Federation of Labor and Congress of Industrial Organizations
(AFL-CIO), and Elizabeth Warren, Leo Gottlieb Professor of Law
at Harvard Law School to the Panel. With the appointment on
November 19 of Congressman Jeb Hensarling to the Panel by House
Minority Leader John Boehner, the Panel had a quorum and met
for the first time on November 26, 2008, electing Professor
Warren as its chair. On December 16, 2008, Senate Minority
Leader Mitch McConnell named Senator John E. Sununu to the
Panel, completing the Panel's membership.
Congressman Hensarling and former Senator Sununu did not
approve this report. Their alternative view is included in the
following section.
VIII. ADDITIONAL VIEWS
Richard H. Neiman
I am pleased to support the Panel's special report on
regulatory reform, which begins to address some of the most
critical issues facing our nation, such as improving consumer
protection, reducing systemic risk, eliminating regulatory
gaps, and enhancing global co-ordination of supervision. These
are precisely the issues we need to address in these
unprecedented times, when Americans are losing their homes, and
the financial system and our economy are at greater risk than
at any time since the Depression.
Addressing any one of these issues individually would be a
challenge; compiling a report that addresses them all within
nine short weeks was a herculean task. Given the diversity of
backgrounds and ideological views of the Panel members, the
fact that we have reached agreement on the critical issues and
on many action items to address those issues is truly
remarkable.
As the only regulator on the panel, I find it appropriate
to highlight certain issues of particular importance and to
which I bring a unique perspective.
STATES MUST BE ALLOWED TO INCREASE THEIR ROLE IN PROTECTING CONSUMERS
States have long strived to protect their citizens from
harmful financial products and should continue to carry out
this vital role. States, like New York, sounded an early alarm
on subprime lending by adopting anti-predatory lending
legislation and reaching landmark settlements with the nation's
top mortgage bankers, providing hundreds of millions of dollars
in consumer restitution and improving industry practices.
Rather than join with the states, however, the OCC and the
OTS thwarted state efforts, by claiming broad field preemption
and then failing to adopt measures that protected consumers.
This federal overreach caused gaps in consumer protection
standards, as more protective state laws were set aside without
being replaced by appropriate national standards or equivalent
enforcement efforts.
I want to underscore the Panel's recommendation to
eliminate federal preemption of state consumer laws and confirm
the ability of states to examine and enforce compliance with
federal and state consumer protection laws. The recommendations
will restore the appropriate balance between federal and state
regulators and provide the basis for a ``New Federalism.'' It
will draw on what is best about our current dual banking
system, close gaps in consumer protection, and maximize the
effectiveness of the joint resources of state and federal
regulators.
THE FEDERAL RESERVE BOARD SHOULD SET MINIMUM FEDERAL STANDARDS FOR
CONSUMER PROTECTION
The Panel's report calls for the establishment of a single
federal regulator that would have overarching consumer
protection responsibilities, such as setting national minimum
standards. We need to establish adequate baseline consumer
protections for all Americans. Under this proposal, states
could adopt more stringent requirements than the federal body,
as local conditions warranted, and could regulate consumer
protection standards in the absence of federal action. This
would allow states to serve as incubators to develop innovative
regulatory solutions. Laws that are tried first at the state
level and found successful often serve as the model for laws at
the national level.
The national minimum standards should go beyond required
disclosures and extend to substantive regulation of consumer
financial products. Disclosure alone does not address the
issues that gave rise to the current crisis. We need to address
key issues, including affordability, suitability, and the duty
of care owed by financial services providers to consumers.
While I wholeheartedly support a heightened emphasis on
consumer issues, I believe the functions of consumer protection
should not be separated from the role of safety and soundness.
Loans that take unfair advantage of consumers adversely affect
the safety and soundness of financial institutions. Regulators
must consider an institution's activities holistically, to
detect emerging problems and have adequate tools to respond.
Too narrow a mission could lead to myopic, impractical
regulations, increasing the likelihood of negative unintended
consequences and threatening to undermine the safety and
soundness of financial institutions. Assigning the consumer
protection function to a new stand-alone agency with a limited
mandate would create yet another federal bureaucracy, at a time
when I believe we need to be streamlining and avoiding counter-
productive regulatory turf wars.
I recognize that the Federal Reserve Board may have been
slow to take up consumer protection responsibilities placed on
it by Congress. However, I believe that the current crisis has
demonstrated to the Fed the importance of consumer protection
to the health of our financial institutions and the economy as
a whole.
THE FEDERAL RESERVE BOARD SHOULD BE THE SYSTEMIC REGULATOR
The Panel's report correctly identifies the need for a
federal systemic risk regulator, and I concur with proposals,
such as those by the Group of Thirty, that this role be
performed by a country's central bank.
The current crisis has demonstrated that the Federal
Reserve Board, our nation's central bank, is ideally suited to
harness the tools available to it to address systemic risk. The
Fed has played a pivotal role in designing and implementing
solutions to the current financial crisis and has gained
unparalleled insight into risks presented by non-banking as
well as banking institutions. However, the Fed still has no
explicit authority over many non-banking organizations that
meet the definition for being ``systemically significant.'' The
Fed's function in setting monetary policy, as well as
supervising banking organizations and providing discount window
facilities, strategically places it at the heart of the
nation's regulatory nerve center. Creating new agencies to
perform these broader systemic tasks would needlessly duplicate
existing functions, dilute current levels of expertise and fail
to take advantage of the wealth of experience accumulated by
the Fed. The Federal Reserve's mission could easily be updated
to formally incorporate these tasks into a broader mandate. I
am confident that result would be a healthier, more vibrant
financial system.
WE NEED TO RESTORE THE CONFIDENCE OF THE AMERICAN PUBLIC
As the Panel's report states, we need to restore a proper
balance between free markets and the regulatory framework, in
order to ensure that those markets operate to protect the
economy, honest market participants and the public. I look
forward to working with Congress to address the issues the
report identifies, so that we can restore the confidence of the
American public in the financial services system.
CONGRESSMAN JEB HENSARLING AND FORMER SENATOR JOHN E. SUNUNU
PREFACE
As part of the Economic Emergency Stabilization Act of 2008
(Pub. L. No. 110-343), Congress required that the newly
established Congressional Oversight Panel (the Panel) prepare a
report ``analyzing the current state of the regulatory system
and its effectiveness at overseeing the participants in the
financial system and protecting consumers, and providing
recommendations for improvement, including recommendations
regarding whether any participants in the financial markets
that are currently outside the regulatory system should become
subject to the regulatory system, the rationale underlying such
recommendation, and whether there are any gaps in existing
consumer protections.'' Even in an environment where dozens of
organizations have already offered their own perspective on the
economic crisis and regulatory reform, assembling such a
document in the short time the Panel has been in operation
would be a daunting task. Adding to the challenge, the Panel is
a diverse group which possessed a dedicated, but minimal staff
well into the middle of January. As a result, much of the work
drafting the Panel Report was given to individuals outside its
operation.
Building consensus over such a broad range of economic
questions would be difficult in any event. The timing and
process for preparing this document, unfortunately, made it
more so. Given the differences that remain regarding our views
of the systemic weaknesses that led to the crisis, and, more
important, policy recommendations for reform, we have chosen
not to support the Panel Report as presented. Instead, we
provide here a more concise statement of the underlying causes
of the current financial crisis and a series of recommendations
for regulatory modernization. While there are several points in
the Panel Report with which we agree, we also provide a summary
of several areas where our disagreement led us to oppose the
final product.
This statement is organized into several sections:
1. Introduction
2. Observations on Current State of Financial
Regulation
3. Underlying Causes of the Credit Crisis
4. Recommendations for Financial Service Regulatory
Modernization and Reform
5. Differences with Congressional Oversight Panel
Recommendations
In preparing this summary, we drew heavily from several
sources, which presented a range of views, but in which we also
shared many common themes and recommendations. These include
the Group of 30's Financial Reform: A Framework for Financial
Stability, the Committee on Capital Markets Regulation's
Recommendations for Reorganizing the U.S. Financial Regulatory
Structure, the GAO's A Framework for Crafting and Assessing
Proposals to Modernize the Outdated U.S. Financial Regulatory
System, and the Department of the Treasury's Blueprint for a
Modernized Financial Regulatory Structure. Others playing an
influential role in helping frame the often complicated policy
questions engendered by this work include the scholars at the
American Enterprise Institute (AEI), particularly Peter
Wallison and Alex Pollock, as well as those at George Mason
University's Mercatus Center, including Professor Todd Zywicki,
Houman B. Shadab, and Satya Thallam.
If one theme emerged among others in these differing
perspectives on the challenges ahead, it is that our pursuit
should not be simply to identify new rules or areas in which to
regulate, but to build a structure and system that is modern
and appropriate to the institutions and technologies being used
every day. A well-designed system should enhance market
discipline, minimize risks to taxpayers, and avoid the pitfalls
of unintended consequences. We hope our recommendations are
true to these objectives.
INTRODUCTION
Since the collapse and rescue of Bear Stearns in March
2008, legislators, regulators, and financial market
participants have found themselves enmeshed in a discussion of
whether the financial system needs to be saved, and, if so, how
best to save it. In October 2008, Congress passed the Emergency
Economic Stabilization Act (EESA), which made available $700
billion for the purpose of purchasing mortgage-backed
securities from financial institutions in hope of stabilizing
the financial system. Shortly after Congress voted to make
these funds available, the Treasury Department changed course
and instead decided to purchase capital in the nation's
financial institutions to free up credit markets.
Recent events--including additional losses by the nation's
financial institutions, new Treasury programs to support two of
the country's largest financial firms, and reports that the
sums spent thus far on recapitalizing financial institutions
have had only modest impact--demonstrate that while identifying
problems in a marketplace might be easy, the task of isolating
those problems, diagnosing their cause, and discerning how best
to address them remains challenging. The conversation over how
best to revive the financial system continues, and despite its
urgency, it is essential that the participants in that
conversation not rush to act in pursuit of a plan that fails to
solve the problems we face, or makes them worse.
Beyond the pressing challenges to stabilize our economic
system, however, is the broader question of how best to oversee
our financial system. If reorganization is to be done
responsibly, it will demand an extraordinary amount of study,
research, thought, and discussion, beginning with a careful,
unbiased consideration of what exactly led to the crisis that
now threatens our financial system. The observations and
recommendations contained in these views should therefore be
viewed as a preliminary contribution to the debate, not the
final word. If not for reasons of modesty, then for reasons of
prudence and responsibility, readers should be cautioned that
this represents the opening round of a longer conversation
regarding the future of our financial system.
While the rapid escalation of the credit crisis last fall
forced Congress to forgo a more deliberative process in
considering policy options to respond, it is widely
acknowledged now by both proponents and opponents of
congressional action that properly addressing this crisis will
involve a more carefully crafted response than the broadly
defined powers given to Treasury under the $700 billion EESA.
The stakes are no less important in regulating our financial
system, for the consequences of mistakes made in rushing to fix
a problem not fully understood will sow the seeds of even
greater problems in the future.
As a precursor for constructive reform, policy makers must
first avoid a reflexive urge to simply write new rules. In the
wake of the largest financial crisis since the Great
Depression, some have called immediately to ``reregulate'' the
financial system to prevent calamities like this from occurring
again. Those that believe that regulation is the only answer,
however, ignore the significant ways in which government
intervention magnified our existing problems. In fact, there
are few, if any, segments of the economy in which government
regulates, intervenes, and legislates as heavily as it does in
the financial and housing sectors. Before embracing more
government regulation as the only answer, such advocates should
consider the many ways in which government regulation itself
can be part of the problem. The history of financial regulation
is replete with such examples as either regulators or
regulation have simply failed or made matters worse.
In fact, the hallmark of past efforts to regulate the
financial system has been that government regulation frequently
fails. History has also repeatedly shown us that adding rigid
new government regulations in the midst of a crisis to solve
existing problems may be like the old military adage of armies
being prepared to fight the last war. For example:
1. For decades, banking regulators tried to fix
deposit prices nationally through ``Regulation Q,''
which effectively denied savers significant amounts of
interest and, in turn, imperiled thrifts and banks as
deposits fled when interest rates were high. As with
all government regulation, Reg Q was grounded in the
belief that government mandates could manage market
forces and keep banks safer.
2. Twenty years ago, in response to the failure of
1,600 commercial banks in the savings and loan crisis,
the federal government enacted the Federal Deposit
Insurance Corporation Improvement Act of 1991 (Pub. L.
No. 102-242) (FDICIA), which significantly tightened
bank and S&L regulation in an attempt to generate
stability. However, the tougher restrictions of FDICIA
did not fix the problem, and the savings and loan
crisis ended up costing American taxpayers over $120
billion.\114\
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\114\ Timothy Curry and Lynn Shibut, The Cost of the Savings and
Loan Crisis: Truth and Consequences, FDIC Banking Review (December
2000) (online at www.fdic.gov/bank/analytical/banking/2000dec/
brv13n2_2.pdf).
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3. More recently, state and federal legislation
mandated the use of credit ratings from a few rating
agencies, which effectively transformed these agencies
into a government-sponsored cartel. What began as an
impulse to bring safety and objectivity to the
regulation of broker-dealers ended by creating a
concentrated point of failure, jeopardizing the entire
financial system.
4. Finally, there is the example of the Federal
Reserve's effort to use monetary policy to avoid the
recessionary effects of the tech bubble's bursting,
only to find that in doing so, it had helped create the
housing bubble.
In addition to its demonstrated failure in preventing
financial collapse, regulation imposes significant costs on the
financial system in several ways. For example, rather than
increasing stability and enhancing safety, regulation can
invite chaos and encourage otherwise irrational risk taking
among market participants who falsely believe that government
will act as a guardian angel to protect them. Market
participants thus underprice risk because they conjecture
government has managed the risks that market participants would
otherwise have had to assess. However, in reality, any
government--from our current one to the most heavy-handed of
all totalitarian central planners--can never completely
regulate a market given its resource constraints and the
ingenuity of individual entrepreneurs with a proper profit
motive.
Regulation can also reduce competition because its costs
are more easily borne by large companies than by small ones.
Large companies also have the ability to influence regulators
to adopt regulations that favor their operations over those of
smaller competitors. This is particularly true when regulations
add costs that smaller companies cannot bear. Take, for
example, the continuing decline in the number of community
banks, the locally owned and operated institutions at the heart
of many small towns and cities across the county. In 2004, the
Federal Deposit Insurance Corporation (FDIC) released a report
on the future of banking that found that although community
banks still make up a majority of the banking industry, the
number of community banks had been cut almost in half since
1985. The report also found that their deposit share has also
declined significantly in that time frame as large banks
extended their geographic reach.\115\ Regulation also may keep
low cost producers or international competitors out of
regulated markets.
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\115\ Tim Critchfield with Tyler Davis, Lee Davison, Heather
Gratton, George Hanc, and Katherine Samolyk, Community Banks: Their
Recent Past, Current Performance, and Future Prospects (2004) (online
at www.fdic.gov/bank/analytical/future/fob_03.pdf) (hereinafter ``FDIC
Future of Banking Study'').
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Regulation can also harm consumers in the form of higher
costs, less innovation, and fewer choices. Regulatory costs are
passed along to consumers through higher prices for services or
products. For an example, one need only look at their monthly
telephone bill to see firsthand how the cost of various
government regulations imposed on phone services are directly
passed on to consumers in the form of new fees. Since the
application of regulations over a population is generally
universal but the direct benefits are often only individually
realized, many regulations end up imposing costs on all
consumers for the benefit of a limited few. Additionally, the
associated cost of some regulations end up exceeding their
value by adding costs to the process of developing new products
or new services. There are countless examples of this
phenomenon in the insurance industry, where it can take years
to achieve the regulatory approval needed to roll out a new
product offering or, in some bewildering cases, to enact rate
reductions for the benefit of consumers if the reduction is
approved at all.\116\
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\116\ John Kennedy, Gov. Crist, State Regulators Reject State
Farm's 7 Percent Rate Reduction, Chicago Tribune (July 31, 2007)
(online at www.chicagotribune.com/business/sfl-
0731statefarm,0,3467689.story).
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Instead of creating new regulatory hurdles, a superior
approach to better protect consumers and preserve wealth-
creating opportunities is to enhance and reinforce wise
regulation while bolstering private sector market discipline.
This belief was well articulated in March 2000, when Gary
Gensler, then Under Secretary for Domestic Finance in President
Clinton's Treasury Department and currently President Obama's
nominee to chair the Commodity Futures Trading Commission
(CFTC), testified before the House Financial Services Committee
regarding systemic risk in our capital markets. Over the course
of his remarks, Gensler explained that instead of advocating
for new or increased regulations, the approach supported by
Treasury emphasized the formative role of the private sector in
protecting market participants:
The public sector has three roles. . . . Promoting
market discipline means crafting government policy so
that creditors do not rely on governmental intervention
to safeguard them against loss.
Transparency is the necessary corollary to market
discipline. The government cannot impose market
discipline, but it can enhance its effectiveness by
promoting transparency. Transparency lessens
uncertainty and thereby promotes market stability.
Promoting competition in financial markets lessens
systemic risk. The task of public policy must be to
ensure the stability and integrity of the market
system. In any sector of the financial market, the
dominance of one or two firms can lessen competition
and the efficiency of the market pricing mechanism. In
addition, the entry of a subsidized financial
institution into a market may motivate other firms to
take on greater risks and weaken their operating
results.\117\
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\117\ House Financial Services Committee, Subcommittee on Capital
Markets, Securities, and Government Sponsored Enterprises, Testimony of
Gary Gensler, Securities and Government Sponsored Enterprises, 106th
Cong. (Mar. 22, 2000) (online at financialservices.house.gov/banking/
32200gen.htm).
Under Secretary Gensler had the right idea then, and his
words should help provide the framework for the structural
changes to our regulatory regime that we are now considering.
OBSERVATIONS ON CURRENT STATE OF FINANCIAL REGULATION
The United States has the most robust, accessible, and
sound financial structure of any country in the world. That
structure has provided unparalleled opportunities for millions,
from seasoned market participants to casual investors to
hardworking teachers and nurses hoping to live out the American
dream. The success of our structure has been based on market
discipline coupled with an appropriate level of regulation that
fosters competition, transparency, and accountability.
Yet recently, this approach has been attacked by a small
but vocal chorus claiming that two decades of financial
deregulation has initiated the crisis that our financial system
is now facing. These advocates of expanded government power
contend that for years, government has been hard at work
repealing all aspects of regulation in our financial sector.
However, while such rhetoric might elicit some populist appeal,
such claims do not bear scrutiny because the facts simply do
not exist to support them.
One frequent argument heard from many critics is that the
Gramm-Leach-Bliley Act (P.L. 106-102), which repealed the
Depression-era Glass-Steagall Act's separation of investment
and commercial banking, was somehow responsible for the current
credit crisis. To the contrary, a wide variety of experts
across the political spectrum have dismissed that claim as ``a
handy scapegoat''\118\ at best. When asked in October 2008 if
Gramm-Leach-Bliley was a mistake, Alice M. Rivlin, the former
director of both the Congressional Budget Office and the Office
of Management and Budget, testified: ``I don't think so, I
don't think we can go back to a world in which we separate
different kinds of financial services and say these lines
cannot be crossed. That wasn't working very well. . . . We
can't go back to those days, we have got to figure out how to
go forward.'' \119\ Even former President Bill Clinton remarked
in a 2008 interview that ``I don't see that signing that bill
had anything to do with the current crisis.'' \120\ If
anything, Gramm-Leach-Bliley has played a significant role in
attenuating the severity of this crisis by allowing commercial
banks to merge with floundering investment banks--like JPMorgan
Chase and Bear Stearns, Bank of America and Merrill Lynch, and
Goldman Sachs and Morgan Stanley--actions that would have been
explicitly prohibited had the Glass-Steagall Act still been in
effect.
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\118\ David Leonhardt, Washington's Invisible Hand, New York Times
(Sept. 26, 2008).
\119\ House Financial Services Committee, Oral Remarks of Alice
Rivlin, The Future of Financial Services Regulation, 110th Cong. (Oct.
21, 2008) (online at financialservices.house.gov/hearing110/
hr102108.shtml).
\120\ Bill v. Barack on Banks, Wall Street Journal (Oct. 1, 2008)
(online at online.wsj.com/article/SB122282635048992995.html).
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Although the advocates for expanded government power would
have you believe otherwise, a careful examination of the
historical record points toward the conclusion that regulation
of the financial services sector has at least held constant if
not substantially increased in recent years. One need only
think about the sprawling regulatory mandate that the Sarbanes-
Oxley Act (P.L. 107-204) imposed upon our financial system.
Intended to toughen financial reporting requirements in the
wake of the Enron scandal, Sarbanes-Oxley has created many
needed reforms but its burden has also resulted in many
companies taking their business--and their money--overseas. The
result has been a flow of capital away from the U.S., capital
which could have helped to shore-up American banks. In addition
to Sarbanes-Oxley, over the last twenty years the federal
government has implemented a wide array of new regulations on
banks, mortgage lenders, and other financial services
companies. These new regulations include:
1. The Federal Deposit Insurance Corporation Improvement
Act of 1991 (P.L. 102-242), which was designed to improve bank
supervision, examinations, and capital requirements.
2. The Home Ownership and Equity Protection Act (HOEPA) of
1994 (P.L. 103-325), which mandates enhanced disclosures by
lenders who make certain high-cost refinancing loans to
borrowers.
3. The 1989 and 2002 expansions of the mandated data
furnished by lenders under the Home Mortgage Disclosure Act
(HMDA).
4. The 2001 Bank Secrecy Act amendments made by the USA
PATRIOT Act (P.L. 107-56), which enhanced anti-terrorist and
money laundering record-keeping requirements for banks.
5. The Fair and Accurate Credit Transactions Act of 2003
(P.L. 108-159), which created new information sharing,
indentify theft protection, and consumer disclosure mandates.
6. The Bankruptcy Abuse Prevention and Consumer Protection
Act of 2005 (P.L. 109-8), which required lenders to provide new
disclosures regarding credit offers and interest rates.
7. Various other Truth in Lending Act (TILA)/Regulation Z
regulations and other federal banking agency guidance regarding
lending, offers of credit, and consumer protections.
In fact, instead of wholesale deregulation, the case can be
made that government has made concerted efforts to strengthen
the very regulations that helped set the stage for the current
financial crisis. To take one obvious example, there has been a
strengthening of the Community Reinvestment Act, which has
encouraged banks to make mortgage loans to borrowers who
previously would have been rejected as non-creditworthy. Also,
the Department of Housing and Urban Development's (HUD)
affordable housing mandates for the government-sponsored
enterprises (GSEs) were steadily increased from the 1990s
through 2008, adding new targets and rules that compelled
Fannie and Freddie to take certain loan purchasing actions to
stay in compliance. Additionally, U.S. bank regulators are
moving to quickly implement new capital requirements through
the Basel II capital accord, which was less than two years old
when plans for its adoption were announced on September 30,
2005. These untested rules will replace the Basel I rules that
generally assigned lower capital charges for housing assets,
which tended to increase the leveraging of housing-related
assets, making our financial system less stable.\121\
---------------------------------------------------------------------------
\121\ Risk-based Capital Standards: Advanced Capital Adequacy
Framework--Basel II, 72 Fed. Reg. 69,288 (Dec. 7, 2007) (to be codified
at 12 C.F.R. pts. 3, 208, 225, 325, 559, 560, 563, 567) (online at
www.setonresourcecenter.com/register/2007/Dec/07/69288A.pdf).
---------------------------------------------------------------------------
Furthermore, proponents of the ``regulation is the cure''
argument must bear in mind that the most egregious financial
failures have occurred not in the unregulated financial markets
of hedge funds and over-the-counter derivatives, but in the
highly regulated world of commercial and investment banking,
where regulation has been the most burdensome. The former U.S.
investment banks--which bought the so-called toxic assets that
have been identified as one of the root causes of the financial
crisis--were regulated by the Securities and Exchange
Commission (SEC). Yet that supervision was insufficient to
prevent the collapse of Bear Stearns or Lehman Brothers, two of
this nation's largest investment banks, or the charter
transformation of two other large investment banks, Goldman
Sachs and Morgan Stanley, into bank holding companies. The
credit rating agencies that blessed these products with AAA
ratings were also regulated by the SEC, yet that supervision
was not enough to prevent the inaccurate evaluations and gross
errors in judgment of those agencies.
This nation's highly regulated commercial banks, subject to
regulation by several agencies similarly snapped up large
quantities of these assets, all while supposedly under the
oversight and supervision of their regulators. Yet the results
of this country's heavy regulation of commercial banks have
also been abysmal. Wachovia, formerly the nation's fourth
largest bank, was regulated by the Comptroller of the Currency
(OCC). Countrywide Financial was a national bank under OCC
supervision until mid-2007, and then it became a federal thrift
regulated by the Office of Thrift Supervision (OTS). Washington
Mutual, IndyMac and Downey Savings and Loan Association were
all also federal thrifts regulated by the OTS. All five were
well regulated. And the housing market collapse caused all five
to fail.\122\
---------------------------------------------------------------------------
\122\ Binyamin Appelbaum and Ellen Nakashima, Banking Regulator
Played Advocate Over Enforcer, Washington Post (Nov. 23, 2008.) (online
at www.washingtonpost.com/wp-dyn/content/article/2008/11/22/
AR2008112202213_pf.html).
---------------------------------------------------------------------------
By contrast, many of the less stringently regulated actors
in the financial system, such as hedge funds and other private
pools of capital, and less stringently regulated products, such
as derivatives and swaps traded over the counter, seem to have
weathered the crisis better than their highly regulated
counterparts. While investors in some of those products have
lost money, and some of the companies engaged in those lines of
business have closed their doors, these failures did not
produce massive systemic risk concerns that required federal
intervention placing taxpayer dollars at risk.
These observations lead to the clear point that heavy
regulation, despite the outsized claims made for its
effectiveness in avoiding crisis, will not solve our problems.
As financial historian Bernard Shull stated in a 1993 paper on
the matter:
Comprehensive banking reform, traditionally including
augmented and improved supervision, has typically
evoked a transcendent, and in retrospect, unwarranted
optimism. The Comptroller of the Currency announced in
1914 that, with the new Federal Reserve Act,
``financial and commercial crises or panics . . . Seem
to be mathematically impossible.'' Seventy-five years
later, confronting the S&L disaster with yet another
comprehensive reform . . . The Secretary of the
Treasury proclaimed ``two watchwords guided us as we
undertook to solve this problem: Never Again.'' \123\
---------------------------------------------------------------------------
\123\ Bernard Shull, The Limits of Prudential Supervision: Economic
Problems, Institutional Failure and Competence (1993) (online at
www.levy.org/download.aspx?file=wp88.pdf&
pubid=378).
More than fifteen years after Shull's paper, many stand
ready to march down the same well-worn path, clinging to the
belief that heavy-handed regulation holds the answer. Those
claims should be rejected. There is a better and more effective
path to choose.
A BRIEF HISTORY OF THE SUBPRIME CRISIS
To some observers, the turmoil in the U.S. financial
markets, caused by severe dislocations in the country's housing
markets, has heralded the end of the free-market system. But
with all due respect to the critics of capitalism, the economic
crisis in which the country now finds itself reflects not the
failure of the free-market system, but more so the result of
decades of misguided government policies that interfered with
the functioning of that system. While recent events demonstrate
a need for regulatory reform, modernization, and improvement,
the larger lesson is that a number of well-meaning but clearly
misguided government policies distorted America's housing
markets, which in turn produced grave consequences for the
financial system and the underlying economy.
In a rush to be seen as doing ``something'' in response,
the advocates of expanded government power have brought forward
a range of old proposals to regulate, reregulate, and
overregulate any and every aspect of our economy. We believe a
more practical approach would be to identify and correct the
government policies that inflated the housing bubble underlying
this crisis and then decide what change is necessary. Thus, the
essential debate is not between deregulation and re-regulation,
but instead between wise regulation and counterproductive
regulation. Wise regulation helps make markets more competitive
and transparent, empowers consumers with effective disclosure
to make rational decisions, effectively polices markets for
force and fraud, and reduces systemic risk. Counterproductive
regulation hampers competitive markets, creates moral hazard,
stifles innovation, and diminishes the role of personal
responsibility in our economy. It is also procyclical, passes
on greater costs than benefits to consumers, and needlessly
restricts personal freedom.
Those who simply advocate for reregulation because they
claim that the free markets have failed ignore the various ways
that government itself helped set the stage for the current
financial crisis. The housing sector--where the difficulties
confronting our markets started--is not a deregulated, free-
market in any sense of the word. This country's housing market
is overloaded with substantial government components, including
the regulatory roles of large government agencies; implicit and
explicit government guarantees supporting the underwriting,
issuance, and securitization of mortgages; and a cluster of
mandates aimed at achieving universal home ownership. Indeed,
the crisis this country finds itself facing does not stem from
deregulation (since little has taken place over the last couple
of decades) or even the mistakes of participants in the free
market (although many harmful mistakes were committed), but
instead from the myriad ways in which government initiatives
interfered with the functioning of private markets.
Our observations have led us to conclude that there are at
least five key factors that led to the current crisis:
1. A highly accommodative monetary policy that
lowered interest rates dramatically, kept them low, and
inflated the housing bubble.
2. Broad federal policies designed to expand home
ownership in an ``off-budget'' fashion, which
encouraged lending to those who could not afford home
ownership.
3. The moral hazard inherent in Fannie Mae and
Freddie Mac, the two failed GSEs, which exploited their
congressionally granted duopoly status to benefit from
privatized profits earned against socialized risks
taken.
4. An anticompetitive government sanctioned credit
rating oligopoly that misled investors and failed in
its responsibility to provide accurate, transparent
assessments of risk.
5. Failures throughout the mortgage securitization
process that resulted in the abandonment of sound
underwriting practices.
Monetary Policy. The Federal Reserve set the stage for a
wave of mortgage borrowing by keeping credit conditions too
loose for too long earlier this decade. In response to the
bursting of the high-tech bubble in 2000, the Federal Reserve
began lowering interest rates in early 2001 to cushion the
economic fallout. These highly accommodative policies were
maintained in response to the 2001 recession and the economic
shock of the 9-11 terrorist attacks. The target for the federal
funds rate--the benchmark interbank lending rate in the U.S.--
was lowered to just 1 percent by mid-2003, and maintained at
that level until mid-2004.\124\ The real funds rate--which is
the difference between the funds rate set by the Federal
Reserve and expected inflation--demonstrates just how
aggressively the Federal Reserve was in conducting monetary
policy during this period. The real funds rate dropped from 4
percent in late 2000 to -1.5 percent by early 2003.\125\
---------------------------------------------------------------------------
\124\ Federal Reserve Board, Open Market Operations (online at
www.federalreserve.gov/fomc/fundsrate.htm) (accessed Jan. 26, 2009).
\125\ Mark Zandi, Financial Shock: A 360+ Look at the Subprime
Mortgage Implosion, and How to Avoid the Next Financial Crisis (2009).
---------------------------------------------------------------------------
The Federal Reserve's decision to cushion the economic blow
from the dramatic collapse in equity prices unleashed a wave of
cheap credit on a housing market that was already experiencing
a boom cycle. By mid-2003, the interest rate on a conventional
thirty-year mortgage dipped to an all-time low of just 5.25
percent, fueling demand in the housing market thanks to
mortgage credit that had become cheap and plentiful in light of
the Federal Reserve's rate cuts.\126\ As a result of demand and
cheap credit, new home construction rose to a twenty-five-year
high in late 2003, and remained at historic levels for two
years.\127\
---------------------------------------------------------------------------
\126\ Federal Reserve Bank of St. Louis, Economic Research (online
at research.stlouisfed.org/fred2/series/MORTG/).
\127\ Remarks of John B. Taylor at the Symposium of Housing,
Housing Finance, and Monetary Policy sponsored by the Federal Reserve
Bank of Kansas City in Jackson Hole, Wyoming (Sept. 2007) (online at
www.kc.frb.org/PUBLICAT/SYMPOS/2007/PDF/Taylor_0415.pdf).
---------------------------------------------------------------------------
It has been widely reported that over the last fifty years,
there has not been a single year in which the national average
home value had fallen despite some regional declines and
various economic troubles and recessions. The allure of this
statistic was so appealing that even former Federal Reserve
Chairman Alan Greenspan and current Chairman Ben Bernanke at
various points attested to it in defense of our housing
markets. In fact, a 2004 report by top economists from Fannie
Mae, Freddie Mac, the National Association of Realtors, the
National Association of Home Builders, and the Independent
Community Bankers of America entitled America's Home Forecast:
The Next Decade for Housing and Mortgage Finance even concluded
that ``there is little possibility of a widespread national
decline since there is no national housing market.'' \128\ This
widely held belief augmented Federal Reserve monetary policy
and further inflated the housing bubble.
---------------------------------------------------------------------------
\128\ David Leonhardt and Vikas Bajaj, Drop Foreseen in Median
Price of U.S. Homes, New York Times (Aug. 26, 2007) (online at
www.nytimes.com/2007/08/26/business/
26housing.html?ei=5090&en=9bd44f2f8b0ef4f4&ex=1345780800&partner=rssuser
land&emc=rss&pagewanted=all).
---------------------------------------------------------------------------
Even with the brisk pace of home construction, demand still
outstripped supply, pushing home prices even higher. Between
1995 and 2002, in the midst of the housing boom, home prices
appreciated between 2 percent and 5 percent a year. By 2004 and
2005, at the height of the bubble, home prices were
appreciating at nearly 15 percent per year. Between 1997 and
2006, real home prices for the U.S. as a whole increased 85
percent. Another measure of the unsustainable inflation that
took place in housing prices is the relationship between house
prices and rents. Over the past twenty-five years, the price-
to-rent ratio was roughly 16.5. In 2003, at the start of the
bubble, the price-to-rent ratio was 18.5. It then quickly grew
to an all-time peak of 25 by the end of 2005.\129\
---------------------------------------------------------------------------
\129\ Zandi, supra note 125; Robert J. Shiller, The Subprime
Solution: How Today's Global Financial Crisis Happened, and What to Do
About It (2008).
---------------------------------------------------------------------------
The bubble grew as cheap credit and sharply increasing home
prices fueled the frenzy of first-time homeowners eager to buy
into a market before prices got out of reach. It also
encouraged current homeowners to purchase bigger homes or to
buy additional properties for investment purposes. Federal
Reserve economists have estimated that the share of investment
real estate purchases jumped to roughly 17 percent in 2005 and
2006 at the height of the housing boom, up from just more than
6 percent a decade earlier.\130\
---------------------------------------------------------------------------
\130\ Robert B. Avery, Kenneth P. Brevoort, and Glenn B. Canner,
The 2006 HMDA Data, Federal Reserve Bulletin (Dec. 2007).
---------------------------------------------------------------------------
These double digit increases in housing prices not only
stimulated demand among home buyers who wanted to get into the
housing market before they were priced out or were eager to
invest on rising home prices, they also created an environment
in which lenders, securitizers, and investors believed that it
was impossible to make a bad loan. The consequences should have
been foreseeable. Borrowers bought bigger, more expensive
homes, betting that perpetually rising housing prices would
allow them to refinance their mortgages at a later date while
benefiting from ongoing appreciation in housing values. Lenders
assumed that even if buyers defaulted, rising house prices
would allow them to sell the home for more than the amount owed
by the borrower.
Economists have consistently identified the Federal
Reserve's accommodative monetary policy as one cause of the
current financial crisis. For example, John B. Taylor, a
professor of economics at Stanford and the creator of the
``Taylor rule'' guideline for monetary policy, has said the
Federal Reserve made a mistake by keeping interest rates so
low. According to Taylor's formula, the Federal Reserve should
have raised interest rates much sooner than it did given the
economic conditions at the time. Taylor himself has said that
``a higher funds path would have avoided much of the housing
boom. . . . The reversal of the boom and thereby the resulting
market turmoil would not have been as sharp.''\131\ Given the
key role that the Federal Reserve's monetary policy has played
in contributing to the credit crisis we now face, it must be
acknowledged that those decisions had a major impact on market
conditions and helped to influence how investors chose to
allocate their capital in our economy.
---------------------------------------------------------------------------
\131\ Taylor, supra note 127.
---------------------------------------------------------------------------
Federal Policy to Expand Home Ownership. For well over
twenty years, federal policy has promoted lending and borrowing
to expand homeownership, through incentives such as the home
mortgage interest tax exclusion, the Federal Housing
Administration (FHA), and discretionary spending programs such
as HUD's HOME block grant program. But perhaps the most
damaging initiative undertaken by the federal government was
the effort to pressure private financial institutions to
subsidize home ownership through the Community Reinvestment Act
(CRA). Undertaken with the best of intentions--expanding home
ownership among poor and underserved communities--the
unintended consequences of the CRA clearly demonstrate that
government's attempts to manipulate market behavior to achieve
social goals often lead to harmful results.
Enacted in 1977, the CRA encouraged banks to extend credit
to ``underserved'' populations by requiring that banks insured
by the federal government ``help meet the credit needs of its
entire community.'' To ensure that banks are meeting this
mandate, each federally insured bank is periodically examined
by its federal regulator. As a result of its enactment, bank
lending to low- and moderate-income families has increased by
80 percent.\132\
---------------------------------------------------------------------------
\132\ U.S. Department of the Treasury, The Community Reinvestment
Act after Financial Modernization: A Baseline Report (Apr. 2000).
---------------------------------------------------------------------------
In 1997, Wall Street firms, the GSEs, and the CRA converged
in a landmark event: the first securitization of CRA loans, a
$384-million offering guaranteed by Freddie Mac.\133\ Over the
next 10 months, Bear Stearns issued $1.9 billion of CRA
mortgages, backed by Fannie or Freddie, and between 2000 and
2002 this business accelerated in dramatic fashion as Fannie
Mae issued $20 billion in securities backed by CRA
mortgages.\134\ By encouraging lenders and underwriters to
relax their traditional underwriting practices, the CRA,
investment firms and the GSEs saddled American taxpayers with
the consequences of mortgages that borrowers cannot repay.
---------------------------------------------------------------------------
\133\ First Union Capital Markets Corp., Bear, Stearns & Co. Price
Securities Offering Backed By Affordable Mortgages Unique Transaction
to Benefit Underserved Housing Market (Oct. 20, 1997).
\134\ Fannie Mae Increase CRA Options, ABA Banking Journal (Nov. 1,
2000).
---------------------------------------------------------------------------
Equally problematic are reports that some of these CRA-
inspired loans are mortgages that borrowers can repay, but
choose not to, given that the property that secures these loans
is now worth less than the amount outstanding. Whether
borrowers cannot or will not repay, the irony is that these
lower-income home buyers--those who were supposed to benefit
from the government's actions--are now defaulting at a rate
three times that of other borrowers. With these defaults, the
damage to homeowners, neighborhoods, state and local
governments as the tax base shrinks, and now to all American
taxpayers, is enormous.
In the course of this crisis, there has been some heated
discussion over the role CRA loans have played in contributing
to our current woes. Proponents of CRA-like mandates have
maintained that only a small portion of subprime mortgage
originations are related to the CRA, and those CRA loans that
have been written are performing in a manner similar to other
types of subprime loans. Such claims, however, miss the
fundamental point that critics of the CRA have made: though
they may be small in volume, CRA loan mandates remain large in
precedent because they inherently required lending institutions
to abandon their traditional underwriting standards in favor of
more subjective models to meet their government mandated CRA
obligations.
For example, in April of 1993, the Boston Federal Reserve
Bank, under the leadership of future Freddie Mac Chairman Dick
Syron, published an influential best practices guide called
Closing the Gap: A Guide To Equal Opportunity Lending. The
guide made several recommendations to lending institutions on
various ways they could increase their low-income lending
practices. Some of these recommendations, which encouraged
institutions to abandon the traditional lending and
underwriting policies used to ensure the quality of loans made,
included:
1. ``Special care should be taken to ensure that
standards are appropriate to the economic culture of
urban, lower-income, and nontraditional consumers.''
2. ``Policies regarding applicants with no credit
history or problem credit history should be reviewed.
Lack of credit history should not be seen as a negative
factor. . . . In reviewing past credit problems,
lenders should be willing to consider extenuating
circumstances.''
3. Institutions can ``work with the public sector to
develop products that assist lower-income borrowers by
using public money to reduce interest rates, provide
down payment assistance, or otherwise reduce the cost
of the mortgage.''
4. ``A prompt and impartial second review of all
rejected applications can help ensure fairness in the
lending decision and prevent the loss of business
opportunities. . . . This process may lead to changes
in the institution's underwriting policies. . . . In
addition, loan production staff may find that their
experience with minority applicants indicates that the
institution's stated loan policy should be modified to
incorporate some of the allowable compensating
factors.'' \135\
---------------------------------------------------------------------------
\135\ Boston Federal Reserve, Closing the Gap: A Guide to Equal
Opportunity Lending (Apr. 1993) (online at www.bos.frb.org/commdev/
commaff/closingt.pdf).
Taken in isolation, the good intentions of these
recommendations is plain; taken together, however, it is also
clear that lenders were being urged to abandon proven safety
and soundness underwriting standards in favor of new outcome-
based underwriting standards. Again, the salient point is not
to debate the notion of could or should more be done to make
affordable loans available to underserved communities. The
question is what damage is done to the overall stability of an
institution when it alters its lending guidelines to comply
with a government mandate to advance a social policy.
Similarly, banks were urged by other private sector parties
to ignore traditional lending guidelines, this time in the
pursuit of greater and faster profit. In May of 1998, Bear
Stearns published an article with guidance on why and how
lenders should package CRA loans into mortgage backed
securities.\136\ That document advised lenders that:
``Traditionally rating agencies view LTV (loan-to-value ratios)
as the single most important determinant of default. It is most
important at the time of origination and less so after the
third year.'' Bear Stearns also encouraged lower lending
standards by arguing that when ``explaining the credit quality
of a portfolio to a rating agency or GSE, it is essential to go
beyond credit scores,'' and that ``the use of default models
traditionally used for conforming loans have to be adjusted for
CRA affordable loans.'' While such advice might have been
important to maximizing profitability, Bear Stearns' guidance
is yet one more example of how the conflict between a social
policy mandate like the CRA and the fiscal requirements of
basic safety and soundness operations led to a dangerous
diminution in lenders' traditional underwriting standards.
---------------------------------------------------------------------------
\136\ Dale Westhoff, Packaging CRA Loans into Securities, Mortgage
Banking (May 1, 1998) (online at www.allbusiness.com/personal-finance/
real-estate-mortgage-loans/677967-1.html).
---------------------------------------------------------------------------
The GSEs. Standing at the center of the American system of
mortgage finance are the two now-failed government-chartered
behemoths created to expand homeownership opportunities: the
Federal National Mortgage Association (Fannie Mae) and the
Federal Home Loan Mortgage Corporation (Freddie Mac). Market
participants have long understood that this government created
duopoly was implicitly, though not explicitly, backed by the
federal government. This ``implied guarantee'' flowed from
several factors, including the very existence of a government
charter that effectively sanctioned this duopoly, access to a
Treasury line of credit, and exemption from payment of state
and local taxes. Although Fannie and Freddie were nominally
designed to be competitors, in practice this implied guarantee
allowed the two largely to work in unison as a cartel to set
and maintain prices in the market.
The dangers inherent in such an implied guarantee were
twofold. First, their unique status allowed Fannie and Freddie
to borrow funds in the marketplace at subsidized rates.
Ostensibly, these funds would be used to purchase mortgages
from lenders, fulfilling their mission to provide liquidity in
the secondary mortgage markets. For over a decade, however, the
GSEs continued to build enormous investment portfolios, earning
profits by arbitraging the difference between their low,
subsidized borrowing costs and the higher yields in their
portfolio's ever riskier assets. Beginning in 1990, their
investment portfolios grew tenfold, from $135 billion to $1.5
trillion,\137\ allowing many of their shareholders and
executives to become personally wealthy thanks to the GSEs'
subsidized borrowing costs while the American taxpayer assumed
most of the risk.
---------------------------------------------------------------------------
\137\ U.S. Department of the Treasury, Remarks of Assistant
Secretary for Financial Institutions Emil W. Henry Jr., before the
Housing Policy Council of the Financial Services Roundtable (June 26,
2006) (online at www.ustreas.gov/press/releases/js4338.htm).
---------------------------------------------------------------------------
Second, their implied guarantee created a false sense of
security and standards for the products they purchased and
securitized. This perception played a major role in the
proliferation of GSE-backed subprime and Alt-A securities,
providing a de facto government seal of approval for even the
riskiest loans as market participants believed these securities
were appropriately priced and represented minimal risk. Their
predominance in the mortgage market meant that Fannie and
Freddie's business practices--credit rating, underwriting, risk
modeling--were seen as the ``gold standard'' in the industry,
despite flaws that later became apparent.
For its part, Congress substantially magnified these
potential risks by charging the GSEs with a mission to promote
homeownership and thus inflating the supply of credit available
to fund residential mortgages. The GSEs' congressional mandate
and their access to cheap funding allowed the government to
pressure Fannie and Freddie to expand homeownership to
historically credit-risky individuals without the burden of an
explicit on-budget line item at taxpayer expense, a budget goal
long sought by housing advocates. For instance, in 1996, the
HUD required that 42 percent of Fannie's and Freddie's mortgage
financing should go to borrowers with income levels below the
median for a given area.\138\ HUD revised those goals again in
2004, increasing them to 56 percent of their overall mortgage
purchases by 2008.\139\ In addition, HUD required that 12
percent of all mortgage purchases by Fannie and Freddie be
``special affordable'' loans made to borrowers with incomes
less than 60 percent of an area's median income, and ultimately
increased that target to 28 percent for 2008.\140\
---------------------------------------------------------------------------
\138\ Russell Roberts, How Government Stoked the Mania, Wall Street
Journal (Oct. 3, 2008).
\139\ Id.
\140\ Id.
---------------------------------------------------------------------------
These ``affordable housing'' goals and other federal
policies succeeded at increasing the homeownership rate from 64
percent in 1994 to an all-time high of 69 percent in 2005.\141\
However, they did so at a great cost. To meet these
increasingly large government mandates, Fannie and Freddie
began to buy riskier loans and encouraged those who might not
be ready to buy homes to take out mortgages. This GSE-
manufactured demand boosted home prices to an artificially high
level and fostered enthusiasm for the wave of exotic mortgage
products that began to flood the market.
---------------------------------------------------------------------------
\141\ Id.
---------------------------------------------------------------------------
For example, in 1999, under pressure from the Clinton
Administration to expand home loans among low- and moderate-
income groups, Fannie Mae introduced a pilot program in fifteen
major markets encouraging banks to extend mortgage credit to
persons who lacked the proper credit histories to qualify for
conventional loans. The risks of such a program should have
been apparent to all. The New York Times, in a prescient
comment on the program at the time, remarked: ``In moving, even
tentatively, into this new area of lending, Fannie Mae is
taking on significantly more risk, which may not pose any
difficulties during flush economic times. But the government-
subsidized corporation may run into trouble in an economic
downturn, prompting an economic rescue.'' \142\
---------------------------------------------------------------------------
\142\ Steven A. Holmes, Fannie Mae Eases Credit to Aid Mortgage
Lending, New York Times (Sept. 30, 1999).
---------------------------------------------------------------------------
During this period, the government also began to push
Fannie and Freddie into the subprime market. In 1995, HUD
authorized Fannie and Freddie to purchase subprime securities
that included loans to low-income borrowers and allowed the
GSEs to receive credit for those loans toward their mandatory
affordable housing goals. Subprime lending, it was thought,
would benefit many borrowers who did not qualify for
conventional loans. Fannie and Freddie readily complied, and as
a result, subprime and near-prime loans jumped from 9 percent
of securitized mortgages in 2001 to 40 percent in 2006.\143\
---------------------------------------------------------------------------
\143\ Roberts, supra note 138.
---------------------------------------------------------------------------
Fannie's and Freddie's heavy involvement in subprime and
Alt-A mortgages increased following their accounting scandals
in 2003 and 2004 in an attempt to curry favor with Congress and
avoid stricter regulation. Data from these critical years
before the housing crisis hit show Fannie and Freddie had a
large direct and indirect role in the market for risky mortgage
loans. In 2004 alone, Fannie and Freddie purchased $175 billion
in subprime mortgage securities, which accounted for 44 percent
of the market that year. Then, from 2005 through 2007, the two
GSEs purchased approximately $1 trillion in subprime and Alt-A
loans, and Fannie's acquisitions of mortgages with less than
10-percent down payments almost tripled.\144\
---------------------------------------------------------------------------
\144\ American Enterprise Institute, Peter Wallison and Charles
Calomiris, The Last Trillion-Dollar Commitment: The Destruction of
Fannie Mae and Freddie Mac (Sept. 30, 2008).
---------------------------------------------------------------------------
Without question, the purchase and securitization of such
loans by Fannie and Freddie was a clear signal and incentive to
all loan originators to write more subprime and Alt-A loans
regardless of their quality. As a result, the market share of
conventional mortgages dropped from 78.8 percent in 2003 to
50.1 percent by 2007 with a corresponding increase in subprime
and Alt-A loans from 10.1 percent to 32.7 percent over the same
period.\145\ The message, as The New York Times noted, was
clear: ``[T]he ripple effect of Fannie's plunge into riskier
lending was profound. Fannie's stamp of approval made shunned
borrowers and complex loans more acceptable to other lenders,
particularly small and less sophisticated banks.''\146\ Soon,
Fannie and Freddie became the largest purchasers of the higher-
rated (AAA) tranches of the subprime pools that were
securitized by the market. This support was essential both to
form these investment pools and market them around the world.
Fannie and Freddie thus played a pivotal role in the growth and
diffusion of the mortgage securities that are now crippling our
financial system.
---------------------------------------------------------------------------
\145\ Joint Center for Housing Studies, The State of the Nation's
Housing (2008) (online at www.jchs.harvard.edu/publications/markets/
son2008/index.htm).
\146\ Charles Duhigg, Pressured to Take More Risk, Fannie Reached
Tipping Point, New York Times (Oct. 5, 2008).
---------------------------------------------------------------------------
Fannie and Freddie also played a leading role in weakening
the underwriting standards that had previously helped ensure
that borrowers would repay their mortgages. For instance, in
May 2008, Fannie and Freddie relaxed the down payment criteria
on the mortgages they buy, accepting loans with down payments
as low as 3 percent.\147\ And in recent years both companies
markedly stepped up their guarantees on Alt-A loans, which
often did not require the verification of income, savings, or
assets for potential borrowers. Between 2005 and the first half
of 2008, Fannie guaranteed at least $230 billion worth of these
risky loans, more than three times the amount it had guaranteed
on all past years combined. However, these poorly underwritten
loans are now increasingly turning sour amid the housing
downturn, especially those concentrated in California, Florida,
Nevada, and Arizona, where the housing bubble was particularly
large and real estate speculation was rampant.\148\
---------------------------------------------------------------------------
\147\ Fannie Mae Relaxes Loan Down Payment Requirements, Reuters
News Service (May 19, 2008).
\148\ James R. Hagerty, Fannie, Freddie Share Spotlight in Mortgage
Mess, Wall Street Journal (Oct. 16, 2008).
---------------------------------------------------------------------------
To preserve their government-granted duopoly powers and
maintain unfettered access to cheap funds, Fannie and Freddie
spent enormous sums on lobbying and public relations. According
to the Associated Press, they ``tenaciously worked to nurture,
and then protect, their financial empires by invoking the
political sacred cow of homeownership and fielding an army of
lobbyists, power brokers and political contributors.'' \149\
Fannie and Freddie's lobbyists fought off legislation that
might shrink their investment portfolios or erode their ties to
the federal government, raising their borrowing costs. In fact,
Franklin D. Raines, Fannie Mae's former chairman, once told an
investor conference that ``we manage our political risk with
the same intensity that we manage our credit and interest rate
risk.'' \150\ Raines's statement was undoubtedly true: over the
past ten years, Fannie and Freddie spent more than $174 million
on lobbying.\151\
---------------------------------------------------------------------------
\149\ Tom Raum and Jim Drinkard, Fannie Mae, Freddie Mac Spent
Millions on Lobbying, Associated Press (July 17, 2008).
\150\ Wallison and Calomiris, supra note 144.
\151\ Fannie Mae, Freddie Mac Spent Millions on Lobbying,
Associated Press (July 17, 2008).
---------------------------------------------------------------------------
As long as times were good, the GSEs were able to point to
their affordable housing goals to distract attention from the
inherent risk their business model posed. But, for more than a
decade, alarms have been sounded about the precarious position
of the GSEs. For example, in Congress, as far back as 1998, GSE
reform advocates like former Rep. Richard Baker were voicing
their concerns over ``the risks and potential liabilities that
GSEs represent.'' \152\ In 2000, Rep. Baker demonstrated he was
far ahead of the curve when he observed that by ``improving the
existing regulatory structure of the housing GSEs in today's
good economic climate, we can reduce future risk to the
taxpayer and the economy.'' \153\ That year, the House
Financial Services Committee held no fewer than six hearings on
the subject of GSE reform, with at least five more over the
following two years.\154\ Yet from 2000 to 2005, although at
least eight major GSE reform bills were introduced in Congress,
Fannie and Freddie exerted enough influence that only one, the
Federal Housing Finance Reform Act of 2005, ever gained enough
support to be passed by either body, but it ultimately did not
become law.\155\
---------------------------------------------------------------------------
\152\ House Financial Services Committee, Statement of Rep. Richard
Baker, Joint Hearing on Government Sponsored Enterprises, 105th Cong.
(July 16, 1997) (online at financialservices.house.gov/banking/
71697bak.htm).
\153\ House Financial Services Committee, Subcommittee on Capital
Markets, Securities, and Government Sponsored Enterprises, Statement of
Rep. Richard Baker, Housing GSE Regulatory Reform Hearing, 106th Cong.
(March 22, 2000) (online at financialservices.house.gov/banking/
32200bak.htm).
\154\ House Financial Services Committee, Archived Hearings (online
at http://financialservices.house.gov/archive_hearings.html).
\155\ H.R. 1461, 109th Cong. (2005)
---------------------------------------------------------------------------
Others in government shared similar concerns. In 1997, the
General Accountability Office cautioned in its testimony before
the House Financial Services Committee that ``the outstanding
volume of federally assisted GSE credit is large and rapidly
increasing.'' \156\ As referenced above, then-Treasury Under
Secretary Gensler testified in March 2000 that ``the
willingness of a GSE to purchase a mortgage has become a far
more significant factor in deciding whether to originate that
mortgage.'' Gensler went on to state that as the GSEs continue
to grow, ``issues of potential systemic risk and market
competition become more relevant,'' and concluded that the
current moment was ``an ideal time to review the supervision
and regulation of the GSEs.'' \157\ In 2004, then-Federal
Reserve Chairman Alan Greenspan warned in his testimony before
the Senate Banking, Housing, and Urban Affairs Committee that
``the current system depends on the risk managers at Fannie and
Freddie to do everything just right. . . . But to fend off
possible future systemic difficulties, which we assess as
likely if GSE expansion continues unabated, preventive actions
are required sooner rather than later.'' \158\
---------------------------------------------------------------------------
\156\ House Financial Services Committee, Subcommittee on Capital
Markets, Securities, and Government Sponsored Enterprises, Testimony of
Jim Bothwell of the Government Accountability Office, Joint Hearing on
Government Sponsored Enterprises, 105th Cong. (July 16, 1997) (online
at financialservices.house.gov/banking/71697gao.htm).
\157\ Gensler, supra note 117.
\158\ Senate Committee on Banking, Housing, and Urban Affairs,
Testimony of Alan Greenspan, Proposals for Improving the Regulation of
the Housing Government Sponsored Enterprises, 108th Cong. (Feb. 24,
2004) (online at www.access.gpo.gov/congress/senate/pdf/108hrg/
21980.pdf).
---------------------------------------------------------------------------
Outside of Congress, more red flags were flown over the
obvious weaknesses of the GSE model. At another House Financial
Services Committee hearing on GSEs in 2000, low-income housing
advocate John Taylor of the National Community Reinvestment
Coalition warned that the lack of a strong regulatory agency
for Fannie and Freddie ``threatens the safety and soundness of
the GSEs.'' \159\ At the same hearing, community activist Bruce
Marks of the Neighborhood Assistance Corporation of America
expressed his fears that without enhanced regulatory control
over Fannie and Freddie, the GSEs might participate ``in
potentially profitable but also potentially risky investments
[sic] schemes [that] pose potential risks for the housing and
banking industry and for the economy in general.'' \160\
---------------------------------------------------------------------------
\159\ House Financial Services Committee, Subcommittee on Capital
Markets, Securities, and Government Sponsored Enterprises, Testimony of
John Taylor, Hearing on Improving Regulation of Housing GSEs, 106th
Cong. (June 15, 2000) (online at financialservices.house.gov/banking/
61500tay.htm).
\160\ House Financial Services Committee, Subcommittee on Capital
Markets, Securities, and Government Sponsored Enterprises, Testimony of
Bruce Marks, Hearing on Improving Regulation of Housing GSEs, 106th
Cong. (June 21, 2000) (online at financialservices.house.gov/banking/
62100mar.htm).
---------------------------------------------------------------------------
Unfortunately, despite all the evidence of systemic risk
and repeated efforts to consolidate, strengthen, and increase
regulatory oversight of Fannie and Freddie, calls for reform
mostly fell on deaf ears. One reason why reform efforts failed
was that the GSEs and their ardent defenders in Congress have
spent the better part of the last decade first ignoring, then
rejecting, then attempting to contradict the mounting evidence
that the whole system was in danger. In 2001, Fannie Mae itself
attempted to dispel the need for any change, declaring before
Congress that ``we operate successfully under the most rigorous
of safety and soundness regimes; we are subject to a high level
of market discipline and provide the marketplace with world-
class disclosures.'' \161\ Freddie Mac, for its part, used the
same hearing to proclaim that their ``superior risk management
capabilities, strong capital position and state-of-the-art
information disclosure make Freddie Mac unquestionably a safe
and sound financial institution.'' \162\
---------------------------------------------------------------------------
\161\ House Financial Services Committee, Subcommittee on Capital
Markets, Securities, and Government Sponsored Enterprises, Testimony of
J. Timothy Howard of Fannie Mae, Hearing on Reforming Fannie Mae and
Freddie Mac, 107th Cong. (July 11, 2001) (online at
financialservices.house.gov/media/pdf/071101th.pdf).
\162\ House Financial Services Committee, Subcommittee on Capital
Markets, Securities, and Government Sponsored Enterprises, Testimony of
Mitchell Delk of Freddie Mac, Hearing on Reforming Fannie Mae and
Freddie Mac, 107th Cong. (July 11, 2001) (online at
financialservices.house.gov/media/pdf/071101md.pdf).
---------------------------------------------------------------------------
After their credibility eroded from their accounting
scandals, Fannie and Freddie increasingly relied on elected
officials to fight attempts at reform. In 2003, Rep. Barney
Frank famously remarked at a hearing on a pending GSE reform
bill: ``I believe there has been more alarm raised about
potential [GSE] un-safety and unsoundness than, in fact,
exists. . . . I do not want the same kind of focus on safety
and soundness that we have in OCC and OTS. I want to roll the
dice a little bit more in this situation towards subsidized
housing.'' \163\ In 2004, Senator Chris Dodd called Fannie and
Freddie ``one of the great success stories of all time,'' \164\
while in 2005 Senator Chuck Schumer confessed that perhaps
``Fannie and Freddie need some changes, but I don't think they
need dramatic restructuring in terms of their mission.'' \165\
The scope of this head-in-the-sand mentality was perhaps most
completely embodied by Rep. Maxine Waters who, in 2002,
categorically rejected the need for any GSE reform bill,
proclaiming at a House Financial Services Committee hearing on
the matter ``If it is not broken, why fix it?'' \166\
---------------------------------------------------------------------------
\163\ House Financial Services Committee, Oral remarks of Rep.
Barney Frank, Hearing on H.R. 2575, The Secondary Mortgage Market
Enterprises Regulatory Improvement Act, 108th Cong. (Sept. 25, 2003)
(online at financialservices.house.gov/media/pdf/108-54.pdf).
\164\ What They Said About Fan and Fred, Wall Street Journal (Oct.
2, 2008).
\165\ Id.
\166\ House Financial Services Committee, Statement of Rep. Maxine
Waters, Hearing on Housing Government Sponsored Enterprises, 107th
Cong. (July 16, 2002) (online at financialservices.house.gov/media/pdf/
071602wa.pdf).
---------------------------------------------------------------------------
Although it is fair to say that no one ought to be blamed
for lacking the ability to predict the future, the fact remains
that for more than a decade there were clear, discernable, and
announced warnings that Fannie and Freddie were growing too big
and that if left unchecked would eventually collapse beneath
their own weight. Too many public policy makers failed to heed
those warnings, or knowingly disregarded them, and as a result
taxpayers have now been left to pick up the pieces by taking on
hundreds of billions of dollars worth of risk. Ironically, when
the housing bubble finally burst, the resulting wave of
foreclosures stemming from loans the GSEs forced into the
market will likely end up reducing homeownership rates across
the country, a direct contradiction to the stated purpose of
Fannie and Freddie that their supporters for so long sought to
advance.
Credit Rating Agencies. In order to sell subprime
securities to investors, those securities first had to be rated
by the credit rating agencies. Like so many other players, the
credit rating agencies were caught up in the pursuit of fees
generated from the real estate boom. This overwhelming desire
to maximize their profits from the housing bubble is perhaps
best captured by an e-mail message from a Standard & Poor's
official who wrote that ``We rate every deal. It could be
structured by cows and we would rate it.'' \167\ To perform
their work, these agencies made extensive use of sophisticated
modeling in an attempt to predict risk and the likelihood of
default on loans. However, much like everyone else, the credit
rating agencies falsely assumed that housing prices would never
go down nationwide, which meant that their elaborate
mathematical models were defective from the start. When
mortgage defaults accelerated and home prices began to plummet,
securities based on those loans that were once highly rated
were downgraded to junk causing a wave of financial turmoil for
scores of market participants at every level.
---------------------------------------------------------------------------
\167\ House Committee on Oversight and Government Reform, Hearing
on Credit Rating Agencies and the Financial Crisis, 110th Cong. (Oct.
22, 2008) (online at oversight.house.gov/documents/20081023162631.pdf).
---------------------------------------------------------------------------
But the failure of the credit rating agencies would not
have generated the disastrous consequences that it did had that
failure not been compounded by further misguided government
policies, which had effectively allowed the credit rating
agencies to operate as a cartel. For decades, federal financial
regulators have required that regulated entities heed the
ratings of a select few rating agencies. For example, since the
1930s regulators have not allowed banks to invest in bonds that
are below ``investment grade,'' as determined by the select few
rating agencies as recognized by the government. Although the
goal of having safe bonds in the portfolios of banks may be a
worthy one, bank regulators essentially delegated a major
portion of their safety assessments to the opinions of these
rating agencies.
This delegation of authority by bank regulators was further
compounded in 1975, when the SEC also delegated its safety
judgments regarding broker-dealers to the credit rating
agencies. As an attempted safeguard against unqualified
agencies from participating in the process, the SEC created a
new Nationally Recognized Statistical Rating Organization
(NRSRO) designation for qualified entities, and immediately
grandfathered the three large rating agencies into this
category. Following the SEC, other financial regulators soon
adopted the NRSRO category for their delegations, assuming this
government stamp of approval would ensure the continued quality
of the ratings produced by those agencies.
Over the next 25 years, the SEC allowed only four more
rating firms to achieve the NRSRO designation, but mergers
among the NRSROs eligible to issue ratings recognized by the
regulators shrunk the number of NRSROs back to three by year-
end 2000. In 2006, Congress passed legislation (Pub. L. No.
109-291) to address part of this situation which required that
the SEC cease being a barrier to entry for legitimate rating
agencies, and gave it limited regulatory powers over the
NRSROs. Although the SEC has designated six additional NRSROs
since 2000,\168\ competition and transparency in the ratings
agency system remains inadequate. The SEC has never developed
criteria for the designation and, once designated, NRSROs have
for too long been allowed to operate without further scrutiny
by the SEC for competence or accuracy.
---------------------------------------------------------------------------
\168\ AEI Center for Regulatory and Market Studies, Lawrence J.
White, Lessons from the Debacle of '07-'08 for Financial Regulation and
Its Overhaul (Jan. 2009) (Working Paper No. 09-01).
---------------------------------------------------------------------------
By adopting this NRSRO system, the SEC thus established an
insurmountable barrier to entry into the rating business,
eliminating market competition among the rating agencies. No
one could be surprised that once they were spared the market
discipline, the quality of the work by protected rating
agencies would diminish.
Market Behavior. Government policies that dominated and
distorted the nation's housing market clearly set the stage for
the housing crisis. But there were also significant mistakes
made by private-sector participants at each step of the
originate-to-distribute model of mortgage financing which
compounded the government's failure. The benefits of this
system--such as lower financing costs and the efficient
distribution of risk--were significant. Over time, however, the
belief that home prices would continue their relentless, upward
path distorted began to distort decision making at every step
along the path.
The belief that real estate prices would only go up led
borrowers, originators, lenders, securitizers, and investors to
conclude that these investments were risk free. As a result,
the traditional underwriting standards, based on the borrower's
character, capacity to repay, and the quality of collateral
were abandoned. What many failed to realize was that those
standards were designed not only to protect the participants in
the system from the consequences of a bubble, but also to
protect the underlying financial system itself.
Borrowers. Building on that belief that housing prices
could never go down, borrowers were encouraged to borrow as
much as possible and buy as much house as they possibly could,
or else invest in other properties that could always later be
resold for a profit. The result was that borrowers often ended
up with mortgage products that they failed to understand, that
they could not afford, or that ended up exceeding the value of
the property securing the mortgage. Those concerns were less
important as property values continued to rise, since borrowers
could always refinance or sell to benefit from the continued
appreciation of the property. However, when property values
began to fall, in many cases borrowers soon realized that the
economically rational course of action for them was to mail in
their keys to the mortgage servicer and simply walk away. Since
mortgages are non-recourse loans, doing so meant that someone
else was bearing the downside risk. While the vast majority of
borrowers continue to honor their commitments and pay their
mortgages, for many of those who put little or no money down
their mortgages became a ``heads I win, tails you lose''
proposition.
Mortgage Originators. Because mortgage originators were
compensated on the quantity rather than the quality of loans
they originated, there was little incentive to care if the
loans they originated would perform. The compensation of
mortgage brokers was also tied to the interest rates and fees
paid by customers, which created a financial incentive for some
brokers to direct borrowers to loans that may not have
otherwise been in their best interest. For example, some
originators who advocated for certain subprime loans received
commissions that were more than twice as high as the
commissions they would have received for higher-quality loans.
This incentives model put a much higher premium on quantity
over quality, which only diminished the safety and soundness of
the entire system as even more risks were externalized while
profits were internalized.
Mortgage Fraud. Integral to understanding the root causes
of our current credit crisis is an acknowledgement of the
rampant mortgage fraud that took place in the mortgage industry
during the boom years. Fueled by low interest rates and soaring
home values, the mortgage industry soon attracted both
unscrupulous originators as well as disingenuous borrowers,
resulting in billions of dollars in losses. As early as 2004,
FBI officials in charge of criminal investigations foresaw that
mortgage fraud had the potential to mushroom into an epidemic.
In 2008, the Department of Treasury's Financial Crimes
Enforcement Network (FinCEN) announced a 44 percent increase in
Suspicious Activity Reports from financial institutions
reporting mortgage fraud, with some 37,313 mortgage fraud
reports filed in 2006, and 52,868 mortgage fraud reports filed
in 2007. According to FinCEN, mortgage loan fraud was the third
most prevalent type of suspicious activity reported, lagging
behind only money laundering and check fraud. From 2000 to
2007, FinCEN found that the reporting of suspected mortgage
loan fraud had increased an astounding 1400 percent from 3,515
cases in 2000 to 52,868 cases in 2007.\169\
---------------------------------------------------------------------------
\169\ Financial Crimes Enforcement Network, FinCEN Assessment
Reveals Suspected Mortgage Loan Fraud Continues to Rise (Nov. 3, 2007).
---------------------------------------------------------------------------
Unfortunately, law enforcement officials failed to stop the
epidemic that they had accurately diagnosed because they did
not devote adequate resources to the problem. Even though the
FBI and the Justice Department are charged with the
responsibility of investigating and prosecuting illegal
activities by originators, lenders, and borrowers, the focus of
those agencies was trained on national security and other
priorities. As a result, inadequate attention was paid to many
of the white-collar crimes that contributed to the financial
crisis. For example, by 2007, the number of agents pursuing
mortgage fraud shrank to around 100.\170\ By comparison, the
FBI had about a thousand agents deployed on banking fraud
during the S&L bust of the 1980s and 1990s. Although the FBI
later increased the number of agents working on mortgage fraud
to 200, others have pointed out that the agency might have
averted much of the problem had it heeded its own warning about
widespread mortgage fraud.\171\
---------------------------------------------------------------------------
\170\ Richard B. Schmitt, FBI Saw Threat of Loan Crisis, Los
Angeles Times (Aug. 25, 2008).
\171\ Id.
---------------------------------------------------------------------------
Lenders. The belief that housing prices would rise forever,
coupled with the ability to package loans for sale to
investors, profoundly changed the way in which lenders
underwrote loans. While underwriting had traditionally been
based on the borrower's ability to repay a loan, as measured by
criteria such as employment history, income, down payment,
credit rating, and loan-to-value ratios, rising home prices
pushed lenders to abandon these criteria. Little concern was
paid to the risks of this change, given that in a worst-case
scenario, servicers could always foreclose upon a property to
satisfy the mortgage in full. As a result, lenders pioneered
new mortgage products, such as no-doc and low-doc loans, low-
and no-down-payment loans, and innovations that took rising
home prices for granted. That is not to say that these exotic
products are illegitimate; each may have its own appropriate
use for borrowers in specific circumstances. But the broad
application of these tailored products to any person in any
circumstance invariably led to some borrowers receiving loans
that were wholly inappropriate for their needs and capacity to
repay. The ability to securitize these loans further degraded
lending standards by allowing lenders to shift the risk of
nonperforming mortgages onto the investors that purchased
securities built around these products. In a world in which
lenders could securitize even the most poorly underwritten of
mortgages, what mattered most to lenders was that the loan did
not default within an agreed-upon period--typically 90 or 180
days. Whatever happened after that time was someone else's
problem.
Securitizers. Securitizers pooled mortgages of all types
and quality together to create complex and often opaque
structured products from these loans, such as mortgage-backed
securities (MBS) and collateralized debt obligations (CDO).
Securitizers knew that some portion of the mortgages they
securitized would fail, but they believed that by structuring
these mortgages into securities with different levels of risk,
they could effectively eliminate any risk from those defaults
with the guarantee of safer, performing loans. This belief grew
from the assumption that others along the chain--the mortgage
brokers and lenders--had adequately underwritten the loans so
that any defaults would be manageable, and that housing prices
would never go down. Those false assumptions belied the fact
remains that in any finance model, you can never eliminate risk
from a system of lending; at best, you can hope to control it
by offsetting smaller sections of riskier loans with larger
sections of safer loans. But that risk, while controlled, is
always there, a lesson which the entire financial system is
currently experiencing firsthand.
Investors. Like so many others, private investors in
pursuit of risk-free investments failed to appreciate that if
housing prices could go up, they could also go down. Rather
than performing their due diligence on these mortgage-backed
securities, many investors put their faith in the rating
agencies and other proxies, and did not fully appreciate the
risks they faced. Some large institutions further compounded
their mistakes by holding their mortgage investments off-
balance-sheet, using a loophole set forth in the regulatory
capital requirements that permitted them to hold low-risk
investments in special investment vehicles or conduits. And
other large institutions--such as the former investment banks--
availed themselves of an exemption granted by the SEC that
permitted them to ignore traditional debt-to-net capital
ratios--traditionally 12:1--and lever up as much as 40:1.\172\
It was in this way that the once highly sought but ultimately
poorly underwritten mortgages came to be the ``troubled
assets'' that have now caused the collapse of so many in our
financial system. Using first the assumption, and by 2008 the
proof, that the government would deem certain institutions that
had gambled on these assets to be too big or too interconnected
to fail, these institutions and their creditors succeeded in
making the taxpayer the ultimate bag holder for the risks they
took, demonstrating yet again that the standard governing the
housing boom and bust was ``heads I win, tails you lose.''
---------------------------------------------------------------------------
\172\ Stephen Labaton, Agency's '04 Rule Let Banks Pile on New
Debt, New York Times (Oct. 2, 2008).
---------------------------------------------------------------------------
Mark-to-Market Accounting. The boom and bust nature of the
housing and financial markets in recent years was amplified by
the application of financial accounting standards that required
financial institutions to write down their MBS assets to
``market value'' even if no market existed. As a result,
institutions that held mortgage-backed securities found
themselves facing the withdrawal of financing, often forcing
them to sell these assets at distressed or liquidation prices,
even though the underlying cash flows of these portfolios might
not have been seriously diminished. In a liquidity-starved
market, more and more distressed sales took place, further
pulling down asset prices. These declining prices in turn
created more lender demands for additional collateral to secure
their loans, which in turn resulted in more distressed sales
and further declines in asset values as measured on a mark-to-
market basis. The result was a procyclical engine which
magnified every downward price change in a recursive spiral,
all of which might have otherwise been avoided had the mark-to-
market standard provided better guidance on how to value assets
in non-functioning markets.
Summary. The financial crisis which has unfolded over the
past two years has numerous causes, and decisions made in the
private sector were, in many cases, unwise. But the failure of
government policy and the market distortions it caused stand at
the center of the crisis. Whether by the Federal Reserve's
engineering an artificially low interest rate, Congress's well-
intentioned but misguided efforts to expand home ownership
among less creditworthy borrowers, or the GSEs' securitization
and purchase of risky mortgage-backed securities, the federal
government bears a significant share of the responsibility for
the challenges that confront us today.
To address these challenges, what is needed most is not
simply reregulation or expanded regulation, but a modernized
regulatory system that is appropriate to the size, global
reach, and technology used by today's most sophisticated
financial service firms. At a time when our nation's economy
desperately needs to attract new investment and restore the
flow of credit to where it can be used most productively, we
must at all costs avoid regulatory changes under the label
``reform'' that have the unintended consequence of further
destabilizing or constricting our economy. We should carefully
consider the so-called lessons of the subprime crisis to be
sure that whatever changes we adopt actually address the
specific underlying causes of the crisis. These reforms should
require the participants in the financial system to bear the
full costs of their decisions, just as they enjoy the benefits.
They should also enhance market forces, add increased
transparency, and strip away counterproductive government
mandates.
Perhaps above all, we should avoid creating a system in
which market participants rely upon an implicit or explicit
government guarantee to bear the risk for economic transactions
gone wrong. If the events of the past two years have
demonstrated anything, it is that whenever government attempts
to subsidize risk--from efforts to stabilize home prices to the
latest government-engineered rescues of financial institutions
deemed too big to fail--those efforts are usually costly,
typically ineffectual, and often counterproductive. We should
all know by now that whenever government subsidizes risk,
either by immunizing parties from the consequences of their
behavior or allowing them to shift risk to others at no cost,
we produce a clear moral hazard that furthers risky behavior,
usually with disastrous consequences.
Any regulatory reform program must recognize the ways in
which government is part of the problem, and should guard
against an overreaction that is certain to have unintended
consequences. Perhaps Harvard economist Edward L. Glaeser put
it best: ``We do need new and better regulations, but the
current public mood seems to be guided more by a taste for
vengeance than by a rational desire to weigh costs and
benefits. Before imposing new rules, we need to think clearly
about what those rules are meant to achieve and impose only
those regulations that will lead our financial markets to
function better.'' \173\
---------------------------------------------------------------------------
\173\ Edward L. Glaeser, Better, Not Just More, Regulation,
Economix (Oct. 28, 2008) (available at economix.blogs.nytimes.com).
---------------------------------------------------------------------------
RECOMMENDATIONS FOR FEDERAL REGULATORY REFORM
Developing an agenda for reform is an inherently
controversial enterprise. As with any suggested change, some
will stand to benefit while others might be forced to adjust to
the new realities of a different regulatory scheme. The
recommendations contained here are not immune from this charge,
and there will invariably be disagreement over the advantages
and disadvantages of some of these proposals. However, we
believe that the following recommendations remain true to our
objectives of helping to make markets more competitive and
transparent, empowering consumers with effective disclosure to
make rational decisions, effectively policing markets for force
and fraud, and reducing systemic risk.
In considering the appropriateness of each item, the devil
will always be in the details regarding how any of these
recommendations might be enacted. Even the best idea, if poorly
implemented, would lose many of the potential benefits it might
otherwise yield. Thus, these recommendations are best
understood as conceptual proposals rather than specific
instructions for how to improve our regulatory system.
Given the limited time and resources available to the Panel
to conduct this review, in many cases there are still
unanswered questions about certain aspects of these reforms and
in some cases even a few qualified reservations between the
authors. Nevertheless, we believe that each proposal contains
clear benefits for our economy, and has been structured to
avoid the potential for unintended consequences. They deserve
open consideration and debate in the public arena, and the
opportunity to stand or fall on their own merits--a fitting
tribute to the competitive free-market system that we are
dedicated to strengthening and preserving.
1. REFORM THE MORTGAGE FINANCE SYSTEM
The current financial crisis originated in the mortgage
finance system, and much of the resulting turmoil can be traced
to government interventions in the housing sector which helped
fuel a classic asset bubble. Reform must begin with Fannie Mae
and Freddie Mac, the GSEs whose influence drove the
deterioration of underwriting standards, growth in subprime
mortgage backed securities, and whose subsidized structure will
result in hundreds of billions of dollars in taxpayer losses.
The mortgage origination market itself should also be improved
by establishing clearer standards, transparency, and
enforcement.
1.1 Re-charter the housing GSEs as mortgage guarantors, removing them
from the investment business
At the center of the need for reform are Fannie Mae and
Freddie Mac. As Charles Calomiris and Peter Wallison of AEI
recently wrote: ``Many monumental errors and misjudgments
contributed to the acute financial turmoil in which we now find
ourselves. Nevertheless, the vast accumulation of toxic
mortgage debt that poisoned the global financial system was
driven by the aggressive buying of subprime and Alt-A
mortgages, and mortgage-backed securities, by Fannie Mae and
Freddie Mac. The poor choices of these two GSEs--and their
sponsors in Washington--are largely to blame for our current
mess.'' \174\
---------------------------------------------------------------------------
\174\ Blame Fannie Mae and Congress for the Credit Mess, Wall
Street Journal (Sept. 23, 2008).
---------------------------------------------------------------------------
The GSEs fueled the housing bubble through their ever
expanding appetite for increasingly risky investments that they
held in their massive portfolios. They financed these
investments by borrowing at low, subsidized rates, and over
time the firms became ever more dependent on their high yields
to meet their earning targets. At one time, Fannie and Freddie
accounted for more default risk than all other U.S.
corporations combined--default risk implicitly backed by the
federal government.\175\ These risks to the taxpayer and the
financial system were obvious, and should have been dealt with
long ago.
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\175\ Peter Wallison, Regulating Fannie Mae and Freddie Mac (May
13, 2005) (online at www.aei.org/publications/pubID.22514/
pub_detail.asp).
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Now that the GSEs have been taken into conservatorship,
Congress has the opportunity to ensure that the damage they
inflicted will never be repeated. This can be accomplished in
one of two ways. One option is for Congress to phase out the
GSEs' government charter and privatize them over a reasonable
period of time following a model similar to that of the
successful Sallie Mae privatization a decade ago. Legislation
to that effect was introduced in the 110th Congress and will
likely be re-introduced in the current Congress. These firms
can and should compete effectively in the financial service
marketplace on a level playing field without implicit or
explicit taxpayer guarantees.
Alternatively, Congress could opt to recharter the GSEs as
government entities whose only mandate is to guarantee and help
securitize mortgages. Such a structure would remove them
entirely from the investment business by prohibiting them from
maintaining massive investment portfolios which have proven to
be a tremendous source of systemic risk. In either alternative,
Congress must avoid a return to the flawed public purpose/
private ownership model that permitted the GSEs' shareholders
to profit at taxpayer expense.
1.2 Simplify mortgage disclosure
The events of the past year have made painfully clear that
the vitality of our financial system depends on a well-
functioning housing market in which borrowers are able and
willing to abide by the terms of the mortgage contracts into
which they have entered. Unfortunately, the needless complexity
involved in obtaining a mortgage appears designed to keep
borrowers from fully understanding these important agreements.
One way to minimize this complexity is to place essential
information for borrowers in a simple, one-page document that
makes clear what borrowers need to know before they enter into
what will be for many the biggest financial transaction they
will ever undertake. This information will permit borrowers to
make an appropriate decision regarding the costs and
affordability of borrowing to buy a house. This one-page
document would include such items as monthly payments, interest
rate, fees, and possible changes in the amount of payments for
adjustable rate mortgages including the maximum possible
interest rate on the loan and the maximum monthly payment in
dollars. The one-page document should also include the warning
that home values can go down as well as up, and that the
consumer is responsible for making the mortgage payments even
when the price goes down.
1.3 Establish minimum equity requirements for government guaranteed
mortgages
Because federally guaranteed mortgages put the taxpayer on
the hook for any potential associated losses, the taxpayer
needs to be protected from opportunistic borrowers that might
otherwise walk away from a mortgage if housing prices fall. One
way to protect the taxpayer is require the borrower to provide
a bigger downpayment. If the taxpayer is going to take on risk,
it is only fair that the borrower share in that risk as well.
FHA loans currently require at least a 3.5 percent
downpayment, which is clearly too low. The minimum downpayment
for all government-insured or securitized mortgages should be
raised immediately to at least 5 percent, and to as much as 10
percent or higher, over the next several years as market
conditions improve. Lest the advocates of government-subsidized
mortgages in which taxpayers bear the risk complain that 5
percent is too high, it bears pointing out that would still be
four times as lenient as the 20 percent standard that was in
place two decades ago.
1.4 Allow Federal Reserve mortgage lending rules to take effect and
clarify the enforcement authority for mortgage origination
standards
In July 2008, the Federal Reserve approved a comprehensive
final rule for home mortgage loans that was designed to improve
lending and disclosure practices. The new Federal Reserve rule
was designed to prohibit unfair, abusive or deceptive home
mortgage lending practices, and it applies to all mortgage
lenders, not just those supervised and examined by the Federal
Reserve.
The final Federal Reserve rule adds four protections for
``higher priced mortgage loans,'' which encompasses virtually
all subprime loans. The final rule:
1. Prohibits lenders from making loans without regard
to a borrower's ability to repay the loan.
2. Requires creditors to verify borrowers' income and
assets.
3. Bans prepayment penalties for loans in which the
payment can change during the first four years of the
loan (for other higher-priced loans, a prepayment
penalty period cannot last for more than two years).
4. Requires creditors to establish escrow accounts
for property taxes and homeowner's insurance for all
first-lien mortgage loans.
In addition, the Federal Reserve issued the following
protections for all loans secured by a consumer's principal
dwelling:
1. Creditors and mortgage brokers are prohibited from
coercing a real estate appraiser to misstate a home's
value.
2. Companies that service mortgage loans are
prohibited from engaging in certain practices, such as
pyramiding late fees.
3. Servicers are required to credit consumers' loan
payments as of the date of receipt and provide a payoff
statement within a reasonable time of request.
4. Creditors must provide a good faith estimate of
the loan costs, including a schedule of payments,
within three days of a consumer applying for a mortgage
loan.
Finally, the rule sets new advertising standards, which
require additional information about rates, monthly payments,
and other loan features. It also bans seven advertising
practices it considers deceptive or misleading, including
representing that a rate or payment is ``fixed'' when it can
change.
These new rules represent a change in federal regulation
that, regardless of whether or not one agrees with the degree
to which consumers might benefit from all of these rules, will
significantly alter the way in which the mortgage lending
industry operates. Thus, before policymakers succumb to the
desire to write additional rules and regulations, they should
allow the Federal Reserve's new guidelines to take effect,
monitor their impact upon mortgage origination, and clarify the
authority for enforcing these new federal standards.
Additionally, for these new rules to work effectively, they
must be appropriately enforced. In particular, Congress should
ensure that federal and state authorities have the appropriate
powers to enforce these laws, both in terms of resources and
actual manpower, for all mortgage originators.
1.5 Enhance securitization accountability standards
The advent of securitization has been a tremendous boon to
the mortgage industry, and countless millions of Americans have
directly or indirectly benefited from the liquidity it has
created. Nevertheless, the communicative nature of loans in the
securitization process has helped diminish accountability among
market participants, eroding the quality of many loans. Thus,
to restore accountability, minimum standards should be set for
all loans that are to be securitized so that securitizers
retain some risk for nonperforming loans.
One proposal would be to link the compensation securitizers
receive for packaging loans into mortgage-backed securities to
the performance of those loans over a five year period, rather
than the six-month put-back period that is the current
standard. This change in compensation would thus give the
securitizer an economic stake in the loan's long-term
performance, aligning the securitizer's incentives with those
of borrowers, investors, and the broader economy. Further,
consideration should be given to applying additional
limitations on the ability to securitize loans that carry with
them an explicit government guarantee.
2. MODERNIZE THE REGULATORY STRUCTURE FOR FINANCIAL INSTITUTIONS
It has become a cliche to observe that if one were
designing a regulatory system from scratch, one would not come
up with the patchwork system of agencies with overlapping
jurisdictions and conflicting mandates. The U.S. financial
regulatory system is fractured among eleven federal primary
regulatory agencies in addition to scores of state regulatory
agencies. The system developed over a 200-year period, during
which institutions largely lacked the ability to transact
business nationwide, let alone globally. Insurance, securities,
and bank products were sold by different institutions, and
little cross-market competition existed.
During the past thirty years, changes in size and
technology have opened financial markets to buyers and sellers
around the globe, transaction times are now measured in
fractions of a second, and consumers have been given access to
a broad range of valuable products from a single provider.
Innovations in products and technology, and the global nature
of financial markets are here to stay. An unnecessarily
fragmented and outdated regulatory system imposes costs in
several ways: inefficiencies in operation, limitations on
innovation, and competition restraints that are difficult to
justify.
2.1 Consolidate federal financial services regulation
The benefits of a more unified federal approach to
financial services regulation have been a constant theme in
proposals for regulatory reform, some of which were under
consideration and announced before the onset of the current
financial crisis. For example, the Group of 30, in its very
first recommendation, called for ``government-insured deposit
taking institutions'' to be subject to ``prudential regulation
and supervision by a single regulator.'' \176\ The Committee on
Capital Markets Regulation has similarly called for a
consolidated U.S. Financial Services Authority (USFSA) that
``would regulate all aspects of the financial system including
market structure and activities and safety and soundness.''
\177\ Treasury's Blueprint for a Modernized Financial
Regulatory Structure recommends a Prudential Financial
Regulatory Agency (PFRA) with oversight over ``financial
institutions with some type of explicit government guarantee
associated with their business operations.'' \178\
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\176\ The Group of 30, Financial Reform: A Framework for Financial
Stability (Jan. 15, 2009) (online at www.group30.org/pubs/
recommendations.pdf).
\177\ The Committee on Capital Markets Regulation, Recommendations
for Reorganizing the U.S. Financial Regulatory Structure (Jan. 14,
2009) (online at www.capmktsreg.org/pdfs/CCMR%20-
%20Recommendations%20for%20Reorganizing%20the%20US%20Regulatory%20
Structure.pdf).
\178\ U.S. Department of Treasury, Blueprint for a Modernized
Financial Regulatory Structure (Mar. 31, 2008) (online at
www.ustreas.gov/press/releases/reports/Blueprint.pdf) (hereinafter
``Blueprint'').
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The current regulatory structure for oversight of federally
chartered depository institutions is highly fragmented, with
supervision spread among at least five agencies including the
OCC, OTS, FDIC, National Credit Union Administration (NCUA),
and the Federal Reserve. Thus, Congress should streamline
oversight of these federally chartered and insured
institutions.
2.2 Modernize the federal charter for insured depository institutions
There are many kinds of insured depositories operating
under unique charters including national banks, thrifts, state
chartered members of the Federal Reserve system, state
chartered nonmembers, credit card banks, federal and state
credit unions, and state charted industrial loan corporations.
While this vast array of institution type may have had a sound
historical basis, changes in the national economy and
regulatory landscape have made many of these differences
functionally obsolete. Although regulatory competition can
prove beneficial, the current state of duplicative banking
regulation has several negative consequences as well, including
unnecessary consumption of federal regulatory resources,
consumer transparency, and differences in charters for largely
similar institutions, which can lead to unfair competitive
advantages for institutions governed by certain charters over
others.
In particular, the OCC and the OTS play a very similar role
for two classes of depository institutions which were once were
quite different in nature, but now compete for the same
customers, offering similar services. The thrift charter was
originally instituted to foster the creation of financial
services organizations to encourage home ownership by ensuring
a wide availability of home mortgage loans. Due to a number of
national policy changes that have been instituted over the last
several decades to encourage homeownership and the decreasing
share thrifts have of the residential mortgage market in
relation to commercial banks, a unique thrift charter is no
longer necessary to meet this goal. Moreover, the constraints
of the thrift charter limit the diversification of thrifts'
loan portfolios, which only exacerbates their ability to remain
financially healthy in a weak real estate market.
Many individuals and organizations reviewing the current
regulatory landscape have come to the conclusion that these
agencies, and their corresponding federal thrift, and federal
bank charters should be unified. In fact, back in 1994, former
Federal Reserve Governor, John P. LaWare recommended combining
the OCC with the OTS.\179\ Similarly, in 1996, the GAO
recommended that primary supervisory responsibilities of the
OTS, OCC, and the FDIC be consolidated into a new, independent
Federal Banking Commission.\180\
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\179\ Walter W. Eubanks , U.S. Congressional Research Service,
RL33036, Federal Financial Services Regulatory Consolidation: An
Overview (July 10, 2008), at 14.
\180\ Government Accountability Office, U.S. and Foreign Experience
May Offer Lessons for Modernizing U.S. Structure (Nov. 1996) (online at
www.gao.gov/archive/1997/gg97023.pdf).
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Congress should consider other steps to modernize and
rationalize the federal charter system. Each class of charter
should be reviewed for purpose, structure, cost and distinct
characteristics. Unnecessary differences are potential sources
of confusion, conflict, or taxpayer risk, and should be
eliminated wherever possible.
2.3 Consolidate the SEC and CFTC
Similar to the rationalization that is needed in banking
regulation, consolidation of securities regulation in the U.S.
through the merger of the SEC and the CFTC should also be
undertaken. Most countries have vested the power to oversee all
securities markets in one agency, and for good reason--more
efficient, consistent regulation that protects consumers in a
more uniform manner. As the Treasury Blueprint states:
``Product and market participant convergence, market linkages,
and globalization have rendered regulatory bifurcation of the
futures and securities markets untenable, potentially harmful,
and inefficient. The realities of the current marketplace have
significantly diminished, if not entirely eliminated, the
original rationale for the regulatory bifurcation between
futures and securities markets.'' \181\
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\181\ Blueprint, supra note 178.
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It further notes that: ``Jurisdictional disputes have
ensued as the increasing complexity and hybridization of
financial products have made `definitional' determination of
agency jurisdiction (i.e., whether a product is appropriately
regulated as a security under the federal securities laws or as
a futures contract under the CEA) increasingly problematic.
This ambiguity has spawned a history of jurisdictional
disputes, which critics claim have hindered innovation, limited
investor choice, harmed investor protection, and encouraged
product innovators and their consumers to seek out other, more
integrated international markets, engage in regulatory
arbitrage, or evade regulatory oversight altogether.'' \182\
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\182\ Id.
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In testimony before this panel, Joel Seligman, President of
the University of Rochester and a leading authority on
securities law, agreed, stating, a ``pivotal criterion to
addressing the right balance in designing a regulatory system
is one that reduces as much as is feasible regulatory
arbitrage. Whatever the historical reasons for the existence of
a separate SEC and CFTC, the costs of having a system where in
borderline cases those subject to regulation may choose their
regulator is difficult to justify.'' \183\
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\183\ Seligman, supra note 18.
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The most significant obstacle to this proposal is a
political one. Congressional oversight of the two agencies is
split between two committees in both the House and Senate.
Consolidation would most likely mean that one committee would
lose out, leading to a classic turf war. Since the nature of
futures trading has evolved significantly over the years, and
is now dominated by non-agricultural products, the Senate
Banking and House Financial Services Committees would be the
appropriate venue for all congressional securities oversight.
2.4 Establish an optional federal charter for national insurance firms
The U.S. federal financial service regulatory
infrastructure contains no agency or organization responsible
for oversight of national insurance firms. As far back as 1871,
regulators saw the need for uniform national standards for
insurance. That year, former New York Insurance Commissioner,
George W. Miller, who founded the National Association of
Insurance Commissioners (NAIC), made the following statement:
``The Commissioners are now fully prepared to go before their
various legislative committees with recommendations for a
system of insurance law which shall be the same in all States,
not reciprocal but identical, not retaliatory, but uniform.''
\184\ That need for uniform standards has grown quite
considerably during the past 138 years.
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\184\ House Financial Services Committee, Subcommittee on Capital
Markets, Securities, and Government Sponsored Enterprises, Testimony of
Rep. Sue Kelly, NARAB & Beyond: Achieving Nationwide Uniformity in
Agent Licensing, 107th Cong. (May 16, 2001) (online at
financialservices.house.gov/media/pdf/051601ke.pdf).
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Congress should institute a federal charter that may be
utilized by insurance firms to underwrite, market, and sell
products on a national basis. While individual state insurance
regulators have effectively managed state guarantee pools, as
well as safety and soundness within their jurisdiction, they
simply are not equipped to effectively oversee a global firm
such as AIG, which had 209 subsidiaries at the time the federal
government acted to prevent its collapse in the fall of 2008.
Of the 209 subsidiaries, only twelve fell under the
jurisdiction of the New York insurance commissioner, which was
effectively AIG's primary regulator.\185\
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\185\ John Sununu, et al., Insurance Companies Need a Federal
Regulator, Wall Street Journal (Sept. 23, 2008) (online at
online.wsj.com/article/SB122212967854565511.html).
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By allowing insurance firms to choose between a unified
national charter or maintaining operations under existing state
regulation, Congress can build upon the success of state
guarantee pools and maintain state jurisdiction over premium
taxes. A national charter would also allow regulators to take a
comprehensive view of the safety and soundness of large
insurance companies and to better understand the potential
risks they may pose to the strength of the broader U.S.
economy. Lastly, a federal insurance regulator would be able to
implement effective consumer protection, provide a clear
federal voice to coordinate global insurance regulation with
foreign counterparts, and ensure appropriate access for U.S.
insurance companies in overseas markets.
3. STRENGTHENING CAPITAL REQUIREMENTS AND IMPROVING RISK MANAGEMENT
The experience of the past two years demonstrates that our
financial system was far more susceptible to shocks from the
housing sector than it should have been, as a result of capital
requirements that were insufficient to sustain financial
institutions in time of stress. Those weaknesses were in turn
further exacerbated by certain standards and practices, such as
a heavy reliance on credit rating agencies and the application
of mark-to-market accounting standards. To ensure that our
financial system can better withstand these kinds of shocks,
capital requirements should be strengthened and risk management
should be enhanced.
3.1 Strengthen capital requirements for financial institutions
One of the key lessons that has emerged from this crisis is
that our financial institutions did not have adequate capital
reserves to weather the turmoil in the housing market due in
large part to the fact that many of the assets they held were
inextricably linked to this market. One way to address this
problem would be to ensure that regulators can demand that
financial institutions increase their capital during flush
times. Those reserves could then serve as a cushion during bad
times when capital is much harder to raise. The provisioning
requirements would be based on the health of the economy as a
whole, thus building upon systemic strength and buffering
against systemic weakness.
These countercyclical requirements would be quite different
from those governing the regulatory capital that financial
institutions are required to hold today. The current capital
rules for lending are out of date, subject to manipulation, and
do not accurately reflect the risks associated with lending
activities. That said, there are also significant flaws and
risks associated with the new capital rules called for by the
Basel II regime.
Much of the initial modeling now available suggests that
average capital requirements for banks subject to Basel II
methodologies would decrease. The determination to allow the
largest and most complex banks to use internally developed,
historical models for the purpose of determining capital risk
charges merits further and closer scrutiny. Given the current
financial crisis and the federal guaranty on deposits that
banks enjoy, weak capital requirements called for by Basel II
could leave taxpayers on the hook yet again.
3.2 End conduits and off-balance-sheet accounting for bank assets
Apart from its procyclicality, Basel II permitted banks and
other financial institutions to keep assets such as mortgage-
backed securities off their books in conduits or structured
investment vehicles on the grounds that these assets were high-
quality and low-risk. Even if such an assessment were
accurate--and the past two years have demonstrated that it was
not--off-balance-sheet arrangements such as this permit
financial institutions to game the regulatory requirements in
place. These off-balance-sheet arrangements were made even more
dangerous by the perception that their liabilities were
implicitly guaranteed by the institutions that sponsored them,
which permitted even greater leverage to build before the
credit crisis hit. Thus, all assets and liabilities of a
financial institution should be held on the balance sheet. If
nothing else, one of the lessons of this credit crisis is the
necessary steps should be taken to eliminate the notion of an
``implicit guarantee'' of anything in our markets.
3.3 Adjust the application of mark-to-market accounting rules
Fair value accounting should be revised and reformed. As
things stand now, the accounting rules magnify economic stress
and can have serious procyclical effects. When markets turn
sour or panic, assets in a mark-to-market accounting system
must be repeatedly written down, causing financial institutions
to appear weaker than they might otherwise be. A superior
accounting system would not require financial institutions to
write down their assets at a time when prices have fallen
precipitously during a rapid downturn as in the collapse of a
bubble. Thus, alternative asset valuation procedures--such as
discounted cash flow--should be used, and it should be made
easier for financial institutions to declare assets as held-to-
maturity during these periods. In normal markets, prices will
fluctuate within a limited range, and will rise slowly if at
all. But in times of crisis--such as the one we are facing--
write-downs beget fire sales, which beget further write-downs.
In late September 2008, the SEC released guidelines that
allowed companies greater flexibility in valuing assets in a
nonfunctioning market. Such changes are encouraging. Moving
forward, accounting rules have to provide transparency and the
most accurate depiction of economic reality as possible. It is
for the best that the development of accounting rules should
not be conducted in the political arena. However, it is clear
that the rules need to be improved, taking into account the
lessons learned from recent events. Ultimately, greater
transparency and accuracy in accounting standards are necessary
to restore investor confidence.
3.4 Eliminate the credit rating agencies' cartel
The failure of the credit rating agencies in the financial
crisis could not be more apparent. Much like the GSEs, the
credit rating agencies benefited from a unique status conferred
upon them by the government. They operated as an effective
oligopoly to earn above-market returns while being spared
market discipline in instances where their ratings turned out
to be inaccurate. The special status of the rating agencies
should be ended so as to open the ratings field to competition
from new entrants and to encourage investors and other users of
ratings not to rely upon a ratings label as a substitute for
due diligence.
3.5 Establishing a clearinghouse for credit default swaps
Despite recent criticism heaped upon them, the thriving
credit default swaps (CDS) market demonstrates the valuable
role that innovation plays in improving the functioning of our
financial markets. Through the use of CDS, investors and
lenders can hedge their credit exposures more efficiently,
thereby freeing up additional credit capacity, which has in
turn enabled banks to expand credit facilities and reduce costs
of funds for borrowers. CDS have enabled asset managers and
other institutional investors to adjust their credit exposures
quickly and at a lower cost than alternative investment
instruments, and have enabled market participants to better
assess and manage their credit. CDS have also enabled market
participants to value illiquid assets for which market
quotations might not be readily available.
Despite their many benefits and the crucial role that CDS
have come to play in the financial system in managing risk,
legitimate concerns have arisen regarding the transparency of
the system and the management of counterparty risk. To address
these concerns, the Federal Reserve, the CFTC, and the SEC have
recently agreed on general principles to provide consistent
oversight of one or more clearinghouses for CDS trades. The
proposed guidelines will result in more public information on
potential risks being provided to counterparties and investors,
as well as the mitigation of any systemic losses caused by
potential fallout from the CDS market.
These principles constitute a valuable first step in
creating a CDS clearinghouse and will further improve a product
that has thus far proven invaluable in managing risk when
prudently used. A properly structured clearinghouse,
capitalized by its members, spreads the risk of default and
fosters market stability by acting as the sole counterparty to
each buyer and seller. A clearinghouse will allow performance
risk to be isolated to net exposure, rather than related to the
much larger gross positions in the market.
A number of reforms have already reduced risk in the CDS
market. The CDS market has already dramatically increased
margin, mark-to-market and collateral requirements for hedge
funds and other investment institutions on the other side of
any trade. And at the behest of the New York Federal Reserve
and other regulators, record keeping has improved; trade
confirmations, for example, now must be tendered quickly.
Buyers of CDS protection now also must formally approve any
switch of their coverage from one insurer to another.
Previously, the insured might not know who was its latest
counterparty.
A clearinghouse, however, may not be appropriate for the
most complex and unique over-the-counter derivatives. Moreover,
because a clearinghouse arrangement spreads risk to other
market participants, it could encourage excessive risk taking
by some, especially if risks associated with more exotic
products are not priced properly due to information asymmetry.
Policy makers and regulators should continue to work with the
private sector to facilitate a CDS clearinghouse that provides
greater transparency and reduces systemic risk in the broader
financial markets.
4. ADDRESS SYSTEMIC RISK
4.1 Consolidate the work of the President's Working Group and the
Financial Stability Oversight Board to create a cross-agency
panel for identifying and monitoring systemic risk
Systemic risk can materialize in a broad range of areas
within our financial system: at both depository and
nondepository institutions, within either consumer or
commercial markets, as a result of poor fiscal or monetary
policy, or initiated by domestic or global activity. Thus, it
is impractical, and perhaps a dangerous concentration of power,
to give one single regulator the power to set or modify any and
all standards relating to such risk. Systemic risk oversight
and management must be a collaborative effort, bringing
together the leading authorities for addressing safety and
soundness, managing economic policy, and ensuring consumer
protection.
One alternative to a single systemic risk regulator would
be to develop a panel of federal agencies to consider jointly
these important questions. The Presidential Working Group (PWG)
was established after the stock market crash of 1987 to make
recommendations for enhancing market integrity and investor
confidence. Similarly, the Financial Stability Oversight Board
(FSOB) was established under the EESA in 2008 as a cross-agency
group to oversee the Troubled Assets Relief Program (TARP) and
evaluate the ways in which funds might be used to enhance
market stability. Both groups include the Treasury, the Federal
Reserve, and the SEC. The PWG adds the CFTC, while the FSOB
includes the Housing Secretary and the Director of the Federal
Housing Finance Agency (FHFA), which oversees the housing GSEs.
While the quarterly evaluation of TARP operations provided
by the FSOB will continue through the life of the program, the
broad mission and structure of these two organizations are, in
many respects, redundant. Moreover, they represent the
collaborative, cross-agency structure that would best provide
insight in to the practices, policies, and trends that might
contribute to systemic risk within the financial system.
By combining and refocusing the efforts of these two
organizations, Congress can establish a body with the requisite
tools to identify, monitor, and evaluate systemic risk. The
panel can make specific legislative recommendations, as well as
encourage immediate action consistent with the significant
regulatory powers already vested in its members.
A Panel comprised of the Federal Reserve, the Treasury, the
primary regulator of federally insured depository institutions,
and the combined SEC/CFTC, would have authority to access
detailed financial information from regulated financial
institutions, require disclosure of information necessary to
evaluate risk, and require that financial institutions to
undertake corrective actions to address systemic weakness.
DISAGREEMENT WITH PANEL REGULATORY RECOMMENDATIONS
In far too many areas, the Panel Report offers
recommendations or policy options that are rife with moral
hazard and the potential for unintended consequences. Given
that some of the principal causes of this financial crisis
include the moral hazard embedded in the charter of Fannie Mae
and Freddie Mac, market-distorting housing mandates like the
CRA, and the unintended consequences of a credit rating agency
certification process which restricted competition, we must be
particularly mindful of these risks. In some cases, a
highlighted action may appear benign, but the more detailed
summary includes proposals or policy ``options'' that cannot be
supported.
Other sections, such as those dealing with systemic risk
and leverage, include highly proscriptive proposals that would
be difficult, if not impossible to implement outside the walls
of academia. Finally, the Panel Report all but ignores the
critical role played by the Federal Reserve's highly
accommodative monetary policy, and the host of troubles created
by the government charter and implicit backing of the GSEs.
Avoiding discussion of such important components of the crisis
will inevitably lead one to set the wrong priorities for
reform. While not exhaustive, the following represents a list
of the more significant disagreements held with the Panel
Recommendations for Improvement:
1. The Panel Report calls for a ``body to identify and
regulate institutions with systemic significance'' and
``[i]mpose heightened regulatory requirements for systemically
significant institutions.'' The recommendations suggest that
firms designated as such are to be subjected to unique capital
and liquidity requirements, as well as special fees for
insurance. Although it is important that regulators work to
identify, monitor, and address systemic risk, such explicit
actions are more likely to have unintended and severe negative
consequences.
Publicly identifying ``systemically significant
institutions'' will create significant moral hazard, the cost
of which will far outweigh any potential regulatory benefits.
Consider the two possible effects of being identified as such.
First, in one case, the cost and burdens of additional capital
and regulatory requirements (as recommended) place a firm at a
competitive disadvantage relative to its peers. Thus, the
competitive strength of a systemically significant firm is
impaired, raising the probability of a business failure--an
undesirable outcome.
In the alternative case, the market may view designation as
a de facto guarantee of public support during times of
financial stress. The firm attains a beneficial market status,
and enjoys advantages such as a lower cost of capital in the
public markets. The costs of failure are thus socialized, while
profits remain in private hands (much as was the case for the
GSEs, Fannie Mae and Freddie Mac). Recent events make clear
that this scenario is perhaps an even more undesirable outcome
than the former.
Unfortunately, these are the only two practical outcomes of
any designation--either markets will view it as a competitive
burden or as a competitive advantage. It is unrealistic to
argue that such a ``significant'' designation would be viewed
as competitively neutral. Moreover, it is unreasonable to
assume that government will manage the potential moral hazard
more effectively than was done in the case of the GSEs.
2. The Panel Report recommends the formation of ``a single
federal regulator for consumer credit products.'' Such an
action would isolate the activity of creating and enforcing
consumer protection standards from oversight of safety and
soundness in financial institutions.
The regulation of any federal financial firm requires the
balancing of multiple policy choices and should be done by one
institution. Experience has shown us with the GSE model that
having two stated goals, one for safety and soundness and one
for social policy, inherently will lead to conflict. Since the
new consumer product regulator would be able to affect all
financial institutions, eventually those rules will conflict
with a bank's profitability, capital levels, and ultimately,
solvency. Under this Panel proposal, an independent agency
would have power to impose regulations that could well
undermine the health of banks, but would not be responsible for
the safety and soundness of those banks.
This balance is of particular significance within
institutions that have been provided with explicit taxpayer
funded guarantees, such as FDIC insurance. By placing both
responsibilities with the same regulator, greater assurance is
provided that taxpayer interests will not be placed in jeopardy
by regulations that unnecessarily weaken capital or competitive
position.
3. The Panel Report broadly calls for the adoption of new
regulations ``to curtail leverage.'' While the recommendation
implies that regulators across the spectrum of financial
institutions set inappropriate standards for leverage, this
simply is not the case.
Few, if any, observers of the current crisis have argued
that capital standards set by the FDIC and other federal and
state banking regulators overseeing depository institutions
were set at dangerously low levels. To the extent that FDIC
insured institutions have become troubled, it has been largely
the result of deteriorating loan quality. Thousands of such
institutions across the country remain strong and healthy.
Raising their capital standards now in an effort to ``curtail
leverage'' would be highly procyclical and would sharply limit
the availability of credit for consumers and businesses.
Without question, there were some financial firms, notably
non-depository institutions such as broker-dealers, that were
allowed to raise their leverage ratios substantially in recent
years. The SEC ruling issued in 2004, which allowed alternative
net capital requirements for broker-dealers, contributed
significantly to the failures of both Bear Sterns and Lehman
Brothers. The regulatory decision to rely on internal models
for risk weighting assets appears, in retrospect, to have been
a major miscalculation.
Moreover, prudent regulators may wish to consider adopting
capital policies that are more counter-cyclical as well, to
encourage the building of stronger reserves during good times
and ensure greater stability in periods of financial stress.
Blanket mandates to ``curtail leverage,'' however, will only
restrict access to credit and limit successful lending models
where they are needed most.
4. The Panel Report argues that: ``Hedge funds and private
equity funds are money managers and should be regulated
according to the same principles that govern the regulation of
money managers generally.'' The recommendation fails to
recognize the important distinctions between investment firms
and fails to explain why these distinctions should be ignored.
There exist clear and dramatic differences between managing
capital allocation on behalf of a $5 billion pension fund, and
investing funds placed in a personal IRA or 401k. Under current
law, private equity, venture capital, and hedge funds may not
be marketed to retail investors. While they remain subject to
all regulations regarding trading and exchange rules and
regulations, they are not subject to the marketing and
registration requirements designed to protect smaller,
unsophisticated investors, because they do not serve that
market.
Suggesting that more regulation should be imposed on these
entities in light of the current crisis ignores the fact that
even under the tremendous financial upheaval of the past year,
no major hedge funds have declared bankruptcy, and taxpayers
have been exposed to no losses resulting from failed hedge fund
or private equity investment activity.
Finally, it may be worth noting that several high-profile
hedge fund management firms were among the first to publicly
and accurately assess the dangers inherent in the housing
finance system, mortgage backed securities, and Fannie Mae and
Freddie Mac.
5. The Panel Report call for Congress to ``[e]liminate
federal pre-emption of application of state consumer protection
laws to national banks.'' Such a change would effectively
defeat the purpose of a uniform federal charter for insured
depository institutions.
As previously mentioned, the regulation of any federal
financial firm requires the balancing of multiple policy
choices and should be done by one institution. By giving state
regulators the power to affect bank profitability, capital
levels, and solvency standards, this proposal would greatly
enhance risk and curtail innovation in our system. Under the
Panel proposal, states would not be responsible for the safety
and soundness of federally chartered banks, but would have
authority to impose regulations that could well undermine the
health of those banks.
Allowing states to impose their own consumer protection
laws also undermines the fundamental purpose of a federal
banking charter. Congress established federal financial
charters to enable firms to offer products and services on a
uniform national basis. Standardization of products and
services lowers costs, and acts as an incentive for innovation
by enabling new products to be brought to market sooner.
Allowing every state to impose its own set of product or
business standards on national banks would represent a step
backwards, away from strong well-balanced federal regulation
that allows national firms to compete effectively with global
peers.
6. The Panel Report calls for new ``tax incentives to
encourage long-term-oriented pay packages,'' which would
represent an unprecedented intervention in the operation of
private employment markets.
The Federal Government should not structure the tax code to
reward, penalize or manipulate compensation. Congress attempted
to do this in the Omnibus Reconciliation Act of 1993, Pub. L.
No. 103-66, which contained the so-called ``Million-Dollar Pay
Cap.'' \186\ It not only failed to achieve the stated goals of
its authors, it had unintended consequences: by raising taxes
on cash compensation, more firms chose to compensate executives
with large packages of stock options, resulting in numerous
high-profile multimillion-dollar ``pay days'' when the options
were exercised.
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\186\ Omnibus Reconciliation Act of 1993, Pub. L. No. 103-66, at
Sec. 13211.
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Compensation committees should establish executive pay
policies that are fair, encourage sound long-term decisions,
and are fully disclosed to shareholders and the public. Using
the tax code to design an ideal pay structure will certainly
have unintended negative consequences, as has been demonstrated
by past action, nor will it be successful in deterring
companies from paying their employees what they wish to attract
and retain the best available talent.
7. The Panel Report calls upon Congress to ``consider
creating a Credit Rating Review Board'' which would be given
the sole power to approve ratings required by pension fund
managers and others to purchase investment securities.
The credit rating system is badly in need of reform, but
the main weakness in the current system has been the existence
and operation of, effectively, a duopoly--a status created by
the restraints of the government certification process. Giving
a government operated Credit Review Board the power to sign off
on all credit ratings brings the system to a single point of
failure, and becomes a significant source of systemic risk.
Improving the credit rating system will require more
competition, an elimination of conflicts, and accountability.
Regulators can facilitate this accountability by tracking the
default levels of rated securities over time, and publicly
disclosing the best and worst rating agency performance.
APPENDIX: OTHER REPORTS ON FINANCIAL REGULATORY REFORM
Other reports on financial regulatory reform that are
comparable to this report in various respects are itemized in
the following list and then briefly summarized in the table
below. Reports in both list and table appear in reverse
chronological order by the name of the issuing organization. In
the list, each item is followed by a short-form reference in
brackets.
Group of 30 (G-30). Financial Reform: A Framework for
Financial Stability. January 15, 2009. http://www.group30.org/
pubs/pub_1460.htm. [G-30 January 2009]
Committee on Capital Markets Regulation. Recommendations
for Reorganizing the U.S. Financial Regulatory Structure.
January 14, 2009. http://www.capmktsreg.org/. [CCMR January
2009]
Robert Kuttner, Prepared for Demos. Financial Regulation
After the Fall. January, 2009. http://www.demos.org/pubs/
reg_fall_ 1_8_09%20(2).pdf). [Kuttner/Demos January 2009]
United States Government Accountability Office (GAO).
Financial Regulation: A Framework for Crafting and Assessing
Proposals to Modernize the Outdated U.S. Financial Regulatory
System. (GAO-09-216). January, 2009. http://www.gao.gov/
new.items/d09216.pdf. [GAO January 2009]
North American Securities Administrators Association.
Proceedings of the NASAA Financial Services Regulatory Reform
Roundtable. December 11, 2008. http://www.nasaa.org/content/
Files/Proceedings_NASAA_Regulatory_Reform_Roundtable.pdf.
[NASAA December 2008]
President's Working Group on Financial Markets (PWG).
Progress Update on March Policy Statement on Financial Market
Developments. October, 2008. http://www.ustreas.gov/press/
releases/reports/q4progress%20update.pdf. [PWG October 2008]
Group of 30 (G-30). The Structure of Financial Supervision:
Approaches and Challenges in a Global Marketplace. October,
2008. http://www.group30.org/pubs/pub_1428.htm. [G-30 October
2008]
Financial Stability Forum (FSF). Report of the Financial
Stability Forum on Enhancing Market and Institutional
Resilience and the Follow-Up on Implementation. April 7, 2008
and October 10, 2008. http://www.fsforum.org/about/
overview.htm. [FSF April 2008 and October 2008]
Basel Committee on Banking Supervision. Principles for
Sound Liquidity Risk Management and Supervision. September,
2008. http://www.bis.org/publ/bcbs144.htm. [Basel Liquidity
Risk Management September 2008]
Professor Lawrence A. Cunningham, for Council of
Institutional Investors. Some Investor Perspectives on
Financial Regulation Proposals. September, 2008. http://
www.cii.org/UserFiles/file/Sept2008 MarketRegulation.pdf.
[Cunningham/CII September 2008]
The Counterparty Risk Management Policy Group (CRMPG) III.
Containing Systemic Risk: The Road to Reform. August 6, 2008.
http://www.crmpolicygroup.org/docs/CRMPG-III.pdf. [CRMPG III
August 2008]
Institute of International Finance (IIF). Final Report of
the IIF Committee on Market Best Practices: Principles of
Conduct and Best Practice Recommendations--Financial Services
Industry Response to the Market Turmoil of 2007-2008. July,
2008. http://www.ieco.clarin.com/2008/07/17/iff.pdf. [IIF July
2008]
Securities Industry and Financial Markets Association
(SIFMA). Recommendations of the Securities Industry and
Financial Markets Association Credit Rating Agency Task Force.
July, 2008. http://www.sifma.org/capital_markets/docs/SIFMA-
CRA-Recommendations.pdf. [SIFMA July 2008]
United States Securities and Exchange Commission Staff.
Summary Report of Issues Identified in the Commission Staff's
Examination of Select Credit Rating Agencies. July, 2008.
http://www.sec.gov/news/studies/2008/craexamination070808.pdf.
[SEC Staff July 2008]
International Organization of Securities Commissions
Technical Committee (IOSCO). Report on the Subprime Crisis.
May, 2008. http://www.iosco.org/library/pubdocs/pdf/
IOSCOPD273.pdf. [IOSCO Subprime Crisis May 2008]
International Organization of Securities Commissions
Technical Committee (IOSCO). The Role of Credit Rating Agencies
in Structured Finance Markets. May, 2008. http://www.iosco.org/
library/pubdocs/pdf/IOSCOPD270.pdf. [IOSCO CRA May 2008]
President's Working Group on Financial Markets (PWG).
Policy Statement on Financial Market Developments. March, 2008.
http://www.ustreas.gov/press/releases/hp871.htm. [PWG March
2008]
Senior Supervisors Group (SSG). Observations on Risk
Management Practices in the Recent Market Turbulence. March 6,
2008. http://www.newyorkfed.org/newsevents/news/banking/2008/
ssg_ risk_mgt_doc_final.pdf. [SSG March 2008]
United States Department of the Treasury. Blueprint for a
Modernized Financial Regulatory Structure. March, 2008. http://
www.treas.gov/press/releases/reports/Blueprint.pdf. [Treasury
March 2008]
Financial Services Roundtable (FSR). The Blueprint for U.S.
Financial Competitiveness. November, 2007. http://
www.fsround.org/cec/blueprint.htm. [FSF April 2007 and October
2007]
United States Chamber of Commerce Commission on the
Regulation of U.S. Capital Markets in the 21st Century. Report
and Recommendations of the Commission on the Regulation of U.S.
Capital Markets in the 21st Century. March 2007. http://
www.uschamber.com/publications/reports/0703capmarkets comm.htm.
[Chamber of Commerce March 2007]
Mayor Michael Bloomberg and Senator Charles Schumer, with
McKinsey & Company and New York City Economic Development
Corporation. Sustaining New York's and the U.S.' Global
Financial Services Leadership. January, 2007. http://
schumer.senate.gov/SchumerWebsite/pressroom/special_reports/
2007/NY_REPORT %20_FINAL.pdf. [Bloomberg/Schumer January 2007]
Committee on Capital Markets Regulation (CCMR). Interim
Report of the Committee on Capital Markets Regulation.
November, 2006. http://www.capmktsreg.org/.[CCMR November 2006]
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]