[Congressional Record Volume 156, Number 55 (Monday, April 19, 2010)]
[Senate]
[Pages S2414-S2417]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]
Rule of Law and Wall Street
Mr. KAUFMAN. Madam President, as we continue to learn more facts from
various investigations into the 2008 financial meltdown, a certain
picture is becoming increasingly clear. Like a jigsaw puzzle slowly
taking shape, we can begin to see the outlines of many of the causes of
the crisis--and the solutions they demand. In my view, it is a picture
of Wall Street banks and institutions that have grown too large and
complex and that suffer from irreconcilable conflicts between the
services they provide for their customers and the transactions they
engage in for themselves. It is also a picture of management that
either knew about the lack of financial controls and outright fraud at
the very core of these institutions or was grossly incompetent because
it did not. And the picture includes regulators who failed miserably as
well, due to malfeasance or incompetence or some combination of both.
Until Congress breaks these gigantic institutions into manageably
sized banks and draws hard, clear lines for regulators to ensure that
effective controls remain in place, we will have done neither that
which is necessary to restore the rule of law on Wall Street nor that
which will ensure that another financial crisis does not soon happen
again.
What have we learned in just the past 5 weeks?
On March 15, I came to the Senate floor to discuss the bankruptcy
examiner's report on Lehman Brothers and said, as many of us have
suspected all along, that there was fraud--fraud--at the heart of the
financial crisis. The examiner's report exposed the so-called Repo 105
transactions and what appears to have been outright fraud by Lehman
Brothers, its management, and its accounting firm, which all conspired
to hide $50 billion in liabilities at quarter's end to ``window dress''
its balance sheet and mislead investors. And this practice does not
appear to be unique to Lehman Brothers.
I went further and noted that questions were being raised in Europe
about whether Goldman Sachs had an improper conflict of interest when
it underwrote billions of Euros in bonds for Greece. The questions
being raised include whether some of these bond-offering documents
disclosed the true nature of these swaps to investors and, if not,
whether the failure to do so was material.
Last week, we learned about more alleged fraud at the heart of the
financial crisis. On Friday, the Securities and Exchange Commission
filed charges against Goldman Sachs and one of its traders for alleged
fraud in the structuring and marketing of collateralized debt
obligations tied to subprime mortgages. Goldman allegedly defrauded
investors by failing to disclose conflicts of interest in the design
and structure of these collateralized debt obligations. The SEC says
this alleged fraud cost investors more than $1 billion.
While I will not prejudge the merits of the case, the SEC's complaint
alleges that Goldman Sachs failed to disclose to investors vital
information about the CDO, in particular the role that a major hedge
fund played in the portfolio selection process and that the hedge fund
had taken a short position against the CDO.
Robert Khuzami, Director of the SEC Division of Enforcement, said:
Goldman wrongly permitted a client that was betting against
the mortgage market to heavily influence which mortgage
securities to include in an investment portfolio, while
telling other investors that the securities were selected by
an independent, objective third party.
Kenneth Lench, chief of the SEC's Structured and New Products Unit,
added:
The SEC continues to investigate the practices of
investment banks and others involved in the securitization of
complex financial products tied to the U.S. housing market as
it was beginning to show signs of distress.
Goldman Sachs has denied any wrongdoing and has said it will defend
the transaction.
This particular case involving Goldman Sachs was almost certainly not
unique. Instead, it was emblematic of problems that occurred throughout
the securitization market.
Late last month, Bob Ivry and Jody Shenn of Bloomberg News wrote
about the conflicts of interest present in the management of CDOs, a
topic also discussed at length in Michael Lewis's book ``The Big
Short.'' The SEC should pursue other instances of conflicts of interest
in the CDO market that led to a failure to disclose material
information.
Last year, Senators Leahy, Grassley, and I, along with many others in
the Congress, worked to pass the bipartisan Fraud Enforcement and
Recovery Act so that our law enforcement officials would have
additional resources to target and uncover any financial fraud that was
a cause of the great financial crisis. However long it takes, whatever
resources the SEC needs, Congress should continue to back the SEC and
the Justice Department in their efforts to uncover and prosecute
wrongdoing.
I applaud SEC Chairman Mary Schapiro and especially Rob Khuzami and
the team he has reshaped in the Enforcement Division. They deserve our
steadfast support as the leadership of the SEC continues its historic
mission of revitalizing that institution and making it clear to all on
Wall Street that there is a new cop on the beat.
Also last week, our colleague, chairman Carl Levin, ranking member
Tom Coburn, and the staff of the Permanent Subcommittee on
Investigations began a series of hearings on the causes of the
financial crisis. It is a testament to the professionalism and
dedication of Chairman Levin that he has brought the subcommittee's
resources to bear in such an effective and thorough manner. I also
commend ranking member Tom Coburn for his dedication and effort as a
partner in this effort. Chairman Levin and the subcommittee staff
deserve credit and our deep appreciation for the work they have put
into this series of hearings on Wall Street and the financial crisis.
Since November 2008, subcommittee investigators have gathered
millions--millions--of pages of documents, conducted over 100
interviews and depositions, and consulted with dozens of experts. It is
truly a mammoth undertaking, and the fruits of their labor were evident
in last week's two hearings on Washington Mutual Bank. I look forward
to the subcommittee's remaining two hearings on this subject, including
this Friday's hearing on the role of the credit rating agencies. I
commend this hearing to all my colleagues.
The Levin hearings deserve comparison to the legendary Pecora
investigations of the 1930s, which were held by the Senate Committee on
Banking and Currency to investigate the causes of the Wall Street crash
of 1929. The name refers to the fourth and final chief counsel for the
investigation, Ferdinand Pecora, an assistant district attorney for New
York County. As chief counsel, Pecora personally examined many high-
profile witnesses who included some of the Nation's most influential
bankers and stockbrokers. The
[[Page S2415]]
investigation uncovered a wide range of abusive practices on the part
of banks and bank affiliates. These included a variety of conflicts of
interest, such as the underwriting of unsound securities in order to
pay off bad bank loans as well as ``pool operations'' to support the
price of bank stocks.
The Pecora hearings galvanized broad public support for new banking
and securities laws. As a result of the Pecora investigation's
findings, the Congress passed the Glass-Steagall Banking Act of 1933 to
separate commercial and investment banking; the Securities Act of 1933
to set penalties for filing false information about stock offerings;
and the Securities Exchange Act of 1934, which formed the Securities
and Exchange Commission, to regulate the stock exchanges. Thanks to the
legacy of the Pecora Commission hearings and subsequent legislation,
the American financial institution rested on a sound regulatory
foundation for over half a century; that is, until we began the folly
of dismantling it.
The Levin hearings have shined a much needed spotlight on the role of
potential outright fraud by financial actors as well as the
incompetence and complicity of bank regulators in the financial crisis.
There is no better example of the danger that fraud and lax regulation
poses to our financial system than the collapse of Washington Mutual
Bank, known as WaMu.
Far too often, the failure of institutions such as Washington Mutual
is blamed on high-risk business strategies. It kind of sounds all
right, doesn't it? While such strategies are clearly part of the
problem, they should not be used to mask other causes such as fraud and
malfeasance which played a significant role in the collapse of WaMu.
Evidence developed by the subcommittee demonstrates that WaMu officials
tolerated, if not outright encouraged, fraud as a byproduct of
promoting a dramatic expansion of loan volume.
The most blatant example of WaMu's culture of fraud was its
widespread use of what are called stated income loans. Stated income
loans is a practice of lending qualified borrowers loans without
independent verification of what they state their income is. Listen to
this. This is unbelievable. Approximately 90 percent of WaMu's home
equity loans, 73 percent of its option ARMs, and 50 percent of its
subprime loans were stated income loans. You go to the bank, you walk
in, they say: Ted, what is your income? You say what it is, and that is
it. Based on that, you can get 90 percent of WaMu's home equity loans,
73 percent of its option ARMs, and 50 percent of its subprime loans--
stated income loans. As Treasury Department inspector general Eric
Thorson said last week, WaMu's predominant mix of stated income loans
created a ``target rich environment'' for fraud.
Because WaMu made these stated income loans with the intent to resell
them into the secondary market, there was less concern whether
borrowers would ever be able to repay them. WaMu created a compensation
system that rewarded employees with higher commissions for selling the
very riskiest of loans. In 2005, WaMu adopted what it called its high-
risk lending strategy because those loans were so profitable. In order
to implement this strategy, it coached its sales branch to embrace
``the power of yes.'' The message was clear. As one industry analyst
has said: ``If you were alive, they would give you a loan . . . if you
were dead, they would give you a loan.''
That this culture led to fraud on a massive scale should have
surprised no one. An internal review by one southern California loan
officer revealed that 83 percent of loans contained instances of
confirmed fraud. In another office, 58 percent of loans were considered
to be fraudulent. What did WaMu management do when it became clear that
fraud rates were rising as house prices began to fall? What did they
do? Rather than curb its reckless business practices, it decided to try
to sell a higher proportion of these risky, fraud-tainted mortgages
into the secondary market, thereby locking in a profit for itself even
as it spread further contagion into our capital markets.
In order for WaMu and institutions similar to it to sell these low-
quality loans to the secondary market, they need a AAA rating from
credit rating agencies. So what did these institutions do? They gamed
the system and manipulated the agencies by engaging in a practice
called barbelling. Apparently, the credit rating agencies did not
examine individual FICO scores when rating mortgage-backed securities
and instead relied on average FICO scores. As revealed at the hearing
by a WaMu risk officer and detailed in Michael Lewis's book ``The Big
Short,'' lenders could create the requisite average score by pairing
loans whose borrowers had relatively high scores with borrowers whose
scores were far lower and would normally warrant a loan, which is the
reason why it is called barbelling. So if the raters wanted an average
FICO score of 615, a lender could compare scores of 680 with scores of
550, even though borrowers with scores of 550 were almost certain to
default on the loan. This barbell effect satisfied the rating agencies,
even though half the loans, in many cases, had little chance of
success. At the hearing, WaMu's CEO, Kerry Killinger, effectively
admitted to barbelling by saying ``I don't have the barbell numbers in
front of me.''
To make matters worse, WaMu scored high FICO scores by seeking out
borrowers with short credit histories. Such borrowers often have high
FICO scores, even though they have not demonstrated the ability to take
on and pay off large debts over time. These borrowers are called ``thin
file'' borrowers. According to a report in the New York Times, WaMu
encouraged thin file loans, even circulating a flier to sales agents
that said ``a thin file is a good file.'' The book ``The Big Short''
even discusses a Mexican strawberry picker with an income of $14,000
and no English who was ostensibly given a $724,000 mortgage on the
basis of his thin file.
Plainly, the Office of Thrift Supervision failed miserably in its
responsibility to regulate WaMu and to protect the public from the
consequences of WaMu's excessive and unwarranted risk-taking, including
the toleration of widespread fraud. Although WaMu comprised fully 25
percent of OTS's regulatory portfolio, OTS adopted a laissez faire
regulatory attitude at WaMu. Although line bank examiners identified
the high prevalence of fraud and weak internal controls at WaMu, OTS
did virtually nothing to address the situation. In fact, OTS advocated
for WaMu, among other regulators, and even actively thwarted an FDIC
investigation into WaMu during 2007 and 2008. The complete abdication
of regulatory responsibility by OTS may find sad explanation in the
fact that OTS was dependent on WaMu's user fees for 12 to 15 percent of
its budget.
The regulatory failures at OTS were not unique. The overall
regulatory environment at the time was extremely deferential to the
market based on the widespread but faulty assumption that markets can
and will effectively self-regulate. Self-regulate. At last Friday's
hearing, the testimony of the inspector general at the Department of
the Treasury was particularly noteworthy. He said bank regulators:
. . . hesitate to take any action, whether it's because they
get too close after so many years or they're just hesitant or
maybe the amount of fees enter into it . . . I don't know.
But whatever it is, this is not unique to WaMu and it is not
unique to OTS.
Let me repeat. It was the conclusion of our Treasury Department's
inspector general that the failure of regulators to harness the lawless
nature of conflicted institutions was not unique to Washington Mutual
or to the Office of Thrift Supervision.
I have said it before and I will say it again: It is time we return
the rule of law to Wall Street, where it has been seriously eroded by
the deregulatory mindset that captured our regulatory agencies over the
past 30 years. We became enamored of the view that self-regulation was
adequate, that enlightened self-interest would motivate counterparties
to undertake stronger and better forms of due diligence than any
regulator could perform, and that market fundamentalism would lead to
the best outcomes for the most people. Some people even say that today.
They say transparency and vigorous oversight by outside accountants is
supposed to help our financial system--keep our financial system
credible and sound. The allure of deregulation led us instead to the
biggest financial crisis since 1929 and to former Federal Reserve
Chairman Alan Greenspan's
[[Page S2416]]
frank admission that he was ``deeply dismayed'' that the premise of
enlightened self-interest had failed to work. Now we are learning, not
surprisingly, that fraud and lawlessness were key ingredients in the
collapse as well.
As we turn to financial regulatory reform, we must remember that
effective regulation requires not only motivated and competent
regulators but also clear lines drawn by Congress. Based on what we
have learned, what must we do?
First, we must undo the damage done by decades of deregulation. That
damage includes financial institutions that are too big to manage and
too big to regulate--as former FDIC Chairman Bill Isaac has called
them: too big to manage, too big to regulate. It also includes a Wild
West attitude on Wall Street, in which conflict of interests are
rampant and lead to fraudulent behavior as well as colossal failures by
accountants and lawyers who misunderstand or disregard their role as
gatekeepers. The rule of law depends, in part, on having manageably
sized institutions, participants interested in following the law, and
gatekeepers motivated by more than a paycheck from their clients.
That is why I believe we must separate commercial banking from
investment banking activities, restoring a modern version of the Glass-
Steagall Act to end the conflicts of interest at the heart of the
financial speculation undertaken by mega banks that are too big to
fail. We further should limit the size of bank and nonbank
institutions, something Senator Sherrod Brown and I proposed in
legislation we intend to introduce this Wednesday. Otherwise, we will
continue to bear these mega banks' claims that they are merely market
makers and no one who deals with them should trust whether the very
creator of a financial product they sell is secretly betting against
its success.
Second, we must help regulators and other gatekeepers not only by
demanding transparency but also by providing clear, enforceable rules
of the road wherever possible. One clear lesson of the Goldman
allegations is, we need greater transparency and disclosure of
counterparty positions in the over-the-counter derivatives market. We
should mandate that derivatives are traded on an exchange or at least
essentially cleared. The rare exemption should carry with it a
reporting requirement so that all counterparties understand the
positions being taken by other clients of the dealer firm.
Clearly, we need to fix a broken securitization market. No market,
regardless of how sophisticated its participants, can function without
proper transparency and disclosure. While I am pleased that the current
reform bill would direct the SEC to issue rules requiring greater
disclosure regarding the underlying loans in an asset-backed security,
I believe we must go further still. Requirements for disclosure should
not merely begin and end at issuance. Instead, disclosure should be
automated, standardized, and updated on a timely basis. This will
provide investors with relevant information on the performance of the
loans, their compliance with relevant laws--fraudulent origination, for
example, is generally uncovered after the fact--and the replacement of
new collateral. This information should empower investors and
countervail the malfeasance of issuers looking to adversely select
dodgy collateral that they are also shorting on the side. Moreover,
such real-time monitoring by investors would also have beneficial
effects further up the securitization supply chain. If originators know
they can't get away with selling fraudulent or poorly underwritten
loans, they will also be forced to improve their standards.
While not a silver bullet, I am also generally supportive of
requirements that those who originate and securitize loans retain risk
by keeping some percentage on their very own balance sheets. WaMu, for
example, developed, in Senator Levin's words, a ``conveyor belt'' that
originated, packaged, and dumped toxic mortgage products downstream to
unsuspecting investors. Their lack of ``skin in the game'' allowed them
to make a mockery of the originate-to-distribute model. While Bear
Stearns, Lehman Brothers, and other firms faltered due to their
excessive retention of risk, this basic requirement will better align
the interests of originators and securitizers with those of investors.
Moreover, a clear lesson of the Levin hearings is that Congress must
ban the widespread issuance of stated income loans.
I understand Senator Levin is developing further reform proposals
based on his conclusions from the hearings.
Third, we must concentrate law enforcement and regulatory resources
on restoring the rule of law to Wall Street. We must treat financial
crimes with the same gravity as other crimes because the price of
inaction and a failure to deter future misconduct is enormous. That is
why I'm pleased the SEC is turning the page on its recent history and
sending a message throughout Wall Street: fraud will not pay.
Madam President, last week's revelations about Washington Mutual and
Goldman Sachs reinforce what I've been saying for some time.
Deregulation was based on the view that rational actors would operate
in their own self-interest within a framework of law. But even with the
most rigorous regulators, it is impossible to trace the financial self-
interest of convoluted financial conglomerates, much less constrict
their behavior before it runs afoul of the law. WaMu made loans they
knew could not be paid back. Goldman Sachs allegedly permitted clients
to take secret positions against the very financial products that it
had created.
The picture being revealed by the jigsaw puzzle of multiple
investigations is now emerging clearly in my eyes. These financial
institutions are too big and conflicted to manage, too big and
conflicted to regulate, and too big to fail. Even Alan Greenspan has
said about our current predicament: ``If they're too big to fail,
they're too big.''
Our country took a giant step backwards during the last financial
crisis, upending the dream of home ownership for millions of Americans,
and throwing millions of people out of work as well. The credibility of
our markets, one of the pillars of our economic success, was badly
damaged. It must be restored. There must be structural and substantive
change to Wall Street, where bankers must resume their central role of
efficiently allocating capital, not taking bets in opaque markets that
no one can understand.
The solution is clear. We must split up our largest financial
institutions into more manageable entities; we must separate their
component parts so they are no longer inherently conflicted and so they
can be properly regulated. Only then, if necessary, can they be allowed
to fail without sending our entire economy to the precipice of
disaster.
I yield the floor and suggest the absence of a quorum.
The PRESIDING OFFICER. The clerk will call the roll.
The legislative clerk proceeded to call the roll.
Mr. DURBIN. Madam President, I ask unanimous consent that the order
for the quorum call be rescinded.
The PRESIDING OFFICER. Without objection, it is so ordered.
Mr. DURBIN. Madam President, I ask unanimous consent that any recess,
adjournment, or period of morning business count postcloture; that
following a period of morning business on Tuesday, April 20, the Senate
resume executive session, and that the time until 12 noon be equally
divided and controlled between Senators Baucus and Grassley or their
designees, with Senator Bunning controlling 15 minutes of the time
under the control of Senator Grassley; that at 12 noon, all postcloture
time be considered expired, and the Senate then proceed to a vote on
confirmation of the nomination of Lael Brainard to be Under Secretary
of the Treasure; that upon confirmation, the motion to reconsider be
considered made and laid upon the table, and no further motions be in
order; that the President be immediately notified of the Senate's
action; that the Senate then stand in recess until 2:15 p.m.; that upon
reconvening at 2:15 p.m., the Senate proceed to Calendar No. 165, the
nomination of Marisa Demeo, to be associate judge of the DC Superior
Court; that there be up to 6 hours of debate with respect to the
nomination, with the time equally divided and controlled between the
leaders or their designees; that upon the use or yielding back of time,
the Senate proceed to vote on confirmation of the nomination; that upon
confirmation the motion to reconsider be considered made and laid
[[Page S2417]]
upon the table; no further motions to be in order and the President be
immediately notified of the Senate's action; that the cloture motion
with respect to the nomination be withdrawn; that upon confirmation of
the Demeo nomination, the Senate then proceed to Calendar No. 333, the
nomination of Stuart Nash to be an associate judge of the DC Superior
Court, and immediately vote on confirmation of the nomination; that
upon confirmation, the motion to reconsider be considered made and laid
upon the table, and the President be immediately notified of the
Senate's action with respect to Calendar No. 333.
The PRESIDING OFFICER. Is there objection?
Without objection, it is so ordered.
____________________