[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

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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

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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.

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