4/01/2008 — 

Good Morning. It's a pleasure to be with you today. Thank you for that introduction Russ and I also want to thank Commissioner Tyler for her leadership as the NASAA President and to Commissioner Borg for his past work with the Association.

Years of Lax Regulation

We are at a critical moment. In the past eight years, we have confronted many financial scandals starting with implosions of Enron and WorldCom, market timing and late trading in mutual funds, stock options backdating, and now the trials and tribulations brought on by conflicts in the subprime mortgage lending.

As a result, we need to step back, and seriously consider and identify what went wrong and what fixes are necessary to prevent repeat episodes and restore investor confidence in our markets and our economy.

When you look across these financial scandals, a number of common themes emerge:

  • A lack of transparency and disclosures in complex financial products, such as subprime loans, structured finance, off-balance sheet transactions and credit derivatives.
  • A lack of accountability as the financial companies were not held responsible through market discipline or by regulators and, overall, the market was somewhat blind to what was occurring.
  • A lack of governance and oversight by those responsible for overseeing these companies, including their management of the risks these companies were engaging in, and the financial reports and information they provided to the investing public.
  • A lack of effective analysis by credit rating agencies.
  • In the area of mortgage securities, an incentive structure driven by fees and a process geared towards fueling the demand for poorly underwritten loans in which each part of the chain delinked as soon as they collected fees. Every participant in the process shares responsibility for this current crisis including the mortgage brokers, the lenders, the appraisers, and the securitizes who then packaged these loans and sold them to investors, even putting them into the safest of funds- such as money markets and retirement products.
  • And lastly, a lax regulatory environment created in part by financial regulators desires to emulate their overseas counterparts' "principles-based" approaches. This has been fueled by an overreliance by financial regulators on communicating expectations with speeches and press releases rather than regulatory guidance, rules and examinations. And even some efforts by federal regulators to block state regulators from trying to put the breaks on from heading in the wrong direction.

The events of the past year no doubt signal a clear and critical need to modernize the country's financial services regulations. But underlying that effort there needs to be a sober review on how we got here.

This examination should not only require the review of the authority of individual financial regulators, but also review the way they undertake their responsibilities when they implement their regulations. The first priority should be to get the regulators to explain what happened in each of their agencies and what they think went wrong.

There should be serious reflection among all the regulators about what they have done in the last several months and years and how they can improve dramatically their regulation and supervision. This is not about pointing fingers but about understanding what went wrong so we can understand how to fix it.

This is a very challenging situation. There is a huge uncertainty in the marketplace and it is hard to find a regulatory agency that performed exceptionally well. As a result, we don't have the luxury of sitting around and waiting until things settle down. We have to get to work.

Treasury's Blue Print

Yesterday, Secretary Paulson unveiled a series of recommendations to restructure the regulatory framework of the U.S. financial services industry. Let me be clear at the outset--the genesis of this report was not to address the turbulence we have seen in the markets over the past year. The Treasury Department had been working on this blueprint since March 2007, dovetailing on earlier efforts that were taken up by numerous financial services trade associations and the U.S. Chamber of Commerce over concerns with growing competition from markets overseas.

To the extent that some of the recommendations from the blueprint deal with eliminating duplicative regulation and streamline, it makes sense to consider these proposals. Indeed, they mirror attempts by previous Administrations and Congresses. Over ten years ago, both Congress and the Administration undertook similar efforts to streamline some of the financial agencies, suggesting that mergers between OTS and OCC and the SEC and CFTC would be beneficial. Since then, with the exponential growth in derivatives and the increasing number of investors who use investment strategies that involve both stock and futures, the time may have come to fully explore such an arrangement.

However, we need to make sure that those mergers do not come at the expense of investor protections as the missions of each of these agencies are different. We need to ensure that we bring out the best aspects of each agency rather than engage to a race to the bottom in terms of regulation.

My experience is that creating new institutions out of old institutions is often a costly process. The blueprint proposes the creation of two new regulators. The first regulator, a "prudential regulator," would have authority over banks and limited access to other financial entities such as hedge funds and private equity firms. The second would be a business conduct regulator, and it would "monitor business conduct regulation across all types of financial firms" and would subsume presumably most of the investor protection role of SEC.

Role for the Federal Reserve

Looking back, it is clear that regulators, including the Federal Reserve, were ill-equipped and underprepared to deal with the boom in complex securities and subprime lending. They took comfort in the fact that many of these products spread risk but generally failed to recognize that a system designed to distribute risks also tends to hide it. One of the phenomena that we are discovering is that many financial entities and companies don't quite now what is on their balance sheets. And investors are leery of investing in companies that don't have a full knowledge of what is on their balance sheets.

With a lack of understanding of the risks behind some of these complex and unregulated products, the regulators could do it, but did very little but watch and try to reassure everybody it was all under control.

We have to look closely at the proposal to expand the functions of the Federal Reserve. Expanded authority at the Federal Reserve without looking closely at the way it discharges that authority, could simply mean a rearrangement of the organization chart without significant improvement and informed regulation. Indeed, if we looked back over the last several years, the Fed's failure, in promulgating rules under HOEPA, which governs the acquisition of some of the exotic and predatory mortgage products by financial institutions, is at the heart of this crisis. If those regulations had been enacted several years ago, we might have headed off some of the problems with financial markets today.

Moreover, we have seen major institutions, supervised by the Fed, write off billions of dollars and seek capital from sovereign wealth funds mostly because of off-balance-sheet transactions. And it is quite clear that the Federal Reserve as the regulator on the premises of these institutions on a daily basis missed the risks within these institutions. As former CEA Chairman, Martin Feldstein, wrote "the Fed's banking examiners have complete access to all the financial transactions of the banks that they supervise and should have the technical expertise to evaluate the risks that those banks are taking." It seems quite clear now, with these off-balance-sheet structures, banks were taking lots of risks that they did not really see as risks and neither did their regulators.

Events of the past year have shown that market discipline cannot be a substitute for good, sound regulation and rules. Market discipline is most effective in limiting systemic risk if every participant had confidence in their counterparts and also if there is appropriate and adequate disclosure and transparency.

And again we are reminded that in times of excess liquidity, rules on market discipline often go out the window. As former Citi CEO Chuck Prince, weeks before his resignation, said "as long as the music is playing, you've got to get up and dance. We are still dancing." Our financial regulators need at critical times to turn down the music.

Failures at the SEC

We have just seen with the intervention of the Federal Reserve, a huge support of the financial services industry particularly with respect to the operations of Bear Stearns. And there are policy implications there. But as we are considering those policy implications, it is also important to analyze these circumstances that led to the Federal Reserve to intervene so dramatically and truly understand the role and the ability of the SEC who is charged with supervision of entities that act as an underwriter, issuer, dealer, or investor in these higher risk products.

It is particularly important in light of the fact that the SEC appears to have been caught off-guard by the seriousness of the situation at Bear Stearns, taking the highly unusual if not unprecedented step of assuring investors all was well just two days before the Federal Reserve was forced to intervene to negotiate a fire sale of the firm.

Enforcement and adequate resources are critical components of strong oversight. It is important to note that despite the current turmoil, the SEC requested less than a 1% increase in its operating budget for 2009. This is a significant concern given that increased demands are being placed on staff and the agency during this critical time. Furthermore, it was recently reported that with the naming of a director of risk assessment at the SEC the total number of individuals working in that office had doubled to two. It is astounding that the office, which is charged with the responsibility to "develop and maintain the overall process for risk assessment through the SEC and serves as a resource for divisions and other offices in their risk assessment efforts to mitigate risk" up until last month had only one person working in it. I understand Chairman Cox has committed to hiring additional staff this year; however, one has to wonder why there was such barebones staffing in an office that has such a critical mission to identifying risks in the system.

On the enforcement front, there has been an almost 50% decrease in disgorgements by the SEC in 2007, which in my mind raises questions about whether changes have taken place in enforcement philosophy or scope of activity. To that end, Chairman Dodd and I have requested the GAO to review whether the SEC's Division of Enforcement has sufficient staff and funds to perform its mission and whether there have been fundamental changes in operation to the way they handle cases.

And, at the same time U.S. markets are in disarray, there are quite a few efforts by the SEC and PCAOB to "converge and harmonize with international standards." I am particularly concerned by the timing of the SEC's mutual recognition announcement, which comes in the midst of a major market crisis that has raised questions in the minds of many about the adequacy of U.S. regulatory oversight.

It is critical that the SEC ensure that U.S. investors do not suffer any diminished protections under a system of mutual recognition. This is particularly crucial given that no other market enjoys comparable participation by retail investors, or the benefits and responsibilities that such participation brings, and no other regulator, no matter how conscientious, is likely to share our same commitment to protecting U.S. investors, particularly if that protection comes at the expense of its domestic firms.

This week, I intend to send the Commission a letter requesting their analysis of issues before undertaking such a radical departure from its current policy. I also intend to follow up with hearings on this topic and other issues of mutual recognition, whether it be international accounting or auditing standards.

Disclosures and Investor Protection

Lack of information and disclosure on structured products has been a consistent theme throughout this crisis and yet the Treasury blueprint does not recommend a better way for these new products to be overseen. This is a shortcoming.

For example, in February, it was reported that the city of Springfield lost all but one million of a $13 million investment with Merrill Lynch that was placed into subprime CDOs. Putting aside for the moment the appropriateness of this type of investment for a municipality, I was struck by this comment from Merrill Lynch spokesperson who said Springfield officials weren't given the CDOs' prospectus last spring, during the sale of the CDOs, because Springfield had purchased them after the initial offering. Under those circumstances, "there was no requirement for a prospectus at the time of the purchase." Just yesterday, the New York Times reported that in the case of auction rate securities markets, investors relied on the assurances of their brokers because the sales were not accompanied by prospectuses. This is something we ought to look at closely.

Another theme is the complexity of these products.

In explaining why JPMorgan never structured CDOs, Jamie Dimon recently said "CDOs, honestly, are just too complex. When you have to run a mainframe all night to do 700,000 Monte Carlo simulations to calculate the value of security, it's just too much."

Investors and Bankers agree. When you have individuals such as Warren Buffett and Jamie Dimon who say that these financial products are too complex and yet, these products are sold without disclosures to pension funds, municipalities, and money market funds and there is no one explicitly tasked with looking at these products in the federal government. That is a problem. As everyone in this room knows, safety and soundness is not just about adequate capital levels but also about ensuring that products offered by banks are safe and sound for consumers and investors and indeed the banks themselves.

These are the types of areas that need to be looked into right now. And yet, the blueprint provides very little in terms of how regulators can and should oversee these new products.

Improved Financial Transparency

One of the reforms that will restore confidence in the markets is improving financial transparency. It is critical that the standard setters and regulators ensure that our accounting rules reflect the actual economics of financial transactions to investors and are vigorously enforced.

Off-balance sheet investment conduits have been the source of some of the largest losses incurred by major U.S. banks over the past few months. Most recent estimates by UBS put the total industry write downs for the financial crises "north of $600b." And to date, banks and financial institutions have recognized roughly $160b in losses. So we have a long way to go to work out this problem.

And these issues have contributed to volatility in the financial markets. There have been a significant number of days with market movements in excess of 100 points just since the beginning of 2008. Investors continue to wonder which institution will be the next to incur a large decline in the value of their assets accompanied by a large writedown that may in turn require the need to raise additional capital and potentially dilute existing shareholders value.

The SIVs and SPEs allowed the banks to place significant amounts of liability beyond the scrutiny of regulators and investors. The FASB and the SEC are the standard setters and enforcers that can ensure investors receive the necessary information to make informed decisions. As Chairman of the Subcommittee on Securities, Insurance, and Investments, I have written letters to the SEC, FASB and the IASB, asking them to address these problems so that investors have full information and that we do not continue to allow companies to hide their exposures and risks.

Reforming Credit Rating Agencies

There is also an important need to address the issues of credit rating agencies. Last September, I chaired a hearing on the role of the credit rating agencies in the financial crises. Throughout this past year, there has been growing evidence on the shortcomings of credit rating agencies and their role in the recent market troubles. Any reform of the system has to involve credit rating agencies and I strongly believe that the oversight of credit rating agencies needs to be strengthened.

At a recent Banking Committee hearing, Comptroller of the Currency John Dugan testified that "it is fair to say that bank management, the most sophisticated people among the banks structurers and the bank regulators were lulled into a sense of complacency by these very high ratings." However, as we all now know, the rating agencies failed to understand what they were rating and failed to proactively monitor these securities resulting in stale and inaccurate ratings.

I believe it was glaring omission on the part of the Treasury's blueprint not to include a recommendation on how and where credit rating agencies can be better overseen and regulated. This has to be a part of the regulatory framework discussion. The SEC either needs to have more authority to ensure that the conflicts are managed appropriately and that the ratings are credible or a new agency needs to be established with that task.

Fundamentally, credit rating agencies, like auditing firms, are gatekeepers and they play a critical role in our capital markets and unlike past episodes, doing nothing is not an option.


In the end, financial regulators are the ultimate gatekeepers. A regulatory structure that limits risk in one area but is unable to contain it in others ultimately leaves all investors exposed to volatility in the financial system. The SEC and other financial regulators have to more rigorously examine these financial institutions and require better disclosures of products to investors so that they are aware of the true risks.

Fundamentally, this is about protecting the savings and well-being of all Americans whether for retirement, college, or home, and providing access to capital for businesses and governments to make investments in our future, so that our economy can continue to be the most healthy and vibrant in the world.

And it is also about creating a climate of confidence that makes the American financial markets the envy of the world. If we loose that confidence, we will lose the greatest competitive advantage we have.