Speech by SEC Commissioner:
Improving Financial Markets
Remarks to the Vanderbilt University Financial Markets Research Center, Conference on Securitization
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
April 17, 2008
Thank you so much, Professor [Hans] Stoll, for that wonderful introduction. I am very pleased to be here with you today as part of the spring conference for the Financial Markets Research Center at Vanderbilt University.
Returning to Nashville always feels like a bit of a homecoming. I fondly remember the three years that I lived here while attending law school at Vanderbilt. When I first arrived in 1980, Nashville was quite a bit smaller. For most of the nation, Nashville was known mainly for being the home of country music, Maxwell House coffee, and (at least nearby) Andrew Jackson.
In 1982, American General launched its billion-dollar hostile tender offer for NLT Corporation, the holding company of National Life and Accident Insurance Company. At the time, NLT was the largest financial services company in the area, headquartered in a tall skyscraper located across from the State Capitol. A great deal of effort was undertaken by NLT to resist the hostile offer — including one of the first uses of the so-called “Pac-Man” defense: this is where the would-be target tries to turn the tables and launches a counter-bid to takeover the would-be acquirer.
The Pac-Man effort was unsuccessful and eventually NLT succumbed to the offer of American General. Many people thought that Nashville would vanish as a financial and commercial center. Fortunately, that was not the case. Since that time, Nashville has grown dramatically, both in terms of the diversity of its population and its economic base. Today, not only do major Fortune 500 corporations call Nashville home, but large foreign companies base their U.S. operations from here — and the city can boast about its pro football and hockey franchises.
Twenty years ago, the Financial Markets Research Center at Vanderbilt University was still in its infancy and holding its very first spring conference. The theme of that conference was “The Stock Market Crash of 1987: What Have We Learned?” and featured a single panel with the president of the NASD, the chairman of the Chicago Board Options Exchange, and a commissioner of the Commodity Futures Trading Commission.
From that modest starting point has evolved this two-day conference, which will address a number of significant issues that affect our financial markets. One of the goals of the Center was to improve the understanding of developments in financial markets, financial instruments, and financial institutions from multiple points of view, including from the perspective of appropriate regulatory policy. So I appreciate the efforts of Dr. Stoll — who has been the director of the Center since its founding — and so many others at Vanderbilt to focus on recent developments in securitization as the theme of this year’s conference.
If 1987 was the year of the stock market crash — or, as many now characterize that event, the market break — then 2007 was the year of the liquidity drought. So what have we learned so far and how can we use this knowledge to improve the financial markets? This is the topic that I would like to address today. I note that the views that I express here today are my own and do not necessarily reflect those of the Commission or of my fellow Commissioners.
It is an interesting time in the financial markets and conditions during the past several months have been challenging. We are living through a period of unprecedented events with the collapse of Bear Stearns and the opening of the discount window of the Federal Reserve to prime brokers in the Treasury market. The liquidity drought that we are experiencing has had widespread ramifications on the markets. When viewed from a historical perspective, a period like this is not necessarily surprising, considering the attributes of the period leading up to it. Markets periodically go through difficult times — they cannot always rise.
Starting in the summer of 2007, the markets witnessed increasing defaults by home purchasers with subprime mortgage obligations — especially those that carried an adjustable rate mechanism. There are a number of reasons for the increase in defaults, including flat or falling home prices, more relaxed underwriting standards, higher loan-to-value ratios, regional economic weaknesses, and interest rate re-sets on subprime ARMs. Speculation in the housing sector bubble also contributed, as can be seen in today’s statistics of the rising defaults on mortgages in non-occupied housing. The troubles in the subprime area have carried over to the broader financial markets, resulting in a significant deterioration of overall credit and liquidity conditions, both here and abroad.
Market participants began to question the value of a variety of financial products. As valuations came into doubt, liquidity in these products fell sharply, further complicating the task of valuing these complex instruments. In many cases, “mark to market” accounting rules resulted in the recognition of large losses for market participants and others.
As a result, investors became increasingly concerned about their level of risk exposure to securities and other financial instruments that were tied to these types of mortgages. Unsurprisingly, yields on mortgage-backed securities, and to a lesser extent, corporate debt securities rose sharply as investor demand for these securities fell. Conversely, as part of the “flight to safety,” demand for U.S. Treasury securities increased significantly as market participants became more risk averse.
What happened to Bear Stearns last month was unprecedented. Here we had a large, well-capitalized investment bank experience a crisis of confidence that denied it not only unsecured financing, but even short-term financing over-collateralized by high-quality agency securities. Contrary to popular myth, it was not hedge funds that ultimately did them in, but other major banks. Counterparties would not provide securities lending services and clearing services and prime brokerage customers moved their cash balances elsewhere. These actions fanned fear and concern, prompting other market participants to also reduce their exposure to Bear Stearns creating, in essence, a run on the bank. No financial institution could have withstood this onslaught.
While ceasing to transact with Bear Stearns in the face of a growing flurry of rumors may have been rational and, for those with fiduciary responsibilities to their own clients, prudent, the effect on Bear Stearns was ultimately devastating to its ability to stay in business. Its liquidity position rapidly worsened because of this sudden and unprecedented inability to obtain secured funding even with the best of collateral. The actions of the regulated entities with which Bear Stearns did business ultimately delivered the final blow to the bank.
Since the onset of the current market conditions, mortgage-backed securities and other securitized instruments have taken a significant hit. The market for these types of securities has all but evaporated. The amount of new issuances of residential and commercial mortgage-backed securities has plummeted nearly 92% in the first quarter of 2008 from over $300 billion issued in the first quarter of 2007.1 Secondary trading markets in these types of securities also have dramatically decreased as the balance sheets of many market participants show a surge in assets categorized as “Level 3” — that is, assets where no market valuations can be obtained.
It is critical that both the primary and secondary markets for securitized products return. Securitization has played an important role in expanding liquidity in the mortgage markets and making it possible for many Americans, for whom credit would otherwise not have been available, to own their own homes. Since the 1990s, more than half of all home mortgages have been securitized.2 As Treasury Secretary Paulson recognized last month, “securitization of credit is one example of an innovation that has made more, more flexible and lower-cost capital available to consumers and companies, and stimulated competition.”3
One key element of the return to normalcy will be the ability of market participants to appropriately price the risks associated with each particular product. For instance, events over the past year show apparent underestimations of the credit risk, prepayment risk, and liquidity risk associated with mortgage-backed securities. As we consider appropriate regulatory responses, we must keep in mind that it is the markets, not government regulators, that are best suited for determining and pricing risk. More importantly we should consider that investors, credit rating agencies, and other market participants have learned some valuable lessons about risk in this area as they should. Perhaps they will probably be less likely to underprice such risk in the future.
We, as regulators, must not stand in the way of investors’ and market participants’ sorting this situation out. It would be most unfortunate for the economy — investors, workers, consumers — if regulators were to contribute to market uncertainty through interfering with contracts, judging the merit of products or business strategies (especially with the benefit of 20/20 hindsight), or setting arbitrary rules based not on economics but on conjecture. Uncertainty breeds aversion to risk. Aversion to risk hinders liquidity and thus has the potential to slow down the real economy.
The SEC’s mission to maintain fair, orderly, and efficient markets is based on a very simple premise: if investors have confidence that they will be treated fairly in the capital markets, they will be more willing to invest their money. The less risky they perceive the markets to be, the lower the risk premium they will demand. So it is my hope that any regulatory response will focus on improving the markets by enhancing investor ability to understand and price risk rather than by restricting access to or prohibiting the offering of new, innovative financial products.
These kinds of market situations — uncertainty regarding valuation, integrity of counterparties, or looming regulatory action — have happened before, and our current experience is mild in comparison. In past situations, especially in the early 1990s in the United States, we saw the amount of bank commercial and industrial loans decline steadily and bank holdings of government or other highly rated securities increase proportionately. Some of this reaction could be attributed to boards’ and credit committees’ being more risk averse. But, unfortunately, some of it also could be attributed to the cumulative actions of thousands of bank examiners sharpening their pencils, tightening their reviews, increasing their questioning, and substituting their judgment for that of banks. I am certainly not advocating forbearance when action is warranted. In some cases additional scrutiny may be needed, especially where banks may have lax risk management or credit review systems. Still, examiners should proceed with an understanding of the scope of their role so as not to aggravate unintentionally a situation that the markets are in the process of solving.
The SEC and the bank regulatory agencies issued a joint statement last year regarding business and lending practices in the complex structured finance transaction area. I hope and expect that banks have adhered to this guidance. Nonetheless, we must be concerned about the potential distortions to the credit marketplace and the effect on entrepreneurs and smaller companies (which are usually the weaker credits) of regulatory overreaction. The pendulum can swing too far in either direction. Fortunately, unlike in the past, the sources of capital today are much more diverse, with private funds taking a larger role in lending and stepping in as lenders when regulated entities do not.
Last month, the President’s Working Group on Financial Markets released a Policy Statement on Financial Markets Development. The President’s Working Group includes the Treasury Department, the Federal Reserve, the Securities and Exchange Commission and the Commodity Futures Trading Commission. The Policy Statement came in response to a call from the President for the PWG to look at the causes of the market turmoil. The PWG assessed the regulatory and market weaknesses that contributed to the problems that we are experiencing. The Statement included a number of recommendations. The objectives of those recommendations are improved transparency and disclosure, better risk awareness and management, and stronger oversight.
The Policy Statement focused, in part, on the credit rating agencies, which fall within the SEC’s jurisdiction. Credit rating agencies, which are known officially as “nationally-recognized statistical rating organizations,” are the subject of a current examination by the SEC staff. The staff is looking at the role played by credit rating agencies in the development of the current problems in the subprime market.
Credit rating agencies have been accused of producing inaccurate ratings, failing to adjust timely those ratings, and not maintaining appropriate independence from the issuers and underwriters. As the President’s Working Group noted, however, part of the problem is in how credit ratings have been used: “[m]any investors seem to treat a credit rating as a ‘sufficient statistic’ for the full range of risks associated with an instrument, when, in fact, credit ratings are assessments of creditworthiness, and not of liquidity, market, or other risks.”
The use of ratings in government rules may inadvertently have encouraged investors to think this way. It was only beginning in 1975 that the SEC began to make explicit reference to credit ratings in its rules, thereby creating a legal and regulatory effect of obtaining certain ratings. Initially, the SEC used the term “NRSRO” solely to determine capital charges under the net capital rule for broker-dealers. Subsequently, NRSRO ratings were incorporated into additional SEC regulations, gaining momentum with Rule 2a-7, which governs which assets may be held in a money-market mutual fund. Rule 2a-7 was promulgated in the early 1990s when some funds came close to breaking a dollar of net asset value because of declining values of certain riskier securities that they held in their portfolios. The new rule looked to high-rated debt instruments as suitable investments for money-market funds. After that, the use of the NRSRO designation continued to expand as a convenience. Congress, state legislatures, and regulators other than the SEC also began to make reference to NRSRO ratings.
Before the implementation of the Credit Rating Agency Reform Act of 2006, the practice of the SEC had been to allow staff, essentially one person in our Trading & Markets Division, to designate credit rating agencies as NRSROs through the no-action letter process. If, in the staff’s view, widespread acceptance of ratings issued by a particular ratings agency had been achieved, the staff would issue a no-action letter. In practice, obtaining designation as an NRSRO was a rather opaque process. Some applications lingered for more than a decade without definitive resolution. In 1997, the SEC proposed a rule regarding NRSRO applications and received significant comments on it, but never took action to adopt a rule.
The unintended consequence of the SEC’s approach to credit rating agencies was to limit competition and information flowing to investors. Over the years, many members of Congress had expressed their frustration with the situation. Ultimately, Congress reacted to change the situation. The legislative history reflects a genuine concern that the SEC facilitated the creation of — and perpetuated — an oligopoly in the credit rating business. Indeed, today, three NRSRO-designated firms have more than 90 percent of the market share.
Since I joined the Commission in 2002, I have been a vocal proponent of increased transparency in the NRSRO designation process. We have promulgated rules to provide greater transparency in issuing NRSRO designations. Of course, although we use the term, “Nationally Recognized,” the SEC is in the registration business, not the recognition, business. The government should facilitate market-based decisions, not substitute its judgment for them.
Our examinations are looking at whether the rating agencies diverged from their stated methodologies and procedures for determining credit ratings. They also will focus on whether the rating agencies followed their procedures for managing conflicts of interest inherent in issuing credit ratings.
In our review, we must not rush to conclusions or view matters solely through hindsight. We must not attempt to substitute our judgment for that of the rating agencies. Instead, we must bear in mind that rating agencies may have reached an incorrect result through no fault of the process. They may have just gotten it wrong. A rating is an expression of opinion — one that, barring self-dealing or lack of integrity, enjoys the protection of the First Amendment.
More importantly, we must remember that an “investment grade” rating issued by a credit rating agency — no matter how much expertise it may have — is not an insurance policy and is no substitute for careful due diligence by an investor. We should not create a regulatory regime that appears to provide insurance or creates a moral hazard for investors by encouraging them to rely exclusively on credit ratings. We should not create a regulatory regime that appears to provide insurance against loss, a level of certainty that the capital markets never offer.
We are considering the need for new rules in this area. One approach that we ought to consider is removing references to NRSROs from our rules. This would help to convey the reality that credit ratings are not an official imprimatur, but a statement of opinion by a private entity.
In addition to looking at how the SEC regulates credit rating agencies, the SEC is taking other steps to address both the current problems in the market and longer-term concerns. The longer-term issues include concerns about whether our current regulatory framework is hindering the markets from performing efficiently, whether we are spending our resources wisely to protect investors, and whether we need to make changes to maintain the international competitiveness of our capital markets.
Over the past couple years, academics, politicians, the Treasury Department, and industry groups have undertaken formal studies to look at the competitiveness of the capital markets in the United States. These studies have asked what we need to do to keep our markets attractive for foreign companies and investors at a time in which other countries’ markets are demonstrating many of the features that used to be unique to the United States. The U.S. Chamber of Commerce has issued two reports in the last two years. The common goal of these reports is to maintain and enhance the attractiveness of the U.S. markets to foreign companies seeking to raise capital and foreign investors. Doing this is vital for our economic health — it builds jobs, opportunity, and productive relations among countries.
In the latest of these reports, which came out last month, the Chamber of Commerce noted that the attractiveness of the U.S. markets faces many challenges. The report noted: “We need to reverse the unintended consequences and costs of our current legal and regulatory systems and make them supportive of a fair, balanced, and efficient financial marketplace today and in the future. Both end users and suppliers of capital will benefit greatly if we act constructively.”
Of course, a strong regulatory structure that is designed to ensure fairness, predictability, and efficiency is a crucial prerequisite for any healthy capital market. Investors need and demand effective recourse to the rule of law and enforceability of contract. They rely on a system of integrity.
If, however, we get the balance wrong, regulation can become part of the problem rather than part of the solution. Central to the issue of attractiveness of our markets is regulatory effectiveness and efficiency. Investors ultimately pay for regulation. If regulations impose costs without commensurate benefits, investors suffer the costs of lack of effectiveness and efficiency, not only through higher prices but also through constrained investment opportunities. That ultimately hurts them in their investment performance, because it means less opportunity for diversification.
Broader concerns about market competitiveness and regulatory efficiency have also been the subject of a long overdue examination of the regulatory structure in the United States by the Department of Treasury. Two weeks ago, Treasury released its long-awaited Blueprint for a Modernized Regulatory Structure. Given the multiplicity of potentially affected parties, the debate about the proposals will no doubt be an interesting one. The Blueprint recommends short-, medium-, and long-term steps to address regulatory issues in the financial markets, including a long-term reordering of the regulatory structure in the United States. This would involve a shift to an objectives-based regulatory approach, in which regulatory authority would be allocated according to regulatory objective rather than industry segment.
The Blueprint identifies three broad categories of regulation: market stability regulation, prudential financial regulation, and business conduct regulation. Treasury envisions an optimal regulatory structure in which the Federal Reserve would be the market stability regulator. A newly created Prudential Financial Regulatory Agency would oversee capital adequacy, impose investment and activity limits, and supervise risk management at institutions that enjoy government guarantees. Finally, business conduct regulation, including most current SEC and Commodity Futures Trading Commission functions, would be carried out by a new Conduct of Business Regulatory Agency.
In suggesting these structural reforms, Treasury did not anticipate that they would occur overnight. These are long-term proposals. Based on past experience with similar Treasury proposals, the debate will be measured in years and maybe even decades. Any changes that we make to our regulatory structure, long-term or short-term, must be made with a consideration of how we can make our capital markets more open and welcoming to goods, services, and capital from abroad and more effective and secure for investors.
Thank you very much for your attention. I appreciate the opportunity to be here today and would be delighted to answer any of your questions.
1 “Loan Securitization to Last, But Experts Say Reforms Loom,” Investor’s Business Daily (Apr. 10, 2008) (citing numbers provided by Dealogic).
2 Richard J. Rosen, “The Role of Securitization in Mortgage Lending,” Chicago Fed Letter, No. 244 (November 2007).
3 Remarks by Secretary Henry M. Paulson, Jr. on Recommendations from the President’s Working Group on Financial Markets (Mar. 13, 2008) available at http://www.treas.gov/press/releases/hp872.htm.