Speech by SEC Commissioner:
Remarks Before the 35th General Assembly of the Geneva Association
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
May 29, 2008
Thank you, Brian [O'Hara] for your kind introduction. It is a pleasure to be speaking here today at the 35th General Assembly of the Geneva Association. Before I begin, I must tell you that the views that I express here today are my own and do not necessarily reflect those of the U.S. Securities and Exchange Commission or of my fellow Commissioners.
As a boy growing up in my home state of Florida, I heard many stories of unexplained ship wrecks and airplane disappearances in the Bermuda Triangle, also more ominously called the Devil's Triangle. Sailors and aviators attributed the wrecks and disappearances to everything from paranormal activity, to the suspension of the laws of physics, to aliens from outer-space. Whenever a ship disappeared or a plane vanished from radar in the area between Bermuda; Miami, Florida, and San Juan, Puerto Rico, people were quick to blame the curse of the Bermuda Triangle.
Last month was the 73rd anniversary of one of the most famous ship wrecks in the history of the Triangle, or so many believed. On April 21, 1925, the Japanese freighter Raifuku Maru sank with its entire crew after sending the purported distress signal in broken English, "Danger like a dagger now! Come Quick!" By the time the nearest ship, the HMS Homeric, arrived on the scene, it was too late. The passengers and crew of the HMS Homeric watched as the Raifuku Maru sank into the depths of the Atlantic.1
For years, so-called "experts" on the Bermuda Triangle attributed the sinking of the Raifuku Maru and its cryptic reference to a "dagger" as an indication that a UFO or some bizarre Triangle phenomenon had cause the sinking. This myth perpetuated for decades until it was determined that the ship was nowhere near the Triangle and that the word "dagger" was not part of the ship's distress call. Apparently, the word "dagger" was really "danger." In reality, the ship sank north of Bermuda due to a severe storm.2
The Raifuku Maru and other stories involving the Bermuda Triangle illustrate the human tendency to rush to a conclusion — often without considering all of the facts — following an unfortunate event. This same tendency has manifested itself recently in the assessment of the subprime and the liquidity crises.
Background of Subprime Crisis
As you all know, starting in the summer of 2007, the number of defaults by U.S. home owners with subprime mortgages — especially those with an adjustable rate mechanism, started to rise markedly. At the end of 2007, more than twenty percent of adjustable rate subprime mortgages in the U.S. were delinquent as compared with eight percent of subprime fixed mortgages.3 The number of foreclosures initiated in 2007 — more than 1.7 million — was fifty-three percent higher than the number initiated in 2006.4 Even more foreclosures are expected in 2008.
There are a number of inter-related reasons for the problems in the U.S. subprime mortgage market. The defaults are, in part, a result of the relaxation of underwriting standards during recent years, particularly for adjustable rate subprime mortgages. As a consequence, mortgage loans were being made to borrowers who, in times of tighter underwriting standards, might not have been able to get those loans. Many mortgages had a high loan-to-value ratio. The theory apparently was that in a period of rising home prices, that ratio would fall over time, and the borrowers' equity in their homes would rise, thus improving their prospects for refinancing. Between 2003 and 2006, home prices increased by a national average of more than thirty-five percent.5 In 2007, however, home prices in many regions flattened or fell. Borrowers with adjustable rate mortgages faced the prospect of their mortgages resetting to a higher interest rate with more limited options for refinancing than in the past. Speculation in the housing sector bubble also contributed to the high rate of default since default rates tend to be higher in non-owner occupied housing. That also portends a longer period of recovery for the housing industry, because of the overhang of available, unoccupied housing. In some areas of the country, another factor contributing to borrowers' likelihood of falling into delinquency is a less robust economy.
The problems did not confine themselves to the subprime market, but spilled over dramatically into the rest of the financial market. Subprime defaults, of course, matter to the broader markets because of securitization. In fact, since the 1990s, more than half of all home mortgages have been securitized. Many of these mortgage-backed securities became the basis for CDOs and other complex structured instruments.6 Unfortunately, the transfer of risk away from the mortgage originators means that they do not have much of an incentive to ensure that borrowers repay their loans.
Spreading the risk in this manner, rather than leaving it entirely with the local mortgage provider, is, in many respects, a good thing. 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. As Treasury Secretary Paulson recognized in March, "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."7
Securitization of mortgages also means, however, that the effects of widespread delinquencies in the mortgage market, such as we are now experiencing, are felt throughout the market.
We saw significant deterioration of overall credit and liquidity conditions, both in the U.S. and abroad, but there are signs that the market is perhaps on the cusp of investors coming back. The drop in liquidity and the accompanying lack of market prices, in turn, affected valuation. In many cases, mark to market accounting rules resulted in the recognition of large losses by financial institutions and other market participants.
Since the onset of the current market conditions, the market for mortgage-backed securities and other securitized instruments has become very restricted. In the first quarter of 2008, $61 billion in mortgage-backed securities were issued, compared with approximately $279 billion in the first quarter of 2007.8 Secondary trading markets in these types of securities also have dramatically decreased.
The lack of liquidity and the credit crunch have highlighted some difficulties in applying our accounting rules, in particularly SFAS 157 and Fair Value Accounting. We have witnessed the difficulty in applying fair value to the liability side of the balance sheet. Under the accounting rules, a firm is to consider changes in its own credit worthiness in determining the fair value of a liability. The problem is, the result is counter-intuitive. As credit worthiness of a firm decreases, so too does the fair value of its liabilities. This results in an increase in earnings and a positive effect on the income statement, although there is no cash realization of this income. In other words, under fair value accounting, as a firm becomes less credit worthy, it actually appears to be making income.
The insurance industry has its own unique problems with fair value accounting for insurance liabilities. Insurance regulators generally do not permit the transfer of liabilities, so there is no two-way market to value the liabilities. However, SFAS 157 requires firms to derive the fair value of the liability based on a hypothetical transfer notion. So, fair value, as currently defined, may not necessarily be the right measurement attribute for insurance liability. Many propose that a settlement value, which indicates the amount at which an insurance company could settle claims with policy holders, is a better indicator of fair value for insurance companies.
Problems with fair value accounting also exist on the asset side of the balance sheet. It is important to note that the Standard for fair valuing securities, SFAS 115, has been around since 1993. Any issues related to fair valuing securities have not been caused by SFAS 157 alone. Generally Accepted Accounting Principles generally do not permit reclassification of a security once it has been given one of the three designations under SFAS 115. The designations under SFAS 115 are trading, available for sale, and held to maturity. If you classify a security as "held to maturity," it has to stay in that bucket. If you sell any of the securities from that bucket prior to maturity, it taints the entire bucket.
The current illiquidity conditions have created a situation where certain performing securities may be trading at a steep discount because of lack of liquidity in the marketplace. If a firm holds the securities to maturity, it would receive a set pay-out. However, under SFAS 157, fair value is based on an "exit notion," that is, not what the company may think it is worth, but the amount at which the company could sell the security under current market conditions. In other words, a company that uses fair value accounting must pretend it is selling the securities, and therefore must take a loss when it may not actually plan to sell the securities. Said differently, the lack of liquidity, which manifests itself in a liquidity discount, has to be recognized in the financial statements regardless of intent to trade. Some argue that permitting intent-based accounting, which some have proposed, could create additional problems such as reducing comparability in financial statements and perhaps fostering earnings manipulation.
GAAP provides extensive guidance for insurance companies, unlike IFRS. I understand that many insurance companies prefer the US GAAP model, which segregates insurance accounting based on whether the policies are short-duration or long-duration contracts.
Because of a dearth of IFRS literature for insurance accounting, the International Accounting Standards Board (IASB) has been examining insurance accounting and has been debating whether fair value or perhaps another form of measurement should be used. The FASB has issued a similar discussion paper in the US. The critical question is whether IASB will reach any different conclusions from FASB on these issues.
Last year, the SEC adopted a rule that permits foreign private issuers who report under IFRS, as adopted by IASB, to file their financial statements with the SEC without reconciliation to US GAAP. Now that we have taken that step, the natural question is whether U.S. issuers likewise should be able to choose to report in IFRS or US GAAP. In August 2007, the SEC issued a concept release that posed this question. The comment period closed on November 13, 2007, and the SEC is in the process of reviewing the comments submitted. In the meantime, efforts continue to achieve greater convergence between IFRS and US GAAP.
The SEC has tried to clarify, albeit unsuccessfully, some of the uncertainty with respect to fair value accounting. In March 2008, the Division of Corporation Finance sent a letter to certain public companies identifying a number of disclosure issues related to SFAS 157. The letter instructed companies as follows:
[C]onsider providing a range of values around the fair value amount you arrived at to provide a sense of how the fair value estimate could potentially change as the significant inputs vary. To the extent you provide a range, discuss why you believe the range is appropriate, identifying the key drivers of variability, and discussing how you developed the inputs you used in determining the range.9
Not surprisingly, companies have been resistant to provide a range. There is a concern that if the company puts forth a range, the market may second-guess the company's best estimate of value within the range and take the lower number of the range as the actual value. Another concern deals with exposure to litigation. Any time a company puts forth a range, private litigants may view the disclosure as being too uncertain.
Another area of concern faced by insurance companies is the accounting for insurance contracts. If a company accounts for an instrument as an insurance contract, then the company records premium income and would claim losses on the income statement. Difficulty arises when an insurance contract, such as a financial guarantee, takes the form of a derivative such as a credit default swap. Do you treat it as an insurance contract or as a derivative? Although fairly similar economically, a contract that is treated as a derivative is marked to market with the change in value of the derivative recorded on one line in the income statement. This accounting causes insurance companies to have lower premium income, which is a key statistic by which their performance is evaluated.
These are only a few of the various concerns that the SEC has been hearing from insurance companies when it comes to valuation. The SEC will be hosting a Fair Value Roundtable in the second week of July so that concerns may be voiced in a public forum. I encourage each of you to have a representative from your company present for the roundtable and to voice any concerns that you may be having. These issues are difficult, and there are a variety of views regarding how they should be handled.
President's Working Group on Financial Markets
Regulators, market participants, politicians, and academics are working to understand the problems that the market is experiencing. Two months ago, in response to a call from the President for an exploration of the causes of the market turmoil, the President's Working Group on Financial Markets released a Policy Statement on Financial Market Developments. The President's Working Group includes the Treasury Department, the Federal Reserve, the Securities and Exchange Commission and the Commodity Futures Trading Commission. 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 underlying those recommendations are "improved transparency and disclosure, better risk awareness and management, and stronger oversight" with an eye towards "mitigat[ing] systemic risk, help[ing to] restore investor confidence, and facilitate[ing] economic growth."
The PWG's Policy Statement and other analyses of the current market problems identify ways in which the market participants and regulators contributed to those problems. The PWG's recommendations also identify concrete steps that each group — investors, financial institutions, credit rating agencies, and regulators — can take to improve their activities in the financial markets. As the PWG explained, the "initial shock [of the subprime problems] both uncovered and exacerbated other weaknesses in the global financial system." We must address those deeper weaknesses, not merely the symptoms.
In the words of the PWG, "Following many years of benign economic conditions and plentiful market liquidity, global investors had become quite complacent about risks, even in the case of new and increasingly complex financial instruments." Investors have learned important lessons about risk and, I hope, will be less complacent in the future. Financial institutions will likewise have to take a fresh look at their risk management models. Last month, the Financial Stability Forum issued a report in which it identified, among other things, financial institutions' risk management practices as in need of improvement and recalibration to take into account newly pressing risks.
As the SEC and other regulators look at ways to address the problems in the subprime market, we must be careful not to aggravate the problems with regulatory actions. For example, 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, including uncertainty about regulatory action, increases risk and thus hinders liquidity. As we are seeing, this has the potential to slow down the real economy. It also would be unfortunate if — to the extent that problems in the market now can be tied back to regulatory actions in the past — regulators simply layered more regulations on top of failed regulatory policies of the past.
In addressing the subprime problems, regulators must also be cognizant of other, longer-term challenges that face our capital markets. The longer-term issues include concerns about whether our current regulatory framework is preventing U.S. capital 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. 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. Last month, 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 interesting — and lengthy. 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.
Perhaps the most important recommendation from your perspective is an optional national charter for insurance companies. This sort of charter has been discussed for many years and probably will be for many more. We have a balkanized system of insurance oversight in the U.S., which raises costs for insurers as well as the insured. It also stifles innovation, which ultimately restricts consumer choice. The devil will be in the details: will the terms of an optional national charter increase the efficiency and competitiveness of our national marketplace, or will it merely add an additional layer of regulation and, thus, additional costs? I look forward to the debate on the Treasury proposals.
We are living through a period of unprecedented events, such as the delinquency problems in the retail mortgage market, the liquidity drought, and the collapse of Bear Stearns. When viewed from a historical perspective, a period like this is not necessarily surprising given the attributes of the period leading up to it. These kinds of market situations — uncertainty regarding valuation, integrity of counterparties, or looming regulatory action — have happened before. Markets periodically go through difficult times — they cannot always rise. Indeed, according to one estimate, there have been thirty-two full business cycles — expansion and subsequent contraction — since 1854. Frankly, our current experience is mild in comparison to some of these prior events. Knowing that market cycles are inevitable, does not necessarily make the difficult times easier, but it reminds us that it is not unrealistic to anticipate improvement.
Predictably, some voices in Washington and elsewhere are claiming that the current situation stems from the folly of the supposedly deregulatory past few years and that yet more government regulation of risk-taking is needed. Any impartial observer would hardly call the last few years deregulatory. No matter how many regulations there are, they are no substitute for market participants' making sound decisions based on good information. No one can guarantee success in any investment. I have now done more than forty town hall meetings with investors of all types — military, retirees, students, investment clubs, and others. The one message that I stress the most is to try to understand your risk and diversify. That goes for everyone from the novice investor to the professional. Government can never substitute for these sound investment principles.
As we react to the subprime crisis, we must not overreact. Unlike those who perpetuated many of the Bermuda Triangle legends, we must not rush to conclusions without fully examining the facts before us. Let us strive to understand thoroughly the causes of the subprime crisis and its effects on our intricately interconnected markets. Let us identify the errors that we have made and correct them, without — in the process — abandoning sound policy.
Thank you very much for listening. I appreciate the opportunity to be here today. I am happy to answer your questions.