Speech by SEC Commissioner:
Remarks Before the Irish Banking Federation
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
June 16, 2008
Thank you, Felix O'Regan, for the warm introduction. Céad mile Fáilte! It is a pleasure to be speaking to the Irish Banking Federation here in Dublin, particularly on Bloomsday. Before I begin, I must say that the views I express here are my own and not necessarily those of the United States Securities and Exchange Commission or my fellow Commissioners.
I was here in Dublin about a year ago at Dublin Castle for the Finance Dublin conference speaking about the challenges and opportunities for the global financial services markets. My, how things have changed in a year! The global financial markets have experienced a bit of turmoil, to say the least. This is not just an American phenomenon, but it affects Ireland and the rest of Europe, as well.
Credit and Liquidity Conditions Stemming from the Subprime Mortgage Market
How did we get here? Following the market downturn of 2000, the recession in the U.S. that began early that year, and then the shock of the attack of September 11, 2001, the American capital markets enjoyed a stunning resurgence. Some of this resurgence was attributable to more money in the system, as the Federal Reserve and other central banks reacted to the various crises. This reaction already had begun at the end of the 1990s with the reaction to the fears of Y2K. But, other forces were at work as well. Because of the growth of economies in Asia and Eastern Europe as they emerged from anti-market, communist regimes and the increasing trade made possible by reducing barriers to trade through international mechanisms, business and finance boomed worldwide. With a billion new workers available, the world became more productive than ever. This huge productivity created new wealth, not just in those emerging markets, but also in their trading partners as corporations and entrepreneurs realized the classic benefits of efficiency.
The growth in available capital manifested itself in a stretch of relatively low real interest rates — inflation was in check; indeed, for a while deflation was a fear of many. How many times did we hear the phrase, "too much money chasing too few good deals"? The laws of supply and demand work in the capital markets as in any other market. Asset prices rose, credit spreads narrowed, the perception of risk in financial instruments tied to appreciating assets diminished, which then encouraged financial institutions to increase leverage.
Innovation in the financial sector answered this demand robustly. Financing through off-balance sheet entities expanded what banks could do outside of the traditional banking system. We have seen that what may have been technically "off balance sheet" came back onto the balance sheet because of reputational and other factors. Of course, the traditional banks had other competitors such as investment banks, which also created products to meet investor demand. Leverage increased and financial institutions financed long-term assets with short-term sources of funding, even though the assets were on the whole riskier and less liquid than traditional assets because of the declining credit and risk parameters demanded in the marketplace.
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.1 The number of foreclosures initiated in 2007 — more than 1.7 million — was fifty-three percent higher than the number initiated in 2006.2 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.3 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.4 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.
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. That process is still working itself out.
Amendments to Rules Relating to Credit Rating Agencies
Credit rating agencies have been the focus of scrutiny in the United States and in Europe. Ratings, of course, have an effect not only in the United States but also abroad. The SEC has been working with our counterparts here in Europe and with multinational groups, including the Financial Stability Forum and the International Organisation of Securities Commissions, to study this area and make recommendations for change. Last week, the SEC considered a proposal to strengthen the SEC's rules governing credit rating agencies. I am generally supportive of the proposal. If adopted, the amendments should provide more information to investors so that they can judge the opinions that credit rating firms provide, especially on investments such as structured products. This enhanced transparency also could lead to increased competition in credit ratings. Transparency and competition make for healthy markets, because investors have a better view of what is going on in the market and can make better decisions.
Towards this end, the SEC's proposal would require disclosure of information that credit rating agencies use in the development and surveillance of their ratings, enhanced disclosures of their rating methods, and more comprehensive information about changes in ratings. The focus of the amendments on ratings of structured finance products is warranted given recent events. I hope that our efforts in this area will help to restore confidence in the market for structured finance products, through providing a basis for investors to have a better understanding of those products.
The SEC is clearly charged by Congress to police for conflicts of interest and improve competition. The explicit intent of Congress was that we not substitute the SEC's judgment for that of the rating agencies. Ultimately, a rating is an expression of opinion — one that, barring self-dealing or lack of integrity, enjoys the protection of free speech. More importantly, we must remember that a triple-A opinion issued by a credit rating agency — no matter how much expertise it may have — is no substitute for an investor's making an informed decision and undertaking careful due diligence. We should not perpetuate a regulatory regime that creates a moral hazard for investors by encouraging them to rely on credit ratings.
Indeed, some investors were not caught off-guard by the recent problems with structured products. One comment by a large mutual fund portfolio manager is indicative that some understood the limitations of credit ratings: "We never rely solely on a credit-rating service. We look at what they have to say, but for us it's just a starting point. Our investments are based on our own independent credit analysis."
I opposed one aspect of the proposed release that would require credit rating agencies, in connection with any structured finance rating, to issue a report along with that rating that describes any unique aspects of the rating methods and risk characteristics of structured finance products. Or as an alternative, the rule would permit the credit rating agency to use a special structured finance ratings symbol. A credit rating agency could, for example, append a "dot SF" to its structured finance product ratings.
This proposed change in my view is merely cosmetic — a shiny, but costly, veneer on an otherwise good set of proposals. Likewise, I did not agree with the inclusion of a recommendation for different symbols in the IOSCO credit rating agency code of conduct. Given that investors in the market for these structured finance products are institutional and other sophisticated investors, the fact that a structured finance product is different from other types of securities ought not to come as much of a revelation to investors. Certainly it will serve as a warning of sorts — will it become "Beware the dreaded 'SF' rating"? That scarlet letter might quickly fade away, though, as people learn to ignore it and focus only on the rating to which it is appended. In addition, how much information can a "dot SF" provide an investor about the underlying investment?
It is a question whether investors would pay attention anyway, since the requirement that certain products bear the warning is somewhat arbitrary. After all, what is a structured finance product? Can a rule properly define the universe of such products, especially in an area that is marked by innovation and creativity over the past twenty years? If the "dot SF" becomes a scarlet letter, how long will it take for smart lawyers, accountants, and investment bankers to design products around it? Will that further skew the marketplace and confuse investors? A distinctive rating for certain products could give investors negative assurance about other products; investors might take comfort in the absence of a "dot SF" and unduly rely on the rating without considering other relevant information. On the other hand, will the "dot SF" moniker one day become the fashionable thing to have appended to a rating, so that everyone will strive to have one?
The tenuous benefits offered by the proposals could come at quite a cost. First, there are the costs associated with updating settlement, clearance, trade confirmation, trading, reporting, processing, and risk management systems, to name a few. Second, pension funds and other institutional investors such as insurance companies might be precluded, by state law in the United States and their own investment guidelines, from purchasing these products with a "dot SF" rating. Should a rating with an extension be considered of a different category as a "normal" rating? After all, that is the rationale for the differentiation in the first place — to point out the differences.
Institutional investors certainly can change their investment guidelines, but that takes time. To change all of the state laws that govern insurance companies and pension funds is likely to take even more time. Would these firms be able to continue to hold this kind of investment, or would they have to sell what they have into a market with limited demand? What will that do to the already depressed prices? This, in turn, could further depress liquidity in the market for structured products, which plays a very important role in today's economy. Home owners, companies, and university students enjoy lower rates and more access to capital through securitized markets.
Another major underlying question is whether the SEC has the authority to dictate how the rates should be presented. The SEC based its proposal on books and records authority, but it seems a tenuous hook to me, especially when we have clear Congressional intent under the Credit Rating Agency Act that the SEC not micro-manage the rating process. Indeed, some ratings firms see symbols as a proprietary matter.
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.
Mutual Recognition and Amendments to Rule 15a-6
As we consider regulation, we must evaluate the effect on foreign participation in our markets, and also participation by U.S. investors in foreign markets. The SEC has made strides toward achieving mutual recognition of foreign securities regulatory regimes. Mutual recognition is a process by which the SEC would allow foreign exchanges or broker-dealers to participate more freely in U.S. markets, provided that they are subject to a satisfactory foreign regulatory regime. At the Transatlantic Economic Council meeting that I attended in May, we discussed the importance of proceeding toward achieving meaningful mutual recognition.
I have long been a proponent of more flexible treatment of foreign firms in the U.S. markets. Increased access by foreign and U.S. securities exchanges to each others' markets should produce great benefits. Investors will be the ultimate beneficiaries through lower costs and more choice, if restrictions are eased.
Last year, the SEC hosted a public meeting on this subject, focused primarily on the issue of whether to allow mutual recognition of foreign regulatory regimes that are substantially equivalent to the U.S. rules. However, we need to be very careful about proceeding in this manner.
Mutual recognition does not mean consolidation or reconciliation of the regulations of two jurisdictions. Mutual recognition must not be an attempt at harmonizing regulations from the U.S. and a foreign jurisdiction through a side-by-side, rule-by-rule comparison.
Such a bottom-up approach would result in a completely unworkable and potentially never-ending process. Would the slightest statutory, judicial, or regulatory change cast doubt upon another country's regime? How would those changes be monitored and addressed? Imagine the effort and personnel that would be needed to monitor and respond to regulatory changes in a dozen or more jurisdictions. Would the SEC find itself with effective veto power over other countries' regulations? It might be good material for an academic publication, but it would not work in the dynamic, resource-constricted real world.
A better framework would be a top-down approach, similar to one employed by other U.S. regulators, such as the U.S. Commodity Futures Trading Commission and the Federal Reserve. Under this approach, the SEC would first identify the important elements that a compatible regulatory jurisdiction should embody. This might include investor protection standards, such as protection against misappropriation of customer assets, fraudulent sales practices, financial responsibility of registered entities, and effective examination, licensing and qualification of brokers.
Instead of examining each rule of the foreign jurisdiction, we would generally assess the adequacy of that jurisdiction's oversight. If the foreign jurisdiction's regulatory regime is deemed adequate, a firm could be eligible for exemption.
In evaluating a foreign jurisdiction's regulatory oversight, we also must resist calls for the country to have the same agencies that we have in the U.S. After all, as we saw with the recent publication of the US Treasury Department's recommendations for change to American financial services regulation, our own system of regulatory oversight may see changes in the coming years. Therefore, a foreign jurisdiction need not mirror our own system. Here in Ireland, for example, you have a principles-based regulatory model that is based on strong consultation. That model has been seen to serve the country well during these challenging times.
The SEC's plans toward mutual recognition include long-overdue amendments to our Rule 15a-6, which governs the relationships of foreign broker-dealers with U.S. customers without registering as U.S. broker-dealers. The Final Communiqué from the May meeting of the Transatlantic Economic Council included the recommendation that Rule 15a-6 be amended so that "sophisticated investors" in the United States be allowed to deal directly with foreign broker-dealers and thereby trade foreign securities.
Along with these proposed reforms to Rule 15a-6, the SEC is in the process of working with Australia, Canada, and the European Union with respect to mutual recognition. We are conducting top-down comparability assessments of one another's regulatory regimes. I applaud the push to reduce or eliminate unnecessary barriers to each other's jurisdictions. A workable mutual recognition regime would go far within the context of the transatlantic framework towards fostering cooperation and reducing regulatory burdens. We should work diligently to craft a practicable top-down approach, and recognize that the alternative bottom-up approach will never work.
Responding to the Current Economic Situation
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 previously. 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. These same people argue that more government regulation of risk-taking is needed. But any impartial observer could call the last few years deregulatory. No matter how many regulations there are, they are no substitutes 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.
In closing, I am reminded of a quote by Friedrich Hayek, the Austrian-born economist. Hayek stated that "'Emergencies' have always been the pretext on which the safeguards of individual liberty have been eroded." 5 As regulators, let us ensure that the current economic situation is not used a pretext to misguided regulation. We must stand together as a united front and take balanced and thoughtful approaches to address the concerns we face.
Thank you. I will be glad to answer your questions.