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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Address to Joint Meeting of the Exchequer Club and Women in Housing and Finance


Chairman Christopher Cox

U.S. Securities and Exchange Commission

Mayflower Hotel
Washington, D.C.
December 4, 2008

Thank you for that kind introduction, Cyndi [Glassman, Under Secretary of Commerce for Economic Affairs and former SEC Commissioner]. Dr. Glassman, as an economist in a lawyer-centric agency, made an enormous and positive impact on the Securities and Exchange Commission during her tenure. In no small part because of her influence, during my Chairmanship the SEC has hired many more economists who are working in important ways to advance the SEC's mission of investor protection, orderly markets, and capital formation. The many contributions that Cyndi made are continuing to have profound impacts, and it was a highlight of my tenure to work with her on the Commission.

It is a special pleasure to participate in a joint meeting of Women in Housing and Finance and the Exchequer Club. This is an excellent forum not only for all of you who can share experiences with your peers from the industry and hear from speakers in the financial services world, but also for those of us who are regulators and policy makers in Congress and the executive branch, because your gatherings provide the opportunity for dialogue with an audience of influential and thoughtful leaders who work in finance and markets.

Many of you were here for the meeting a few months ago when my regulatory colleague Sheila Bair addressed the Exchequer Club. She talked about why the FDIC was, as she put it, spending time worrying about what a year ago seemed such a low probability event — the failure of a large bank. And she observed that the failure of a large bank was no longer unthinkable, because, for example, the UK's FSA had recently taken over Northern Rock. Even so, she said back in June, "the failure of a large bank remains highly unlikely."

I am sure that back then, that was the view of most of you in this room as well. I mention this only to highlight the remarkably rapid pace of events since June of 2008. It seems a world away, in light of what has happened in the second half of this year.

As we meet here today, we find ourselves just days away from the federal government having had to rescue no less an exemplar of a large bank than Citigroup, by providing a guarantee of up to $306 billion for its loans and securities backed by residential and commercial real estate. In addition, the federal government has twice made equity injections into Citigroup totaling $45 billion, and received additional preferred stock in connection with the guarantees. Leaving aside the one-third of a trillion dollar guarantee for Citi, the U.S. government's $52 billion in preferred equity makes all of you in this room who are taxpayers 7.8% owners of Citigroup.

Beyond that, as part of the rescue of Citi the FDIC agreed to insure its newly issued debt, which has the effect of giving it a AAA credit rating. Just this week Citi issued $5.5 billion in debt against this guarantee. Nor is this federal debt guarantee limited to Citigroup; it also has been extended to such large institutions as Wells Fargo, Bank of America, JP Morgan, Morgan Stanley, and Goldman Sachs. We have come a long way since your June meeting — from considering the failure of a large bank to be highly unlikely, to having to prevent one with previously unimaginable commitments of taxpayer dollars.

And of course, it is not just commercial banks and thrifts such as Wachovia, Washington Mutual, and IndyMac, or investment banks such as Bear Stearns, or the nation's largest insurance company, AIG, that have preceded Citi in having had to be rescued by the taxpayers, but even the enormous government sponsored enterprises Fannie Mae and Freddie Mac. The total amount of federal support committed so far this year to bail out financial institutions is conservatively estimated at well over six trillion dollars.

And as the bank failures in Europe and Asia have made clear, regulated enterprises around the world have been susceptible as well.

These developments are only the most recent reminders that we are living through one of the most challenging economic times in our nation's history.

I'd like to share some thoughts with you about how we got where we are today, and report on the most recent regulatory actions the SEC is taking even this week to deal with the crisis. But more importantly, having gotten the government so deeply involved in so many private financial institutions, I believe we must now begin to build a framework for our exit strategy from this myriad of new programs and commitments. That exit strategy should be consistent with the fundamental policy objectives of the interventions themselves, and also with the protection of taxpayers, a point that Chairman Bair made earlier this week as well. Even though we are on the front end of what are multi-year government investments, guarantees, and conservatorships, it is vital to understand where we are headed, or else we will never arrive at the desired destination of returning these institutions to fully private ownership and financing.

No audience knows better than you that at its root, the current credit market crisis began with the noble goal of broader home ownership. But it is now widely acknowledged that this goal led to a range of bad policies and dangerous lending practices, in particular in the subprime arena. This was typified by the notorious no-down payment loans, and "no-doc" loans in which borrowers not only didn't have to disclose income or assets, but even employment wasn't verified. It is now abundantly clear, as the SEC's former Chief Accountant testified at a recent Congressional hearing on the failure of AIG, that "if honest lending practices had been followed, much of this crisis quite simply would not have occurred."

Securitization of these bad loans was advertised as a way to diversify and thus reduce the risk. But in reality it spread the problem to the broader markets through financial instruments that packaged risky loans into products that won top credit ratings from the credit rating agencies. Most of those ratings were quickly exposed as unfounded — Moody's alone had to downgrade over 5,000 mortgage-backed securities. As of September 2008, banks had reported over one-half trillion dollars in losses on U.S. subprime mortgages and related exposure, and that figure is far higher today.

In September of last year, Ray McDaniel, the CEO of Moody's, told a meeting of the firm's managing directors that the subprime market "was a slippery slope." He said that what happened in 2004 and 2005 with respect to subordinated tranches was that firms in the credit rating industry "went nuts" and that "[e]verything was investment grade. It didn't really matter." A Standard and Poor's employee in the structured finance division wrote in an internal email: "It could be structured by cows and we would rate it." Another S&P internal email stated that "Rating agencies continue to create [an] even bigger monster — the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters."

While this was taking place and the credit rating agencies were enabling the securitization of record amounts of complex mortgage securities, the credit rating industry wasn't regulated by the federal government. Today, however, that is changed. Under new statutory authority from Congress that authorized the SEC to register and examine credit rating agencies, we conducted an extensive 10-month examination of the three major credit rating agencies' processes for rating subprime related securities from January 2004 to 2008, and reported the results to Congress and the public last summer. The examinations uncovered significant weaknesses in ratings practices, serious conflicts of interest, and the need for major improvements in disclosure to investors.

Based on the findings of these examinations, the SEC last summer proposed comprehensive reforms to regulate the conflicts of interest, disclosures, internal policies, and business practices of credit rating agencies. Yesterday, we issued final rules for reform in many of these areas. These new rules will promote the goals that Congress laid out in the Credit Rating Agency Reform Act of improving ratings quality for the protection of investors, and advancing the public interest by fostering accountability, transparency, and competition in the credit rating agency industry. The new rules have also benefited from consultation with other regulators and supervisors of financial markets both here and abroad, including the Financial Stability Forum and the International Organization of Securities Commissions, where during the last year I have served as Co-Chairman of the Credit Rating Agency Task Force.

Beyond the impact of the new rules enacted this week, the Commission's implementation of the Credit Rating Agency Reform Act over the last year has already produced more competition in this concentrated industry than ever before. Ten credit rating agencies have registered with the Commission since the law was passed. This competition, as we know, promotes higher-quality ratings and provides a check on slack and inferior practices.

The SEC's response to the credit crisis has included several other regulatory and enforcement initiatives as well. When the auction rate securities markets froze early in 2008, we immediately commenced investigations of potential securities law violations by the largest sellers of these instruments. The settlements in principle that we've reached with six of the largest firms would return more than $50 billion to injured investors. The settlements, when concluded, will be by far the largest in the SEC's history.

The Commission currently has over 50 pending subprime related investigations involving lenders, investment banks, credit rating agencies, insurers, and broker-dealers. During the past year the Commission returned $356 million to investors who were harmed when Fannie Mae issued false and misleading financial statements. And the SEC's Division of Enforcement is currently in the midst of a nationwide investigation of potential fraud and manipulation of securities in some of the nation's largest financial institutions through abusive short selling and the intentional spreading of false information.

The exceptional economic turmoil of the past year has created dangerous new opportunities for market manipulation. As a result, during 2008, the SEC brought the highest number of enforcement actions against market manipulation in the agency's history, including a precedent-setting case against a Wall Street short seller for spreading false rumors. Overall during the past year, the SEC has completed the highest number of enforcement investigations in any year to date, by far. We also initiated the second highest number of enforcement actions in agency history.

As you know, accounting issues have also been central to the evaluation of credit and liquidity risk in our markets. The Office of the Chief Accountant and the Division of Corporation Finance have acted on multiple occasions in recent months to address questions regarding the disclosure of fair value measurements of hard-to-value assets in inactive markets, consolidation of off-balance sheet entities, and the accounting treatment of bank support for money market funds.

Most recently, I have been focused on oversight and advisory responsibilities for both the Troubled Asset Relief Program administered by the Department of the Treasury, and the conservatorship of Fannie Mae and Freddie Mac. The Emergency Economic Stabilization Act, and the Housing and Economic Recovery Act of 2008, gave the Chairman of the SEC a formal role on the oversight boards for both the TARP and the GSEs.

It is in this capacity that I have had the opportunity to consider how our national government came to intervene to such an extent in the private sector, and how we can ensure that this intervention comes to an end and is unwound as early as possible.

While each of us here today is undoubtedly aware of the significant recent decisions by the Treasury, the Federal Reserve, the FDIC, and the FHA to commit massive federal resources to support the financial markets, housing, and financial institutions, it has all happened so quickly, and the scale is so vast, that a quick summary is in order. After all, before discussing exit strategies it is important to focus on exactly what it is we will have to be exiting from.

The total amount of federal resources committed so far this year to support the financial markets, housing, and financial institutions conservatively exceeds $6.4 trillion. This amount is certain to grow, as already-announced programs are brought online and existing programs are expanded.

This $6.4 trillion figure, I should hasten to point out, does not include the $5.7 trillion in Fannie and Freddie debt and mortgage-backed securities that is currently outstanding, and that Congress has not backed with the full faith and credit of the U.S. government. Nor does it include the $165 billion stimulus package enacted earlier this year.

To recap the various sources of this $6.4 trillion in federal support so far:

The Treasury's Troubled Asset Relief Program accounts for $700 billion, and its Money Market Mutual Fund Guarantee program accounts for $50 billion. For the Treasury, this totals three-quarters of a trillion dollars.

The Fed's GSE Debt and MBS Purchase Program accounts for $600 billion, and its swap lines for another one-half trillion. Its Money Market Investor Funding Facility has been estimated at $540 billion. Beyond that, its Term Auction Facility represents $400 billion; its Commercial Paper Funding Facility, $280 billion; the Term Asset-Backed Securities Lending Facility another $200 billion; and the Term Securities Lending Facility, $190 billion.

The Fed's share of the Citi bailout is $291 billion. Its commitment to the AIG bailout, including the credit facility, Maiden Lane II, and Maiden Lane III, is currently $113 billion. The Fed's Primary Credit Facility is $100 billion. And the Fed's Asset-Backed Commercial Paper Money Market Fund Liquidity Facility is $60 billion, on top of its Primary Dealer Credit Facility at $52 billion. All total, this comes to just under $2.5 trillion for the Fed — not counting the $29 billion to fund the JP Morgan Chase acquisition of Bear Stearns.

The FDIC has committed $1.4 trillion to its Senior Unsecured Bank Loan Guarantees. And its Non-Interest Bearing Deposit Guarantees account for another $500 billion. Its guarantee to GE Capital represents $139 billion. And its share of the Citigroup bailout is $10 billion. That is a total of $2.049 trillion for the FDIC.

Finally, the FHA's Hope for Homeowners Guarantee Program represents a commitment of $300 billion.

As a Member of Congress for 17 years, I became accustomed to budgeting in large numbers. When I first came to Washington to work in the White House in 1986, the total annual budget of the federal government was less than $1 trillion. The amount of taxpayer money that has been committed in just the last few months for bailouts and guarantees is more than six times that. By comparison, that is far more, even in inflation-adjusted dollars, than we spent fighting all of World War II.

The $700 billion TARP program alone is worth more, in inflation-adjusted dollars, than the combined cost of the Hoover Dam, the Panama Canal, the first Gulf War, the Marshall Plan, the Louisiana Purchase, and all of the moon missions. Multiply that ninefold, and you have the current running total of the federal government's economic rescue programs.

Beyond the sheer magnitude of this new federal spending and the debt burden that it has added, one has to be equally concerned about the new role that it has given to the federal government in our economy. Uncle Sam is now a shareholder in banking and financial institutions and other private firms across the United States. Recipients of federal funding and guarantees are naturally coming under scrutiny by Congress, which rightfully believes it should control the purse strings in our system of government. As a result, there will be demands for compliance with congressional investment preferences and corporate governance policies, which will grow in direct proportion to the length of time that the federal investments and guarantees remain outstanding.

All of these are good reasons for policy makers today to carefully and deliberately construct an exit strategy for each and every aspect of these extraordinary federal interventions in the markets. But there are more good reasons as well. Virtually every aspect of the federal regulatory system is premised on the notion that markets will make investment decisions, while government will regulate both the market and the market actors at arm's length. Conflating the roles of market regulator and market actor would ultimately threaten the integrity of the regulatory system, and is certain to produce dangerous unintended consequences.

When the SEC was created, its purpose was to serve as an independent regulator of the unbridled profit-seeking activity of self-interested individuals and firms in the securities markets. It was not, however, to supplant the market or directly participate in it. Government ownership of the economy was an issue in other countries at that time, but not in America. In Germany during the 1930s, the independence of the private sector was a pre-World War I memory. In the Soviet Union, where the Bolshevik Revolution was not yet a generation old, government virtually occupied the field. And in Italy, where Benito Mussolini's Fascist party promoted an economic approach called syndicalism, nominally private property was devoted to state purposes. Even in France at that time, the corporatist spirit was in the ascendancy, and the government controlled many industries.

But for all of the time since America's founding, our country had far less government involvement in the economy than Europe. This was true mostly because we had far less government, period. Federal revenues totaled less than 5% of GDP in the early 1930s. Even today — at least, prior to the extraordinary actions of 2008 — more than 70% of the U.S. economy remained in private hands, with the balance accounted for by federal, state, and all other government.

It is true that during the 1930s, America first experimented seriously with government ownership in industry. Since our earliest days, of course, government had carried the mail, but under FDR the United States embarked upon experiments in other federally-owned enterprises, such as energy production. The repeal of Prohibition in 1933 put many states into the retail liquor business, and many were already involved in the ownership of public utilities. But these were exceptions, and the essential approach of the Roosevelt administration was to regulate business, not own it. So, for example, the government did not attempt to acquire ownership of farms (putting aside the question whether that would have been constitutionally permitted), but rather chose to closely regulate production. From minimum wage laws to the abolition of child labor to a National Planning Board that provided production recommendations across many industries, the New Deal aimed to forge all elements of society into a cooperative unit. This was America's response to the more radical integration of business and government that was underway abroad.

In the case of the securities markets, which also came under regulation for the first time in the 1930s, there was never an impulse for the federal government to own the exchanges, the investment banks, or the broker-dealers. The creation of the Securities and Exchange Commission in 1934 marked a deliberate effort to clearly define and separate the role of the national government, on the one hand, and the capital markets, on the other. Henceforth, fraud and unfair dealing in the stock and bond markets would be subjected to external discipline by the federal government. Minimum standards would be enforced, such as requiring that every investor be told the essential details about the security in which he or she was investing. Registration of securities, and licensing of broker-dealers, would be required. It was, in short, arms-length regulation of an unabashedly private market, rather than nationalization.

Over the years, as the role of the SEC and its relationship to the markets has been refined through experience, the agency has acquired three explicit goals: protecting investors; maintaining fair and orderly markets; and promoting capital formation. These three complementary missions are logically consistent with the original premise of the securities laws, which was that government is an auxiliary to the market, not a substitute for it or a participant in it. Virtually every aspect of the 1933 and 1934 Acts, and the regulations implementing them, follows from the notion that markets should be efficient, competitive, transparent, and free of fraud.

The normative judgment implicit in this legislative and regulatory scheme is that markets are good. So long as they are in fact operating efficiently, competitively, openly, and honestly, they are good for consumers, investors, producers, and our entire economy.

We have not spent enough time reminding ourselves of this essential premise during the past several months, when events have called it into question. But because the idea of the market is so fundamental to everything that the SEC does, it is now incumbent upon us to revisit the reasons that we value markets so highly.

Our emphasis on private ownership is directly tied to America's dedication to individual freedom. It's in our DNA. It is in large part why the United States came to be at all. Our Declaration of Independence is a recitation of the abuses of excessive government power. Our Constitution is a brilliantly crafted system of checks and balances to prevent that abuse by limiting government's authority over individuals — including in the economic realm, where we're guaranteed our constitutional rights to liberty and property, to freedom from expropriation, and to freedom of contract.

But beyond that, beyond ideals of freedom, the national preference for private ownership is also based on the most basic practicality: it works. America's rise from New World outpost to global superpower was fueled by the dramatic growth of our free enterprise economy into the world's largest. Free enterprise has produced spectacular results. Compared to other national economies with substantial government ownership and central planning, America's economy has been more creative, resilient, and dynamic. We've found that decentralized decision-making, in which millions of independent economic actors make judgments using their own money, results in the wisest allocation of scarce resources across our complex society. And we've found the market to be more reliable in heeding price signals and meting out discipline to failing enterprises than government could ever be.

Financial markets, of course, are not perfect. In particular, they are susceptible to boom-and-bust cycles. Cycles of this sort have been a hardy perennial over the past 400 years of experience with organized markets. Addressing the results of these cycles is why we have protective mechanisms such as the Federal Reserve System and federal deposit insurance. Clearly, these mechanisms have proved inadequate to prevent the current crisis. We will need to carefully examine what needs to be done as a result, but that is a topic for another discussion.

From the standpoint of the SEC, the most obvious problem with breaking down the arm's length relationship between government, as the regulator, and business, as the regulated, is that it threatens to undermine our enforcement and regulatory regime. When the government becomes both referee and player, the game changes rather dramatically for every other participant. Rules that might be rigorously applied to private sector competitors will not necessarily be applied in the same way to the sovereign who makes the rules. On several occasions during the past year the Treasury and the Fed took on the unusual role of negotiators and principals in merger and acquisition transactions that normally would have been arranged by private parties. Even in these extraordinary cases, however, it remained the role of the SEC to regulate these transactions for the protection of investors. We took pains to stay at arms length in these cases, but our close collaboration with these same government agencies has made this truly terra incognita.

For all of these reasons, it is incumbent upon federal policy makers to ensure that the extraordinary actions of the past month are understood to be temporary, and constructed so that they are self-liquidating. Since government programs do not on their own go away, there has to be a deliberate design to eliminate them, and a relentless adherence to execution of that plan. Anything short of this will almost certainly guarantee eternal life for these vast new federal roles.

Let's begin with the TARP. There are four different types of securities that we will need, or may need, to exit from. The first is the perpetual preferred stock issued under the Capital Purchase Program and the Systemically Significant Failing Institutions Program. The second category is the warrants acquired under any of the programs. The third is any debt purchased. And finally, there are the guarantees issued for the various kinds of debt.

Our objective in each case should be to monetize the federal government's positions as quickly as possible. But our ability to do so will be highly contingent on the type of instrument, the type of individual issuer, and the then-prevailing market conditions. As a result, we will need to constantly monitor these positions, the firms, and the markets. We will also need to be very mindful that the size of our positions is material, and we should seek strategies for liquidating them that are the least disruptive to the capital markets. Liquidations must be regular and predictable, in order to reduce market surprises and to avoid depressing the market into which we are selling.

An exit strategy for the government's currently substantial role in Fannie Mae and Freddie Mac will require resolving an inherent conflict in their current status. Back in September, when the magnitude of the residential mortgage crisis became clear, the Federal Housing Finance Agency announced that they were placing both Fannie Mae and Freddie Mac into conservatorship — and that the Department of the Treasury would commit to purchase up to $100 billion in senior preferred stock from each, to support them during the conservatorship.

The Federal Housing Finance Agency established the conservatorship for five stated reasons. First, both Fannie and Freddie were operating in an unsafe and unsound manner. Second, the current market conditions were deteriorating. Third, the financial performance at each company was poor. Fourth, the companies were unable to access the private capital markets for regulatory capital. Fifth and finally, they were critical to supporting the residential mortgage market in this country. But recent political pressures have added a new dimension. As the economic slowdown continues, and more homeowners risk losing their homes, it has become a political priority to reduce the number of foreclosures. Toward that goal, the government, as the functional owner of Fannie and Freddie, has committed both entities to ambitious plans to reduce foreclosure. The goal of reducing foreclosures, however, does not necessarily align with the goal of returning both entities to fiscal stability and solvency.

How do we balance these priorities? Job one should be ensuring that Fannie and Freddie return to financial health, because the alternative is that Congress and the taxpayer will be asked to bail out these institutions at far greater cost than already has been absorbed. Fannie and Freddie own or guarantee $5.7 trillion of mortgage assets. By comparison with that $5.7 trillion, the entire U.S. public debt in late November was $10.6 trillion, so Fannie and Freddie carry more than an additional 50% of that between the two entities alone. Maintaining the viability of an exit strategy requires that, in the near term, Fannie and Freddie not be forced to engage in unsound business practices that would threaten their financial stability.

A further priority must be ensuring that the full cost of purchasing and guaranteeing mortgages is borne by those from whom these companies purchase mortgages. Since the establishment of the conservatorship, investors have required a greater spread over Treasuries for Fannie and Freddie debt, and for mortgage-backed securities. The FHFA has indicated that the statutory capital levels that Fannie and Freddie operated at were too low, and that they should be increased. Both of these input costs need to be factored into the pricing that Fannie and Freddie offer to the market. To ignore these costs, both legacy and current, will result in greater financial distress at these firms, and therefore a greater likelihood that the government will not be able to execute its exit strategy.

The final critical element of an exit strategy for Fannie and Freddie is the determination of what structure we should adopt for these firms in order to have the greatest chance of restoring their financial health. Congress and the new administration must decide if we want to continue the programs in their current form as shareholder-owned structures with linkages to the U.S. government through the congressional charter, whether they can be privatized and broken up into several competing companies, or whether a cooperative structure, such as the Federal Home Loan Bank System, makes sense.

To make this choice, we will have to consider what role we want the firms to play in the implementation of federal policy, and how best to regulate the risks to which that choice exposes the taxpayer. Are these entities intended to advance the interests of their investors? Or is it more important that they advance the policy goal of broader home ownership? Should there be more than two players in this space, and if so, how do we encourage additional competition among potential entrants? Should there be a statutory guarantee for their obligations? On this point, recent experience suggests that in no case should we be left with an ephemeral "sort-of" guarantee that increases uncertainty in both the companies and the system around them.

An exit strategy for the alphabet soup of new facilities created by the Federal Reserve is far easier to devise. That is because these guarantees are more easily undone as the capital markets return to normalcy. What is of greatest importance to ensuring a successful unwinding of the Fed's extraordinary lending and guarantee programs is that the markets be assured that the Fed will in fact do so, and in the most prudent manner possible. To this end, a concerted strategy of public diplomacy, with consistent messaging commenced well in advance, will provide welcome guidance and comfort.

The FDIC's intervention is by its construction also temporary, as the senior unsecured debt guarantees expire on June 30, 2012. An exit strategy for these guarantees requires simply that policy makers adhere to that date and resist temptations to extend or expand the program.

Constructing an exit strategy for the FHA's recent extraordinary expansions of its programs will require, in the short run, that these new authorities be carefully implemented as the private market increasingly originates to FHA standards. Since the FHA advertised underwriting standards require no minimum credit score, accept non-traditional credit, and provide for a low 3% down payment, care must be taken to ensure that the moral hazards of lax underwriting standards and under-pricing of risk that contributed greatly to our current crisis do not inhere in federal programs. Beyond being a responsible lender, maintaining a viable exit strategy means the FHA should seek to originate to standards that will allow these loans to be sold without a federal guarantee when the capital markets return to normal functioning.

Focusing on exit strategies now is of vital importance to ensure that we do not stumble along a dangerous path of confusion that may end in far greater financial exposure for the American people, and a far worse situation for America's taxpayers and investors. If we answer the tough questions now, and make sturdy plans for the future, we can position our mortgage market, our financial services industry, and the broader economy for renewed growth and prosperity.

That is the destination, and it is up to us to find the path to it. We will only arrive at this destination if, once our course is set, we keep that path clearly in focus, every step of the way, starting right now.

Once again, I want to thank all of you who are leaders and participants in Women in Housing and Finance, and in the Exchequer Club, for all that you do to promote the economic health and well-being of our nation. These are challenging times and daunting issues, and we will only surmount them by working together. So let me conclude by saying, on behalf of the thousands of dedicated men and women of the SEC who work to protect investors and markets every day, that we are grateful for your leadership, and proud to be your partners.


Modified: 12/05/2008