Speech by SEC Commissioner:
Remarks Before the Los Angeles County Bar Association 40th Annual Securities Regulation Seminar
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
Millennium Biltmore Hotel
Los Angeles, California
October 19, 2007
Thank you very much John for that kind introduction. I am delighted to be here in Los Angeles and I very much appreciate John, Randall Lee, Roz Tyson, and others for giving me the opportunity to speak to you today. Also, I am pleased that our Los Angeles Regional Office continues to co-sponsor such a comprehensive and informative event.
I have to say at the outset that it is very interesting to be speaking at a seminar on securities law today because — as you may know — this marks the twentieth anniversary of "Black Monday." On October 19, 1987, the Dow dropped nearly 23% — its worst one-day percentage drop in history. So today presents an opportunity for me to reflect briefly on that event, and also turn to more recent events caused by the turmoil in the mortgage and credit markets. I will discuss some of the lessons learned from each experience and what steps regulators have taken in response to these events. Ultimately, major market events such as those in 1987 and those of more recent vintage affect each of us in various ways — whether directly or otherwise.
Before I get too far along, though, please let me remind you that my remarks represent my own views, and not necessarily those of the Commission or my fellow Commissioners.1
During October 1987, our nation's securities markets experienced extraordinary volatility in both prices and volumes. Over the preceding several years, stocks had been rising steadily, and by August 1987, the Dow was on a tear, surging more than 43% for the year. On October 2, it closed at 2,641, but then during the next two weeks, it declined by a total of 394 points. And then, seemingly without warning, on October 19, the Dow declined an additional 508 points — an unprecedented one-day drop of nearly 23%. It continued to decline the following day to a low point of 1,708, and although the Dow eventually recovered to close at 1,994 on October 30, it was still down 26% from its August high.
To this day, the debate continues as to the causes of the October 1987 market break. Some speculate that it might have been a combination of factors, including investor psychology, economic developments, and trading technology issues. Whatever the triggers, the experience demonstrated the interconnected nature of the financial markets. For example, it showed the linkages that had developed between the cash markets and exchange-traded derivatives through the use of program trading strategies by sophisticated investors who bought and sold futures in order to provide downside protection through so-called "portfolio insurance" strategies.
Subprime and Credit Markets
In the more recent events in the financial markets, the dynamics have been both more subtle and farther reaching than those in 1987. Although by no means equating the market turmoil then with today's market issues, it is interesting to note that last Friday the Dow closed at 14,093, up 711% since Black Monday, and its volume routinely measures in the billions of shares. It clearly has experienced some choppy waters this year, as when it declined by 1,155 points in August from its mid-year high in July. But in just the last several weeks, the Dow has recovered by approximately 10%.
It is interesting that the recent volatility in the equity markets was largely a result of turmoil in the mortgage and credit markets. The press often characterizes the broader effects in the financial markets overall as a "subprime" crisis, and certainly that is an apt description, particularly for communities directly affected by defaults among mortgage borrowers. From a capital markets perspective, although the events may have begun in the subprime mortgage market, they had ramifications in other markets that might have seemed distant from those trading subprime mortgage loans. To understand the complicated interrelationships involved, I would like to take you through the events of this summer.
As I reviewed the effects that seemingly unrelated events had on each other, I could not help but think of one of my favorite children's books, "If You Give a Mouse a Cookie," by Laura Numeroff. You might want to keep the plot of this delightful tale in mind if my descriptions of collateralized loan obligations and quant funds become too much to bear. In the book, a very demanding little mouse asks for a cookie. Of course, if you give a mouse a cookie, he's going to ask for a glass of milk. And when you give him the milk, he'll probably ask you for a straw. I think you probably are beginning to get the drift of the plot. While some have asserted that the book is an extended allegory for industrial capitalism and others for the dangers of giving in to terrorism, my take is more straightforward. I see the story as an introduction into the lessons of cause and effect. Try to keep these lessons in mind as I take us through our more complex tale of the markets.
Over the last several years, lower interest rates in the United States led to significant demand for homes and price appreciation in the housing market. Falling interest rates also spurred existing homeowners to refinance their mortgages, something that happened in droves. When prime borrowers had mostly locked in their new rates, the mortgage industry turned to less creditworthy purchasers and those otherwise stretching to afford homes in an appreciating housing market. This led the industry to increase its marketing focus on subprime and nontraditional mortgage loans, a practice facilitated in part by the issuance of asset-backed securities.
As you may know, mortgage lenders don't usually hold on to individual mortgage loans after origination. Instead, they may sell them to third parties who package them into pools and sell the cash flows to investors in the form of bonds. These bonds are mortgage-backed securities. Their purchasers may resecuritize the mortgage-backed securities to create collateralized debt obligations or "CDOs." Perhaps the most relevant point of this securitization process is that it led to an ample supply of mortgage loans, with the proceeds from loan sales providing the mortgage lender with the funding to make more and more mortgage loans. Also, increased competition in this area eventually led to a weakening of underwriting practices. Despite this, when interest rates were low, and home prices increasing, times were good, and mortgage-backed securities performed well.
When interest rates edged upwards and real estate appreciation slowed, however, problems began to surface. Cracks in the subprime mortgage market first became visible in the fourth quarter of 2006, when a sharp increase occurred in the number of so-called "early payment defaults," which occur when borrowers fail to make the first several payments on their mortgages. When this happened, the third parties who purchased the mortgages sought to exercise their right to return them for new ones or receive a cash refund. When they attempted to do this, however, a number of the mortgage lenders who originated the defective loans with little capital and limited liquidity ultimately failed. During the first quarter of 2007, this problem spread to some of the larger mortgage lenders, including a firm called New Century that failed at the end of February.
When New Century's problems became public, market participants began to reprice subprime mortgage assets and the related asset-backed securities significantly. Among those hit hard by the repricing were two hedge funds run by Bear Stearns Asset Management, or "BSAM," that held instruments tied to the subprime market in their portfolios. In March, the BSAM funds reportedly hedged their exposure by using derivative positions in the ABX, a widely-traded index that is correlated with subprime mortgage products. To make a long and sad story short, the ABX then proceeded to rally over the next few months. Although the rally led to gains in the funds' asset-backed instruments, the losses from their ABX hedges exceeded those gains. The end result was that by the middle of June, the funds were down significantly for the year and faced massive redemption requests from their investors. By the end of that month, they faced a full-blown liquidity crisis. Eventually, in July, they failed.
The problems at the two BSAM funds and other hedge funds active in highly-rated structured products tied to subprime mortgages impacted the asset-backed market as a whole. But by early July, the effects were far broader. Other products that had structures similar to the asset-backed securities tied to subprime loans were also suspect. This is where collateralized loan obligations, or "CLOs," come in. Non-investment grade, leveraged loans had become an important financing tool used to acquire public companies, and many of them were sold to CLOs. You may recall reading about a number of leveraged buy-outs that were being done by firms such as KKR and Bain Capital. During 2006 and the early months of 2007, the use of CLOs spiked, with commercial and investment banks originating ever larger lending commitments with confidence that they could sell them in the CLO market.
In fact, by 2007, many of the banks agreed to lending commitments without the traditional covenants designed to protect lenders. Investors stopped buying CLOs in July, however, because of fears that they — like the asset-backed securities tied to subprime — were not the safe bet that their investment grade ratings would imply. The banks then were faced with the prospect of being unable to sell leveraged loan commitments, and possibly having to first fund them and then hold them on their own balance sheets for an extended period of time.
By the end of July, a number of investors in asset-backed securities, including hedge funds, experienced severe liquidity problems, or a "credit crunch," as interest in these securities dried up. These investors could not sell or finance the securities, so they raised cash or reduced their market exposure by instead unloading securities less affected by the credit crunch, including equities. The impact of these sales was magnified by the fact that a large number of hedge funds were following very similar trading strategies, essentially driven by complex quantitative computer models.
As these hedge funds sold their equity positions, it did more than drive down equity prices. Instead, in early August it changed market dynamics in a way that some fund managers thought was statistically impossible — the prices of the securities the quant funds owned tended to decline, and the prices of those they sold short tended to increase. Regardless of whatever statistical improbability may have existed, these events occurred, and the hedge funds performed very poorly as a result. Also, as the funds sought to reduce their portfolios sharply, they rushed for the exits in a manner that only accelerated the underlying trends.
While I will not attempt to fully explain this connection, some now speculate that when these large funds covered their short positions, one effect may have been to exacerbate the stress on the asset-backed commercial paper market. In this market, longer term, less liquid assets are financed through the sale of short-term commercial paper issued by the vehicles such as "conduits" and structured investment vehicles, or "SIVs." In good times, these vehicles earn a good return by effectively borrowing short-term to fund higher-yielding assets. But the assets that resided in these conduits sometimes included leveraged loans, subprime mortgages, and related structured products.
As nervousness grew about all of those instruments in July, there was increasing stress on the commercial paper market as investors began to worry about the particular assets backing the commercial paper in their portfolio, and directed their short-term investments into U.S. Treasury securities instead. The conduits then faced difficulties in reissuing, or "rolling," the commercial paper, placing additional pressure on the balance sheets of some large financial institutions. For example, a number of large commercial banks in the U.S. and Europe had committed to provide the conduits with back-up funding if they were unable for some reason to reissue the commercial paper. When these contingencies occurred, the banks were forced to lend or absorb assets onto their balance sheets. In addition, financial institutions used conduits to fund a variety of assets. In the event that the conduits lost funding, there existed a danger that these assets might return to the balance sheets of the banks where they would have to be funded by other means.
Do you now see why I encouraged you to keep the mouse and the cookie in mind? And you were skeptical! To my way of thinking, this rather remarkable chain of causes, effects, and interrelationships makes the links that program trading and portfolio insurance created between the cash and equity derivative markets back in 1987 seem rather straightforward.
As in 1987 and always — we are actively monitoring events in the securities markets. After the market break in October 1987, the Commission implemented a number of reforms to address the systemic weaknesses that the break had highlighted. For example, we worked with the securities exchanges to increase substantially their capacity to handle high volumes of trades. In addition, we reduced settlement times from five days to three, and implemented certain order execution rules and circuit breakers. These reforms improved the securities markets significantly, leaving them better equipped to handle the challenges of today.
But, of course, today's challenges are often quite different from yesterday's, and it is incumbent upon us to reflect continuously on the causes of market events, assess any weaknesses they highlight, and consider what lessons can be learned from the experience.
The recent subprime and credit problems have evidenced that our financial markets are more subtle, complex, and interconnected than ever before. That lending practices at the lower end of the housing market could have such a spillover effect across the equity markets certainly demonstrates this assertion. So, as a preliminary matter, what are the areas that regulators are likely to focus on as a result?
First, it should come as no surprise that we are focusing on the role of credit rating agencies in the development of structured finance products, how investors use credit ratings, and how securitization has changed the mortgage industry and related business practices. Much of this examination will be conducted in cooperation with the members of the President's Working Group on Financial Markets, including the Treasury, Federal Reserve Board, and the CFTC.
As you may know, in June of this year we implemented the Credit Rating Agency Reform Act of 2006. The Act gave the Commission greater authority over credit rating agencies that register with us as Nationally Recognized Statistical Rating Organizations, or "NRSROs," something that all the major credit rating agencies have done. Under the Act, the Commission has the authority to require NRSROs to keep certain records, have written policies and procedures regarding their ratings processes, and manage their conflicts of interest.
The Commission also has explicit authority to conduct examinations of the credit rating agencies and enforce the provisions of the Act. It is under this authority that the Commission has begun examinations of how NRSROs rate structured products, with particular emphasis on whether they adhere to their published policies and procedures and mitigate any conflicts of interest. These exams are currently ongoing.
Second, we have been spending a good deal of time reaching out to the major participants in the markets that we regulate, most notably to the Consolidated Supervised Entities, or "CSEs." The CSEs are the five largest securities firms that we supervise on a consolidated, or group-wide basis: Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley.
One of the key things we focus on in the CSE program is risk management. For example, we carefully examine the liquidity management practices of these firms, because liquidity is the primary determinant of their ability to withstand periods of market stress. Thus, the Commission layers liquidity requirements on top of the capital requirements customarily imposed on internationally-active financial institutions such as the CSE firms. In practice, these firms must maintain large pools of liquidity at the parent level, where it is available without regulatory restriction to address any financial or operational weakness in regulated and unregulated entities within the group.
We have also focused on the valuation process at the CSE firms, which mark most positions to market. The recent events in the securities markets have made this more difficult for certain complex and illiquid positions for which there may not be a ready market, however, and we are reviewing the firms' valuations methods to ensure that they are robust and applied consistently across their businesses.
Significant market events such as Black Monday, and the dislocation resulting from the turmoil in the mortgage and credit markets are important to understand, as they affect each of us. As with the 1987 market break, the Commission has remained vigilant and is taking the steps necessary to address any effects from recent events on the securities markets. Although the full effect of these events remains to be seen, the Commission stands ready to fulfill its mandates of investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation. I appreciate the opportunity to be here to share my thoughts on these important matters.