Mary Schapiro, chairman of the Securities and Exchange Commission, made these remarks at the George Washington University Center for Law, Economics and Finance's Fourth Annual Regulatory Reform Symposium on Oct. 26.
Four years ago, this nation was suffering from a near-collapse of our financial system.
While there are differences of opinion as to what was the most significant trigger, a bipartisan Senate committee report — known as the Levin-Coburn Report — asserted that the crisis was the result of “high-risk, complex financial products; undisclosed conflicts of interest; and the failure of regulators, the credit-rating agencies and the market itself to rein in the excesses of Wall Street.”
While this period of our history will be written and rewritten over and over again, Congress and the administration knew that the status quo was unacceptable. So together, they passed landmark legislation to address many of the issues that were highlighted by that tumultuous period.
The Dodd-Frank Wall Street Reform and Consumer Protection Act is a vital and comprehensive response to the financial crisis — an event that devastated the American economy, cost the American people trillions of dollars and millions of jobs, and undermined the confidence that our financial system requires if it is to thrive and support a growing economy.
The sweeping scope of this financial reform legislation sometimes obscures the fact that despite its breadth, it is rooted in a handful of sound principles that should have been more firmly in place before the crisis and whose embrace serves to make markets more stable and efficient. Simple principles like:
• Markets should be transparent.
• Regulation should be consistent, without gaps that can be exploited by those who wish to indulge in risky, destabilizing or illegal behavior.
• Market participants, not taxpayers, should bear the risks of their market activities.
• And regulators should have the willingness and the tools they need to apply these principles to the day-to-day workings of the financial markets.
The Dodd-Frank Act translated these principles into law that is the foundation for effective regulation.
Interestingly, the title of this historic legislation may seem to suggest that there are two parts to the bill — “Wall Street reform” on the one hand and “consumer protection” on the other. Yet a closer examination of the law reveals that both portions are rooted in those same important fundamentals.
When I arrived as chairman of the SEC in January 2009, there were some calling for the agency to be abolished or split up and divided among other entities — so when the financial reform legislation was being drafted, I took a particularly active role in advocating for the importance of the SEC's mission — a mission to protect investors and ensure the efficient operation of our markets and formation of capital. And I impressed upon policymakers that the SEC could step up and fulfill its mission.
In the process, I worked with those in Congress and in the administration to ensure the SEC would have its authority bolstered, not weakened — and I am pleased that that occurred. It was a sign that Congress appreciated the need for a strong SEC.
At the same time, I am also proud that Congress gave us the tools in Dodd-Frank that I sought: to create a new whistle-blower program that is resulting in high-quality tips from insiders at financial firms; to require hedge fund advisers for the first time to register and be subject to our rules; to proceed with additional clarity in establishing a uniform standard governing the conduct of investment advisers and broker-dealers; and to develop a comprehensive regulatory regime for over-the-counter derivatives, among many other things.
TOUCHED BY TITLE IX
The provisions of Title IX are much more likely to directly touch the lives of you and me. Designated the “consumer protection” section, it is in fact full of systemic safeguards, designed to limit practices which at first seem only to affect individual investors or specific kinds of participants in the financial system.
But these practices, cumulatively, shook the financial system to its foundation. And despite the difference in the size and nature of the players engaged by Title IX, the need to have the playing field defined by the same sort of fundamentals remains.
Take home mortgages. Persuading potential homebuyers to assume a mortgage they have no ability to repay sounds like a classic consumer protection problem. But when millions of bad mortgages were written, bundled and chopped into securities, the financial system shuddered.
It's impossible, of course, to pinpoint the exact moment the financial crisis began. But clearly, a major turning point was when [The] Bear Stearns [Cos. Inc.] collapsed in March 2008, dragged down by the billions of dollars in toxic mortgage-backed securities two of its affiliated hedge funds had acquired.
During the housing bubble, companies found that they could write mortgages and then sell them off — pocketing the origination fee and passing the risk down the securitization chain.
Since originators bore no risk, they had every incentive to let underwriting standards slide. In the era of “interest only,” “option [adjustable-rate mortgage]” and “liar” loans, mortgage originators pushed loans out the door with little or no consideration of whether the homeowners would be able to pay.
Even before the Dodd-Frank Act passed, the SEC had proposed regulation to bring reform to this market, by requiring that securitizers of these [asset-backed securities] provide investors with the data and time needed to analyze independently the soundness or risk offered by the assets underlying the securities — bringing greater transparency to an important financial product.
This sort of regulation would have given investors insight into the quality of the subprime loans underlying the securities they purchased, giving them the opportunity to discover just how much risk they were assuming, and would have required some risk retention.
Title IX attacks the problem even more broadly. This provision attempts to incentivize high-quality origination by requiring that securitizers retain at least 5% of the credit risk of any asset it sells. It also prohibits a securitizer from directly or indirectly hedging or otherwise transferring that credit risk.
Using risk retention to align the interests of originators and securitizers with investors' minimizes the moral hazard that contributed to the mortgage crisis. The commission, jointly with the banking agencies, has proposed rules that are designed to improve the quality of underwriting and research by originators and securitizers, and it does so as much by ensuring that market forces are in place as it does through regulatory prescription. It protects in-vestors and the financial system as a whole.
But that's just a start. The negligence and sometimes outright fraud that too often marked bubble-era mortgage underwriting was compounded by excessive investor reliance on fatally flawed ratings of securities built on top of those loans.
As late as January 2008, 64,000 asset-backed securities were rated triple-A. Unfortunately, as the Senate Investigations Subcommittee stated, “Analysts have found that over 90% of the AAA ratings given to subprime [residential mortgage-backed securities] originated in 2006 and 2007 were later downgraded by the credit rating agencies to junk status.”
As I mentioned, the SEC had begun rule makings designed to lessen investors' dependence on rating agencies in the ABS market by dramatically increasing visibility into the underlying assets. The Dodd-Frank Act furthered that effort.
For instance, in January 2011, the commission adopted the first of approximately a dozen required rule makings related to nationally recognized statistical rating organizations — known as NRSROs. And in May 2011, the commission published for public comment a series of proposed rules that would further strengthen the integrity of credit ratings.
The SEC is acting to end regulator reliance and reduce investor reliance on credit ratings, and to ensure that ratings are produced independently.
For instance, we've removed references to credit ratings in 18 of our rules — and about half of those were removed before the Dodd-Frank Act was even passed.
And earlier this year, as required by the Dodd-Frank Act, we established the Office of Credit Ratings within the SEC, which will play a key role as we move to finalize rules, including among other things:
• Proposals designed to prevent sales and marketing activities from influencing the production of ratings.
• Proposals to make the actual performance of NRSRO ratings visible to investors.
• Proposals that would require certification by third parties retained for the purpose of conducting due diligence related to asset-backed securities.
• Proposals that would establish standards for rating analysts' training, experience and competence, as well as putting in place a testing program.
The financial world is full of zero-sum games. If you short a stock, your profit or loss is exactly the same as the loss or profit incurred by the entity that bought your shares.
But financial reform isn't like that. Of course, in individual cases, investors and consumers of financial products may have different priorities than brokers and banks. But broadly speaking, good regulation, rooted in fundamentals that are, frankly, no secret — transparency, risk management, fairness — benefits all stakeholders.
Transparent markets more efficiently distribute capital. Fair markets bring investors and their capital into the game. Properly allocated and managed risk curbs irrational behavior that can have devastating consequences. It's not hard to figure out.
Unfortunately, there are powerful individuals and entities which profit — at least in the short run — from inefficiencies and opacity, from differentials in information and power, and from taking irrational risks, knowing that profits and compensation will accrue to them, while losses are often assumed by consumers, shareholders and the economy at large.