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Hearing of the House Oversight and Government Reform Committee - Executive Compensation II: CEO Pay and the Mortgage Crisis


Location: Washington, DC

Hearing of the House Oversight and Government Reform Committee - Executive Compensation II: CEO Pay and the Mortgage Crisis


MR. GALVIN: I am William F. Galvin, secretary of State and chief securities regulator of The Commonwealth of Massachusetts. I commend the committee's decision to ask those who have profited from this mortgage bubble to explain how it happened.

I'm here to give specific examples as to its destructive effect on citizens and communities, but I would respectfully suggest that it's not enough to simply ask how it happened and who profited, but it also must be asked: Did the regulatory process fail? Why was this bubble allowed to build, and are we prepared to prevent another destructive speculator bubble not just in mortgages or housing, but in any area of our economy that affects the day-to-day lives of our citizens -- commodities such oil and wheat come to mind?

With respect to mortgages, there has been a growing awareness of CDOs and collateralization of pools of mortgage loans. We have seen the bursting of a credit bubble and frozen credit markets. I would like to testify as to my experience, as the head of the Massachusetts Securities Division, about some of the consequences of these events to individual investors, small businesses and local governments.

CDOs are artificially fabricated financial instruments collateralized by certain assets such as pools of subprime mortgage loans. In certain CDOs, the collateral consisted of pieces of other CDOs, which can magnify their risk exponentially. A recent administrative complaint brought by my office involved the sale of CDOs to the city of Springfield, Massachusetts. Springfield had struggled financially over the last decade. In 2004, it had a $20 million operating deficit, but with an intensive restructuring, it staged a miraculous recovery, resulting in a surplus at the end of the 2006 fiscal year. The city hired two agents of Merrill Lynch to invest its hard-earned surplus cash.

The city's goal was to invest in safe, cash-like investments. However, according to the allegations in our complaint -- which Merrill, of course has the opportunity to rebut -- Merrill's representatives invested much of the city's money into three highly risky CDOs, including CDOs collateralized by other CDOs. Merrill received underwriting fees and remarking fees in connection with these CDOs. We have also alleged that at the time of the sale, the Merrill agents did not discuss the risks of owning the CDOs with the city.

Shortly after the sale of these CDOs to the city, and despite their alleged AAA rating, the market for them began to dry up and their market value began to plummet. The estimated market value of one of the CDOs dropped, in a couple of months, to 5 percent of the purchase price.

Merrill initially disclaimed responsibility for these sales. But after my office and other regulators began to investigate, it agreed to buy these instruments back. The Springfield case is not unique. In November, we filed an administrative complaint against Bear Sterns with respect to two failed hedge funds that invested heavily in mortgage related CDOs. The allegations involved improperly disclosed conflicts of interest. We're also looking into the sale to the state of Maine by a Massachusetts-based broker of approximately $20 million of structured investment vehicles -- commercial paper backed by subprime mortgages that has precipitously dropped in value.

These cases have also spawned a number of investigations by my office. We are examining other CDO sales to governmental entities in Massachusetts. We are also examining how some of the riskier CDOs manage to receive a triple-A rating. In addition, we are acquiring -- inquiring as to the effect of the bond insurers' insuring of risky CDO transactions on the value of insured municipal bonds and the impact of downgrades on bond insurers. We are particularly concerned about the frozen auction markets on the following cost -- (audio break) -- municipalities. I believe when the final tally is taken, the magnitude of investor loss will be breathtaking, and I fear that such losses will not be limited to wealthy, savvy risk-takers, but the small risk-averse investors and local governments who've been unwittingly caught up in the rampant raft of risk-taking who will incur significant and unnecessary costs.

The cumulative effect on our overall economy has been paralysis and decline. In my opinion, what you are examining today is nothing less than the roots of recession. The effects of the reckless mortgage lending that was enabled and fed by the securitization of these mortgages is now being felt by homeowners across the country. Recently, a land registration division in my office prepared an analysis of foreclosures in Lowell, Massachusetts, which is another Massachusetts city. From 2000 to 2005, there were fewer than 50 foreclosures per year in Lowell. In 1006, there were 93. In 2007, there were 283. The report anticipates that foreclosures in Lowell will continue to spike in 2008 as the interest rates of many adjustable mortgages begin to reset.

Some common attributes of those mortgages include no-money-down mortgages, interest-only mortgages and mortgages with very low introductory teaser rates. Often, these loans were made by national -- not local -- lenders. The traditional relationship between lender and borrower with respect to a particular piece of property has been severed. National lenders made unsuitable loans to lower-income borrowers knowing they would not have to live with the mortgage loans for their entire lifespan. Instead, many of those loans were bundled into mortgage-backed securities and CDOs, and sold to cities, towns, individual investors and pension plans. The middlemen profited in these transactions from a wide variety of fees, including mortgage origination fees, investment banking fees for underwriting the securities and the sales and commissions for selling pieces of them.

Finally, the recent freezing of the auction market appears to be yet another aftereffect of the subprime lending excesses and the CDO market meltdown. Within the last couple of weeks, my office has received calls from people who thought they were investing in state liquid investments only to find that they, in fact, had purchased auction market securities that are now frozen. They cannot be liquidated. We receive calls from a young saver whose house down payment is now frozen, two siblings whose family trust is now frozen, a small business owner who finds their business interrupted because money they thought was liquid is tied up in frozen auction market securities. My office will be investigating these cases in order to determine whether investors were informed their investments might become a liquid.

In addition, we're looking into the role of the major investment banks that sold these securities, and had in these events such subprime mortgages CDO marketed, but because such -- as the subprime mortgage CDO market crashed, the triple-A ratings provided to all but meaningless -- and all but meaningless bond insurance becoming very tenuous that led to the freezing of these markets. What we are left with is mortgage originators, investment banks and their CEOs walking away with profits derived from subprime lending and securitization, and deceived investors and would-be homeowners trying to repair the damage to their lives and communities.

I respectfully urge this committee and the federal -- and federal and state regulators to work together to continue to uncover the details of the harm suffered by investors and mortgage borrowers, and to hold the promoters of these exploitive financial arrangements responsible and to demand greater and continuing scrutiny by regulators. Thank you for the opportunity to provide this testimony today.


REP. PETER WELCH (D-VT): Thank you. Thank you, Mr. Chairman. I want to thank the witnesses. You all are on the front lines. I really appreciate your leadership in trying to get some relief and also frame the issues. Let me ask you a couple of questions.

One of the things that was occurring with Mr. Mozilo is that between November of '06 and December of '07, he sold about 5 million shares of his stock. And that was occurring at a time when countrywide, under his leadership, had designed a plan to buy back over a billion dollars' worth of stock, and borrowed money in order to do that.

As an expert on corporate governance, Ms. Wachter -- or, I'll ask Ms. Minow. I'll start with you first. What's your reaction to that apparent contradiction?

MS. MINOW: I find that to be possibly the most deeply concerning of all of the facts that have come out about his pay package. I have to tell you, Mr. Welch, I'm a very, very hardliner on this. I don't like to see executives sell stock at all. He had a substantial stock holding and I think he would have done better in being a steward of the company's assets if he had to hold onto it.

REP. WELCH: Mr. Galvin, how about you?

MR. GALVIN: Well, I think it points up the conflicts that are inherent in this whole situation. You've raised the point that many of the lenders here, the people who package these things, who allowed this process to go on, were publicly traded corporations. So that's another whole dimension.

When you look at the coverage they received, once again, there were many elements of conflict. They were oftentimes receiving coverage from some of the same investment banking houses that were engaging in business with them.

So I think the bigger question, I guess, is we recognize that housing is a fundamental need, a necessity of life. And the impact of this crisis, I think, is evidenced by the testimony you've heard this morning, has been not only devastating to those who need housing, but also to our economy. And the question is -- and that's what I tried to raise in my original testimony -- is how do we make sure this doesn't happen again?

I understand the mission of this commission -- Committee, rather, is to look at oversight with a view towards making sure it doesn't happen again. And how do you fix what's happened?

And so I think there's a real problem when you have this type of activity on the part of CEOs. I share Ms. Minow's concern. When you see a sale -- we regulate securities, I regulate securities in Massachusetts. When you see this kind of sale, it raises red flags.


REP. WAXMAN: Well, from a shareholder perspective, what rational would there be to give a former CEO who had just presided over a loss of $10 billion, perks of $1.5 million, a cash bonus of $10 million? From a shareholder -- because the board's supposed to be representing the shareholders, aren't they?

MS. MINOW: That's my belief. It doesn't always work that way. From a shareholder perspective, I do not think it is possible to justify that payment.

REP. WAXMAN: Mr. Galvin, you represent an institutional investor. Do you have a comment on this?

MR. GALVIN: Yes. I'm concerned about this, because it continues -- the continuation of this practice, or the acceptance of these practices, may well lead to additional abuses in the future.

I mean, one of the big problems in the whole financial services area historically, I believe, is that there's been a history here of allowing people, at great public expense, to make big mistakes and simply either be dismissed with pay or the company to pay a fine and move on their merry way until they do it again.

And one of my greatest concerns about this is obviously, the crisis we've all been speaking to this morning, as far as the housing market, but it also is: What are we learning from this? What are we doing about -- to make sure this type of problem doesn't occur again?

You know, one of the issues that came up in the context of Congressman Issa's questions, is the whole issue of securitization. The reason this big pool of money was available was of securitization. Severing the link between a specific value for a home and, in fact, the pool of money that was available, it fostered the abusive loans that were just chronicled by the professor.

So the question is, if you continue to reward people for making mistakes, if you continue to reward people for screwing up, you know what? They're going to screw up again. It may be in a different context, a different company, but it's going to happen. And the question is, what are we doing about it?

And I'm particularly concerned when it affects things that are essential life -- shelter, fuel -- things that we all need and things that destroy our economy overall and I think that's what we're seeing now.


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