Ensuring A Sound Credit System

Floor Speech

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Ms. KAPTUR. Madam Speaker, last Sunday, Treasury Secretary Geithner and the President's economic adviser, Larry Summers, both Wall Street men, wrote an editorial laying out their case for financial regulatory reform, or at least that is what they called it. It fell far short of the mark.

They stated the basis of their proposal is the theory ``the financial system failed to perform its function as a reducer and redistributor of risk.'' Let me repeat that. Their fundamental principle is ``the financial system failed to perform its function as a reducer and redistributor of risk.'' They then advised the President to use that idea as the basis of what he proposes.

I beg to disagree. The purpose our financial system should be to assure sound credit. A financial system should be structured to promote responsible lending and responsible savings practices. We have seen the result of a financial system that lost its way and traveled down the road of high risk-taking with other people's money, a system with no boundaries, no accountability and inherently unstable.

Securitization and risk were at the heart of that failed system. Have we learned nothing? Securitization may spread out risk, but it does not spread out damage when it fails. We see that clearly enough today.

Who on Wall Street who led the charge on high risk-taking is suffering today? They are getting bonuses. I cannot say that for those Americans who are losing their jobs, their homes and their businesses.

Enshrining securitization and risk at the heart of their proposal is absolutely the wrong end of the road to be starting at. Securitization has nothing to do with sound credit. Securitization removes the connection between the lender and the borrower. It does nothing to assure sound credit, nor encourage savings and prudent lending. The lender sells the loan, and they are done. What does the lender care if the profit has been made? They don't.

We don't need more securitization, more credit default swaps, more derivatives and more obligations that are hedged so many times that no one can even find them.

The financial regulatory reforms the administration released this week do not restore prudent financial behavior. That is what is necessary to lead us out of this economic darkness. America needs a credit system that is safe and sound, not risky and not overleveraged.

Yesterday in The New York Times, and I will place this article in the Record, Joe Nocera said that if President Obama wants to create regulatory reform that will last for decades, he needs to do what Roosevelt did. ``He is going to have to make some bankers,'' and I would add security dealers, ``mad.''

But why are Mr. Geithner and Mr. Summers protecting Wall Street? To date, the executive branch has been barking about the too-big-to-fail institutions. But the best they have done is nip at the edges of real reform and fixing what is wrong. Did AIG teach us nothing? An institution that is too big to fail is too big to exist.

Wall Street's bailout taught banks exactly the wrong lesson. It taught them, be reckless. The U.S. Government will make sure you do not take a hit. Just keep your campaign contributions rolling our way.

Take a look at derivatives in their proposal. Why only regulate normal boring derivatives when the derivatives that got us here are the exotic ones that are being protected from regulation? Do we need yet another credit default swap debacle to teach us that every derivative needs to be regulated in a transparent way and over the counter? Didn't the President campaign on transparency? Isn't the best disinfectant sunshine? Let the sun shine too on the Federal Reserve.

Do you know that the Federal Reserve is responsible for regulating mortgage lending? But did the Federal Reserve act when the FBI warned in 2004 that the subprime mortgage fraud could become an epidemic? No. So if the FBI warned an epidemic was ahead on something that the Federal Reserve regulated and the Federal Reserve failed to act, what makes us think that they can actually regulate anything, and why should we give them more power, which the administration proposal does?

Many more questions need to be asked about financial regulatory reform. We should not rubber-stamp the administration's first idea. Our people want a sound credit system. We should ask for no less.

The first goal of our banking system, as opposed to a securities system, should be to create a safe and sound credit system, one that promotes responsible savings and lending practices. Prudent financial behavior by individuals and institutions should be its primary purpose. The administration's priorities tell me they plan a much larger role for higher-risk securities in whatever system they are envisioning, which to me threatens higher-risk behavior.

Banks traditionally have served as intermediaries between people who have money--depositors--and those who need money--borrowers. The banks' value-added was their ability to loan money sensibly and manage and collect the loans. Securitization broke down that system. The banks didn't much care about making sensible loans as long as they could sell them. The regulators didn't stay on top of it because they foolishly thought the banks had gotten the loans off their balance sheets and the chickens would not come home to roost.
[From The Washington Post, June 15, 2009]

A New Financial Foundation
(By Timothy Geithner and Lawrence Summers)

Over the past two years, we have faced the most severe financial crisis since the Great Depression. The financial system failed to perform its function as a reducer and distributor of risk. Instead, it magnified risks, precipitating an economic contraction that has hurt families and businesses around the world.

We have taken extraordinary measures to help put America on a path to recovery. But it is not enough to simply repair the damage. The economic pain felt by ordinary Americans is a daily reminder that, even as we labor toward recovery, we must begin today to build the foundation for a stronger and safer system.

This current financial crisis had many causes. It had its roots in the global imbalance in saving and consumption, in the widespread use of poorly understood financial instruments, in shortsightedness and excessive leverage at financial institutions. But it was also the product of basic failures in financial supervision and regulation.

Our framework for financial regulation is riddled with gaps, weaknesses and jurisdictional overlaps, and suffers from an outdated conception of financial risk. In recent years, the pace of innovation in the financial sector has outstripped the pace of regulatory modernization, leaving entire markets and market participants largely unregulated.

That is why, this week--at the president's direction, and after months of consultation with Congress, regulators, business and consumer groups, academics and experts--the administration will put forward a plan to modernize financial regulation and supervision. The goal is to create a more stable regulatory regime that is flexible and effective; that is able to secure the benefits of financial innovation while guarding the system against its own excess.

In developing its proposals, the administration has focused on five key problems in our existing regulatory regime--problems that, we believe, played a direct role in producing or magnifying the current crisis.

First, existing regulation focuses on the safety and soundness of individual institutions but not the stability of the system as a whole. As a result, institutions were not required to maintain sufficient capital or liquidity to keep them safe in times of system-wide stress. In a world in which the troubles of a few large firms can put the entire system at risk, that approach is insufficient.

The administration's proposal will address that problem by raising capital and liquidity requirements for all institutions, with more stringent requirements for the largest and most interconnected firms. In addition, all large, interconnected firms whose failure could threaten the stability of the system will be subject to consolidated supervision by the Federal Reserve, and we will establish a council of regulators with broader coordinating responsibility across the financial system.

Second, the structure of the financial system has shifted, with dramatic growth in financial activity outside the traditional banking system, such as in the market for asset-backed securities. In theory, securitization should serve to reduce credit risk by spreading it more widely. But by breaking the direct link between borrowers and lenders, securitization led to an erosion of lending standards, resulting in a market failure that fed the housing boom and deepened the housing bust.

The administration's plan will impose robust reporting requirements on the issuers of asset-backed securities; reduce investors' and regulators' reliance on credit-rating agencies; and, perhaps most significant, require the originator, sponsor or broker of a securitization to retain a financial interest in its performance.

The plan also calls for harmonizing the regulation of futures and securities, and for more robust safeguards of payment and settlement systems and strong oversight of ``over the counter'' derivatives. All derivatives contracts will be subject to regulation, all derivatives dealers subject to supervision, and regulators will be empowered to enforce rules against manipulation and abuse.

Third, our current regulatory regime does not offer adequate protections to consumers and investors. Weak consumer protections against subprime mortgage lending bear significant responsibility for the financial crisis. The crisis, in turn, revealed the inadequacy of consumer protections across a wide range of financial products--from credit cards to annuities.

Building on the recent measures taken to fight predatory lending and unfair practices in the credit card industry, the administration will offer a stronger framework for consumer and investor protection across the board.

Fourth, the federal government does not have the tools it needs to contain and manage financial crises. Relying on the Federal Reserve's lending authority to avert the disorderly failure of nonbank financial firms, while essential in this crisis, is not an appropriate or effective solution in the long term.

To address this problem, we will establish a resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system. This authority will be available only in extraordinary circumstances, but it will help ensure that the government is no longer forced to choose between bailouts and financial collapse.

Fifth, and finally, we live in a globalized world, and the actions we take here at home--no matter how smart and sound--will have little effect if we fail to raise international standards along with our own. We will lead the effort to improve regulation and supervision around the world.

The discussion here presents only a brief preview of the administration's forthcoming proposals. Some people will say that this is not the time to debate the future of financial regulation, that this debate should wait until the crisis is fully behind us. Such critics misunderstand the nature of the challenges we face. Like all financial crises, the current crisis is a crisis of confidence and trust. Reassuring the American people that our financial system will be better controlled is critical to our economic recovery.

By restoring the public's trust in our financial system, the administration's reforms will allow the financial system to play its most important function: transforming the earnings and savings of workers into the loans that help families buy homes and cars, help parents send kids to college, and help entrepreneurs build their businesses. Now is the time to act.

[From the New York Times, June 18, 2009]

Talking Business--Only a Hint of Roosevelt in Financial Overhaul
(By Joe Nocera)

Three quarters of a century ago, President Franklin Roosevelt earned the undying enmity of Wall Street when he used his enormous popularity to push through a series of radical regulatory reforms that completely changed the norms of the financial industry.

Wall Street hated the reforms, of course, but Roosevelt didn't care. Wall Street and the financial industry had engaged in practices they shouldn't have, and had helped lead the country into the Great Depression. Those practices had to be stopped. To the president, that's all that mattered.

On Wednesday, President Obama unveiled what he described as ``a sweeping overhaul of the financial regulatory system, a transformation on a scale not seen since the reforms that followed the Great Depression.''

In terms of the sheer number of proposals, outlined in an 88-page document the administration released on Tuesday, that is undoubtedly true. But in terms of the scope and breadth of the Obama plan--and more important, in terms of its overall effect on Wall Street's modus operandi--it's not even close to what Roosevelt accomplished during the Great Depression.

Rather, the Obama plan is little more than an attempt to stick some new regulatory fingers into a very leaky financial rather than rebuild the dam itself. Without question, the latter would be more difficult, more contentious and probably more expensive. But it would also have more lasting value.

On the surface, there was no area of the financial industry the plan didn't touch. ``I was impressed by the real estate it covered,'' said Daniel Alpert, the managing partner of Westwood Capital. The president's proposal addresses derivatives, mortgages, capital, and even, in the wake of the American International Group fiasco, insurance companies. Among other things, it would give new regulatory powers to the Federal Reserve, create a new agency to help protect consumers of financial products, and make derivative-trading more transparent. It would give the government the power to take over large bank holding companies or troubled investment banks--powers it doesn't have now--and would force banks to hold onto some of the mortgage-backed securities they create and sell to investors.

But it's what the plan doesn't do that is most notable.

Take, for instance, the handful of banks that are ``too big to fail''--and which, in some cases, the government has had to spend tens of billions of dollars propping up. In a recent speech in China, the former Federal Reserve chairman--and current Obama adviser--Paul Volcker called on the government to limit the functions of any financial institution, like the big banks, that will always be reliant on the taxpayer should they get into trouble. Why, for instance, should they be allowed to trade for their own account--reaping huge profits and bonuses if they succeed--if the government has to bail them out if they make big mistakes, Mr. Volcker asked.

Many experts, even at the Federal Reserve, think that the country should not allow banks to become too big to fail. Some of them suggest specific economic disincentives to prevent growing too big and requirements that would break them up before reaching that point.

Yet the Obama plan accepts the notion of ``too big to fail''--in the plan those institutions are labeled ``Tier 1 Financial Holding Companies''--and proposes to regulate them more ``robustly.'' The idea of creating either market incentives or regulation that would effectively make banking safe and boring--and push risk-taking to institutions that are not too big to fail--isn't even broached.

Or take derivatives. The Obama plan calls for plain vanilla derivatives to be traded on an exchange. But standard, plain vanilla derivatives are not what caused so much trouble for the world's financial system. Rather it was the so-called bespoke derivatives--customized, one-of-a-kind products that generated enormous profits for institutions like A.I.G. that created them, and, in the end, generated enormous damage to the financial system. For these derivatives, the Treasury Department merely wants to set up a clearinghouse so that their price and trading activity can be more readily seen. But it doesn't attempt to diminish the use of these bespoke derivatives.

``Derivatives should have to trade on an exchange in order to have lower capital requirements,'' said Ari Bergmann, a managing principal with Penso Capital Markets. Mr. Bergmann also thought that another way to restrict the bespoke derivatives would be to strip them of their exemption from the antigambling statutes. In a recent article in The Financial Times, George Soros, the financier, wrote that ``regulators ought to insist that derivatives be homogeneous, standardized and transparent.'' Under the Obama plan, however, customized derivatives will remain an important part of the financial system.

Everywhere you look in the plan, you see the same thing: additional regulation on the margin, but nothing that amounts to a true overhaul. The new bank supervisor, for instance, is really nothing more than two smaller agencies combined into one. The plans calls for new regulations aimed at the ratings agencies, but offers nothing that would suggest radical revamping.

The plan places enormous trust in the judgment of the Federal Reserve--trust that critics say has not really been borne out by its actions during the Internet and housing bubbles. Firms will have to put up a little more capital, and deal with a little more oversight, but once the financial crisis is over, it will, in all likelihood, be back to business as usual.

The regulatory structure erected by Roosevelt during the Great Depression--including the creation of the Securities and Exchange Commission, the establishment of serious banking oversight, the guaranteeing of bank deposits and the passage of the Glass-Steagall Act, which separated banking from investment banking--lasted six decades before they started to crumble in the 1990s. In retrospect, it would be hard to envision even the best-constructed regulation lasting more than that. If Mr. Obama hopes to create a regulatory environment that stands for another six decades, he is going to have to do what Roosevelt did once upon a time. He is going to have make some bankers mad.

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