Sep 23 2008

Shelby: Turmoil in U.S. Credit Markets

Recent Actions Regarding Government Sponsored Entities, Investment Banks and Other Financial Institutions


“Thank you, Mr. Chairman.  This may be the most important hearing our Committee has conducted in the twenty two years I have been a member.

“Over the last decade, trillions of dollars were poured into our mortgage finance markets, often with the encouragement of well-intended government programs.  At first, the money backed conventional mortgages with standard down payments and properly verified incomes.  Over time, however, the number of home buyers that met conventional loan requirements dwindled rapidly.  In order to fuel the upward spiral, mortgage products became more exotic, requiring less of borrowers and involving more risks.  Without regard for fiscal prudence and simple economics, mortgage brokers, Realtors, homebuilders, mortgage bankers, and home buyers created the conditions that helped inflate the housing bubble.

“At the same time, Wall Street was developing ever more sophisticated finance vehicles to ensure that money continued to flow into the mortgage markets to meet the demand.  Mortgages were pooled, packaged, and rated ‘investment grade’ by the credit rating agencies.  They were then sold into a market eager to purchase securities with a wide range of risks and yields.  Many purchasers employed massive amounts of leverage, layering risk upon risk in an effort to maximize return.  To cover their risks, many of these buyers also bought credit protection from one another, entering into derivatives contracts with nominal values in the hundreds of trillions of dollars.

“All the while our financial regulators appeared to be unaware as they sat on the sidelines.  As early as July of 2003, I asked Chairman Greenspan whether he was concerned about the growing number of loans to borrowers with weak credit histories and the number of homeowners who spent more than fifty percent of their income on housing.  I also asked if he was concerned whether an economic down turn could lead to increasing delinquencies and foreclosures.  He assured us that increasing home prices provided an equity cushion for mortgagors and that lending to such borrowers would pose a ‘rather small’ risk to the mortgage market and the economy as a whole.  As recently as March of this year, Vice Chairman Kohn assured us that the banking system was in ‘sound overall condition’ and that losses ‘should not threaten their viability.’  We now know that was not the case. 

“Eventually, economic reality caught up with our housing market, and housing prices stalled and then began falling.  Many who bought homes with unconventional loans found that they were unable to afford their rising payments.  Because home values were dropping, they were unable to refinance and delinquency rates skyrocketed.  Once homeowners began defaulting, the value of mortgage-backed securities plummeted.  Collateralized debt obligations, or CDOs, that were comprised of the riskiest mortgage-backed securities became worthless.  As a result, financial institutions holding securitized assets have suffered enormous losses and have been desperately trying to raise new capital.

“Of the five investment banks regulated at the beginning of the year by the SEC under its Consolidated Supervised Entities Program, two have failed, one was forced to merge with a bank, and the remaining two have now left the program to become bank holding companies.  The recent demise of our investment banks lies in stark contrast to the vote of confidence we received from Chairman Cox in February of this year when he assured us that the CSE program was up to the task, and I quote: ‘The purpose of the CSE program is to monitor for, and act quickly in response to, financial or operational weakness in a CSE holding company . . . that might place regulated entities, or the broader financial system, at risk.’  ‘The Commission seeks to . . . ensure that the holding company has sufficient stand-alone liquidity and financial resources to meet its expected cash outflows in a stressed liquidity environment for a period of at least one year.

“In late 2007, Mr. Erik Sirri, head of market regulation for the SEC described a consolidated supervision program that had ‘demonstrated its effectiveness during the current credit market difficulties.’  He likewise assured us that the SEC’s consolidated supervision had achieved ‘the goal of reducing the likelihood that weakness within the holding company or an unregulated affiliate will place a regulated entity . . . or the broader financial system, at risk.’  Notwithstanding assurances to the contrary, uncertainty about housing prices and the value of mortgage-backed securities has brought our markets to a halt.  We are now facing the most serious economic crisis in a generation.
“So far, the Treasury Department’s and the Fed’s response to the crisis has been a series of ad hoc measures.  First came the bailout of Bear Stearns which we were told was unavoidable. Then came Lehman Brothers which was allowed to fail.  And then, just last week, the Fed and Treasury organized a bailout of AIG.  I believe the absence of a clear and comprehensive plan for addressing this crisis has injected additional uncertainty into our markets and has undermined the ability of our markets to tackle this crisis on their own.

“Unfortunately, the Treasury Department’s latest proposal continues its ad hoc approach, but on a much grander scale.  The plan contemplates the purchase of up to $700 billion in troubled mortgage-related assets from financial institutions.  Treasury expects, but is not required, to purchase most assets through a type of reverse auction process.  There are very few details in this legislation.  In fact, Treasury officials admit that they will have to figure out the mechanics as they go along.  Rather than establishing a comprehensive workable plan for resolving this crisis, I believe this legislation merely codifies Treasury’s ad hoc approach.

“My hope is that this hearing will give us an opportunity to explore fully the parameters of the plan and why Secretary Paulson believes it will work.  I also hope to hear why the plan does nothing to address the root cause of this crisis - the rising default rate on mortgages.  While Wall Street banks get to sell their bad investments to the Treasury Department, homeowners will still be saddled with mortgages they cannot afford.

“My record is very clear on taxpayer funded bailouts.  I have long opposed government bailouts for individuals and corporate America alike.  As a Congressman, I voted against the loan guarantees for Chrysler in 1979.  However, if the government is going to get into the bailout business, shouldn’t we also be focusing our resources on average Americans, rather than sophisticated and well-compensated bankers?  The Treasury’s plan has little for those outside of the financial industry.  It is aimed at rescuing the same financial institutions that created this crisis with their sloppy underwriting and reckless disregard for the risks they were creating, taking, or passing on to others.  Wall Street bet that the government would rescue them if they got into trouble.  It appears that bet may be the one that pays off.

“Once again, what troubles me most is that we have been given no credible assurances that this plan will work.  We could very well spend $700 billion and not resolve the crisis.  Before I sign off on something of this magnitude, I want to know that we have exhausted all reasonable alternatives.  I don’t believe that can be done in a weekend.  Unfortunately, the incredibly accelerated process for considering this bill means that Congress does not have time to determine if there are better alternatives to Treasury’s plan.  I am very concerned that the expressed need to pass something now may prevent us from devising a plan that actually works.  Without question, our markets and financial institutions need serious attention.  I do not believe, however, that we can solve this crisis by spending a massive amount of money on bad securities.  It is time that the Administration and Congress do the hard work of devising, as quickly as possible, a comprehensive and workable plan for resolving this crisis, before we waste $700 billion of taxpayer money.

“Thank you, Mr. Chairman.”