Speech to American Banker Symposium - Washington, DC: Sept. 19, 2011

Too Big Too Overlook


19 September 2011

Thank you for the opportunity to address you.

Let me begin by observing that it’s important to keep in mind the reason we are here. Nominally, it’s to discuss the Banking Reform and Consumer Protection Act, the so-called Dodd-Frank bill. We must not, however, forget the background: we are coping with the aftermath of a financial crisis which began in 2007, which was devastating. The damage to residential real estate is particularly severe. This is due to the virtual collapse of the home mortgage market, the financing of which was as much responsible for the enactment of Dodd-Frank as any other cause.

Since 2007, the market value of residential real estate in the United States has declined precipitously from its $21 trillion peak, falling, on average, 7.7 percent each year—or by nearly 25 percent so far. This has had consequences. During the same period of time, some 3.1 million homes were taken into foreclosure. Nor does the horizon look any sunnier. An additional 1.5 million are in some stage of the foreclosure process, the owners of an another 1.6 million are more than 90 days delinquent in their mortgage payments and, at the end of the second quarter, an estimated one-in-four households with a mortgage—14 million homes—owed more on that mortgage than their homes were worth.

Although the losses in home values represent only half, specifically 45 percent, of the total loss of wealth during the crisis, the personal devastation experienced by ordinary Americans and, for that matter, customers of banks such as mine, is much more severe–indeed, difficult to calculate. While other aspects of the economy have improved, the value of Americans’ homes continues to deteriorate, with no end in sight for the immediate future.

There is no question that there is a connection between the collapse of the housing market and the increase in the nation’s jobless rate. Taken together, nearly one of every five persons in the workforce (18.3 percent) is unemployed, underemployed or has become so discouraged as to not have looked for work in over 12 months. Millions have suffered. As a result, even those of us fortunate enough not to have personally experienced great loss are reminded every day of the enormity of the problem by the stories and editorials in the media describing both hardship and political indignation – heartrending accounts which cry out for change.

As we know, this crisis was caused by a number of factors. These include the poor judgment and speculative actions of Wall Street, the imprudent lending of major banks, some now defunct, and a failure of political and governmental leadership and oversight. Combined, they have caused the suffering I’ve discussed and created conditions which threaten to undermine the leadership of the United States among the nations of the world.

All this has led, as well, to the enactment of Dodd-Frank on July 21st of last year. It is among the most significant legislative actions since the Great Depression. Some 2,319 pages long, it includes by one estimate, 400 new rulemaking requirements, of which only 61 have, to date, been finalized. One devoutly wishes to be able to say that this new law has done that which it was passed to do: prevent a recurrence of a financial crisis like the one we have experienced. I fear very much, however, that it will likely fall short.

This is not to say that Congressional action was not warranted, or to be expected. I well understand that banks in general, Wall Street in particular, and, for that matter, the federal government have inspired tremendous hostility in the wake of the crisis—and that drastic legislation was inevitable and probably necessary. I am concerned, however, that the actual law has neither resolved nor seriously addressed a number of significant problems implicated in the financial crisis.

In particular, I think of those posed by three major types of institutions and their activities: credit rating agencies, key enablers of the transactions which sparked the crisis; the government-sponsored enterprises Fannie Mae and Freddie Mac, whose indeterminate status continues to impede recovery in the housing market; and large bank holding companies who continue to avail themselves of the ill-advised protection offered by government for risky activities not traditionally associated with banking. Even as an excessive bureaucracy has been created with little thought as to the consequences involved for the taxpayer and the economy, the problems associated with these players persist. I will discuss each, citing some examples.

Permit me to begin with some historic context, as regards the credit rating agencies. The rating of bonds was first begun by John Moody in 1909 to provide an individual assessment of the relative risk among fixed-income securities. Over the next 100 years, three institutions, Moody’s, Standard and Poor’s, and Fitch, developed rating systems that have been recognized by courts as qualifying them as disinterested authorities and accepted as evidence of sound discretion on the part of executives, executors and trustees. Ratings have also become recognized inputs to the regulatory process for banks, investment firms and insurance companies.

Historically, a bond rating did not actively determine value but, rather, simply mirrored the market assessment of a bond’s risk. Hence, a rating change typically would not affect, but, instead, reflect the market’s altered estimation of a bond’s value—and draw on objective, factual information in the marketplace. It is worth noting, too, that prior to the early 1970s, rating agencies were compensated for their services not by the issuers of bonds but by those investing in them—a further means of ensuring the disinterested role of the rating agencies.

Another significant event was the consequential action by the Securities and Exchange Commission to create what became a de facto oligopoly among the major rating agencies through its 1975 rulemaking establishing the concept of a so-called “nationally-recognized statistical rating organization” and endorsing the use of their ratings in setting broker/dealer capital requirements. This action served to impede competition for nearly 30 years, until action by Congress forced the SEC to recognize new entrants to the business.

What, then, does the record show? How has this oligopoly handled what amounts to a public trust? There is little doubt that, in less-than-turbulent economic times, ratings are easy to discern and the rating agencies have provided an adequate service. But in times of crisis—when their services could be of greatest value—the record does not reassure.

Notably, the financial crisis from which we are still trying to recover is not the first major crisis in which the rating agencies, rather than sounding a timely alarm, were, instead, part of the problem. Consider municipal finance in the period shortly before the Great Depression. In 1929, the bonds of nearly 98 percent of the 310 cities that had a population of over 30,000 were rated double-A or better. Of these, 79 or 25 percent defaulted within one year of having a double-A rating and 24 were still double-A in the year of the default.

These included the state of Arkansas in 1933, as well as the cities of Detroit, Cleveland, Miami, Mobile, Grand Rapids, Akron and Cook County, Illinois—home to the city of Chicago—all rated investment grade shortly before they defaulted on their obligations between 1930 and 1933.

Nor have mistakes been limited to public finance or the Great Depression. In more recent times, the bonds issued by such prominent firms as Penn Central, Lehman Brothers, Washington Mutual and Pacific Gas & Electric went from an investment grade rating to default in just one to three months.

It cannot be emphasized enough that, in the years leading up to the recent financial crisis, rating agency assessments of structured finance were poor to the point of inaccuracy—creating a false sense of confidence on the part of investors and regulators alike and in turn contributing to the crisis. Consider the following new data, compiled for these remarks by M&T Banks’ mortgage operations department.

In a sample of 2,679 residential mortgage-backed issues originated between 2004 and 2007 with a current balance of over $100 million and totaling $564 billion in face value, 2,670 or 99 percent were rated triple-A at origination. Today, 90 percent of these bonds are rated non-investment grade (below triple-B minus) by both count and dollar balances.

The magnitude of this miscalculation is staggering. Moreover, investors have not forgotten these events and their confidence in the rating agencies has been shaken.

Their record has not, however, prevented Standard and Poor’s, in the past year, from broadening the reach of its analytical system and taking on the role of political pundit as well. I refer, of course, to its recent outlook on United States treasury obligations. Let’s review the record. Remember that on October 25, 2010, S&P announced it was holding its rating of the United States steady at triple-A with a stable outlook for the typical rating horizon of three to five years. Nonetheless, on April 18, 2011, Standard and Poor’s warned that if policy makers could not reach a budgetary agreement and implement changes by 2013, then the resulting United States fiscal policy would be meaningfully weaker than those of its triple-A peers. Eighty-seven days later, on July 14, Standard & Poor’s placed the U.S. on negative watch and stated that there was a 50 percent chance that the U.S. would have its rating lowered in the next 90 days. On August 5, the rating of the United States was, indeed, lowered to double-A plus.

In other words, over the course of 284 days, S&P changed its position on a matter of exceptional gravity. Yet had anything truly changed as regards the fundamental strength of the U.S. economy to suggest it now has less wherewithal to honor its scheduled debt payments?

This action suggests reason to be concerned—as much about Standard & Poor’s, as the safety and soundness of U.S. treasuries. As I mentioned earlier, changes in bond ratings typically have reflected the market’s altered estimation of a bond’s value. This has not been the case with Standard & Poor’s statements regarding U.S. debt. On the contrary, when faced with their own assessment of the situation when S&P issued its negative statement, investors moved not away from, but into Treasuries, causing the value of U.S. government securities to actually increase. Unfortunately, although the market and Standard and Poor’s were going in opposite directions, the perceived stature of Standard and Poor’s created much turbulence, which never should be the effect desired by a rating agency.

In this context, some have suggested that the rating agencies have also been hyperactive in re-rating countries in the European Union – sometimes reflecting but also sometimes anticipating the direction of fixed income securities in the marketplace. According to a study by the European Central Bank, there is a significant correlation between government bond yields and changes to credit rating levels as well as the outlook. The results are particularly important in the case of negative announcements, while the reaction to positive events is more muted. In other words, the rating agencies, through their sovereign debt downgrades, appeared to be influencing market behavior, rather than reflecting it.

Broadly, then, the activities of the rating agencies have caused uncertainty in the markets and caused bond yields to move more in both directions than they would if the agencies had been following the same conservative efforts that they do with respect to corporate securities. As a result, they’ve not only created the conditions which make possible casino-like financial gains and losses but inspired angst and uncertainty among the citizens of the nations impacted.

It is important to note that, despite this poor record, the rating agency oligopoly which government has helped to install amounts to a near gold mine for the so-called nationally-recognized firms. For 2008 through 2010, the pretax profit margin from the ratings business at both Moody’s and Standard and Poor’s exceeded 45 percent. In 2006, it exceeded 60 percent at Moody’s. From 2000 to 2007, Moody’s profits quadrupled and, for five years in a row, the firm had the highest profit margin of any company in the S&P 500.

It is true that the Dodd-Frank legislation paid some attention to the need to disentangle the rating agencies from the requirements of government regulation—and that the Securities and Exchange Commission, this past July, issued rules to begin that process. Nonetheless, as a practical matter, the rating agency oligopoly remains in place and will not be dislodged quickly or easily.

There is little evidence to suggest that significant new entrants are on the horizon, as the normal commercial anticipation of opportunity arising from regulatory change would suggest. It is one thing to remove requirements—quite another for an oligopoly which government has, over past generations, helped to establish and embed, to be replaced with what we need: an open, competitive, effective and accurate ratings system. Yet that is exactly what must happen.

We cannot allow a group of organizations which have gotten so many important things so wrong for so long—including assessments of municipal debt, the likelihood of major corporate bankruptcies, and, of course, the value of subprime mortgage-backed securities—to continue, unchallenged. Nor should they now be allowed to become political pundits.

If Dodd-Frank has done little to reform the rating agencies, that is still more than it did to address the problems inherent in two institutions which were not only central to the financial crisis but continue to play a critical role in the economy—even as they require ongoing taxpayer assistance at high levels. I refer, of course, to the government-sponsored housing finance enterprises or GSEs, Fannie Mae and Freddie Mac. Like the rating agencies, they are deeply embedded in the American economy—again, thanks to their government backing.

In the last 20 years, Fannie and Freddie have underwritten $13.5 trillion in mortgages, of which $5.3 trillion are still outstanding. In the last eighteen months, they guaranteed $1.7 trillion or some 71 percent of all mortgages written in the U.S. As of June 30, 2011, they held a portfolio of $1.4 trillion and had guaranteed additional mortgage-related debt instruments valued at $3.9 trillion.

Any institution playing such a central role in the U.S. economy should inspire confidence and respect. Yet the losses with which Fannie and Freddie have saddled taxpayers have been nothing less than staggering. Since 2007, they have lost $246.5 billion and have been taken over by the government, as the illusion of their being bona fide private stock corporations has melted away. Consensus projections have them losing another $90 billion by the end of 2013.

Such projections reflect the fact that, as of June 30, the two GSEs had $54 billion or four percent of their portfolios either in foreclosure proceedings or more than 90 days delinquent. Seventeen percent of their mortgagees had loans worth more than the value of their homes. What are, for all practical purposes, agencies of the federal government today are led by CEOs each of whose total compensation exceeded $5 million in 2010. In other words, these CEOs of what amount to government bureaucracies are paid nearly 14 times more than the salary of the President of the United States.

Beyond such cost figures, it is worth keeping in mind why Fannie and Freddie were created in the first place—and question whether they have helped achieve public purposes or merely private ones. Their public purpose, of course, was that of helping more Americans realize the dream of homeownership.

Yet, notwithstanding our collective investment in their operations, such countries as Sweden, Spain, Poland, Greece, Ireland and Italy actually have higher homeownership rates than the U.S., as do the UK and Canada. The latter does not even provide special tax incentives for homeownership. Indeed, despite the astronomical costs to which Fannie and Freddie’s activity have led, the percentage of American households owning their own homes did not, on net, increase, as the housing bubble inflated and then burst, between 2000 and 2009.

Despite the enormity of the problem, no action has been taken to resolve the question of how to restructure Fannie Mae and Freddie Mac so as best to serve the private housing market without exposing taxpayers to yet more risk. The sheer delay in reaching a decision about the extent of that role, whatever it will be, helps to prolong our housing market crisis, as lenders and borrowers alike are left to wonder about the future structure of housing finance. Nor is this a minor matter: while Dodd-Frank calls for myriad changes in reporting and oversight on the part of community banks, it leaves untouched these GSE giants who are currently the buyers of almost three-quarters of the single family mortgages originated in 2011. Like the credit rating agencies, they are deeply embedded in our economy—and too big to overlook.

Surely if anything has changed because of Dodd-Frank, it is America’s banking system. And, indeed, a flurry of new requirements and regulations affecting banks can be found in the bill. But, unfortunately, a great deal about banking regulation which actually helped create the financial crisis has also been left unchanged.

I have spoken publicly before to express my concern about increased concentration in the financial services sector and the emergence of a business model driven not by the prudent extension of credit that furthers commerce, but by how well one trades in speculative investment vehicles. This new type of banking continues, in my opinion, to pose significant potential problems for the banking system in which it is housed.

Over the past few decades, the profile of the financial services industry has changed dramatically. While traditional community banks have continued to depend on fundamental, bread-and-butter banking services, larger institutions have come to rely on a much broader and more complex range of activities, including trading, as a source of income. As a result, their risk profiles are uniquely different from traditional banks. Additionally, these large institutions now hold a significant concentration of all U.S. based deposits.

Trading revenue at the six largest U.S. banks represented 91 percent of such revenues of all American banks in 2010. Looked at in a different way, revenues represented 23 percent of the total non-interest income at these six institutions compared to 2.6 percent for the rest of the American banks. The manner in which the largest banks are structured helps create far more fees than realized in the rest of the banking industry—not necessarily to assist in trade and commerce but to provide a means for banks to go far afield from their traditional endeavors, all the while taking on exponentially more risk, both for themselves and, crucially, for the U.S. economy.

Last week’s $2 billion scandal at a major European bank is an all too poignant example. Again, this all has the earmarks of a casino—participation in which is further encouraged by the outsized levels of salary and bonuses which this “industry” makes possible—even as it draws talent from the ranks of top college graduates who could, through new start-ups and innovations, help to expand the economic pie, rather than engaging in activities rooted in financial speculation.

It is true that the Dodd-Frank law at least acknowledges these issues by imposing additional capital requirements for those engaged in this business model. It is far from obvious, however, that the new law portends significant change. Crucially, the major bank holding companies who engage in and rely on trading revenue can continue to do so with the protection of the FDIC system—established to protect depositors, not speculators. It is a system in which a number took refuge in the wake of the 2008 financial crisis and in which they remain.

This FDIC protection both encourages risk-taking and increases the likelihood that banks who do not engage in trading—in other words, the vast majority of U.S. banks—will need to increase their FDIC contributions, as has already happened because of excessive risk taking related to the housing bubble.

Overall FDIC contributions have risen from $32 million in 2006 to more than $13 billion in 2010, for as we all know, it is not the taxpayer but rather the banking system, through FDIC assessments that pays the cost of bank failures. Such assistance inevitably diverts capital that might otherwise be helpful in extending credit to our struggling economy. Simply put, Dodd-Frank, rather than beginning the necessary process of changing the model for bank holding companies said to be too big to fail, has acquiesced in the perpetuation of their problematic business model and linked the fortune of traditional banks with their fate.

Let’s keep in mind the big picture. It is clear that the U.S., which once set the moral tone for financial standards and oversight of financial markets, has lost, or is at least at risk of losing, its moral high ground. It is also clear that strong, but fair, regulation that minimizes the risk of the next crisis while preserving America’s entrepreneurial spirit is needed to maintain U.S. economic leadership. We must do so without exacerbating the unlevel playing field in which regulatory oversight and the associated costs are out of synch with the risk that each institution undertakes. Consider, for instance, a communication I recently received from our Chief Financial Officer:

“Bob. Understanding our deposit insurance obligation has become significantly more complex. The new FDIC scorecard requires no fewer than 60 inputs and 20 mathematical equations to derive a “performance score” which is then divided by 100, cubed, added to .09 and multiplied by 42.735 to determine a bank’s base assessment rate. I’m told that this formula is based on a statistical relationship between the total scores of large institutions and their estimated probability of failure within three years.

Several of the data fields required by the FDIC require a significant amount of information gathering not currently undertaken, including exposure to leveraged lending and subprime borrowers. At M&T, this has meant the creation of 4 working groups with no fewer than 18 employees working to collect the required information.”

This at an institution which boasts one of the lowest cumulative charge off rates among the largest 20 commercial banks since the onset of the financial crisis. In fact, it’s notable, that the complicated FDIC formula does not directly value the quality of a bank’s most important function: its loan underwriting.
By comparison, calculating our FDIC assessment under the prior methodology, which used information already compiled for our regulatory filings, could be completed by a single analyst in a matter of hours.

So it is that, as we take stock of what Dodd-Frank has accomplished, we must not fail to be clear about the important matters which it failed to address: in particular, the problems associated with the activities of too-big-to-fail banks, Fannie Mae and Freddie Mac and, finally, the major credit rating agencies. All were key contributors to the financial crisis from which the American economy has yet to recover.

Yet even as we consider this major new law and how it may or may not prevent another financial crisis, it is worth keeping in mind that the laws and the regulations they engender have their limits. Something tells me that there is, in fact, no legislative or rule-based substitute for the same intangible quality which allowed U.S. Navy seals to find Osama Bin-Laden: human intelligence and skill. We must, ultimately, rely on regulators of the highest intelligence and integrity to be able to examine any financial institution, from the smallest to the largest, and, through a combination of looking at the books and talking to the principals, assess an institution’s quality.

Formulas and algorithms, whether those used by the rating agencies or the issuers, were wrong in the run-up to the housing finance crisis. A new generation of complex government rule-making will not likely do much better—especially if it permits the continued concentration in the banking industry to grow worse and does little to do what, above all, needs to be done … get the American economy moving again.

In short, Dodd Frank, passed in the name of preventing future crises, failed to address at least three causes of the one we continue to experience. Those of us here—whether we are regulators, risk managers or executives—have too great an understanding and role in the allocation of capital—the lifeblood of a healthy economy—to acquiesce in this failure.

Thank you very much.

Robert G. Wilmers
Chairman of the Board and Chief Executive Officer