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Rep. Barney Frank Headshot

The "Loan Arrangers" Will Not Ride Again

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This post was originally delivered as a speech at the National Press Club on July 27, 2009

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Thank you. I very much appreciate the forum that the Press Club offers for these kinds of discussions and let me reinforce what may have been an entirely unnecessary admonition. No one who has been familiar with the media in America could ever think hearing those applause that it came from members of the media.

I want to first address an issue about financial reform that puts it in context. One question that has been raised about President Obama is whether or not he is asking Congress to do too much -- a refreshing change, I think, from the past. And the answer is no. And in particular, there is no validity to any suggestion that because many of my colleagues are so deeply engaged now in trying to deal with health care or were earlier dealing with cap and trade, or are dealing with other very important issues, like labor law reform, to make real the right of men and women to bargain collectively about their own job situation, which they have lost, unfortunately, or to improve education. These are not conflicting, and nothing in what is being done elsewhere is in any way retarding our efforts to deal with the financial system.

Those efforts are essential. We are in the midst of a debate about who is responsible for what in the past, and I will touch on that because having some sense of that is important in deciding what to do in the future. But our primary goal is not to try to undo the past, but to prevent its recurrence. The goal of the Congress today, with our committee having a major piece of it, is to try to prevent things from recurring, the financial crisis that we have had.

Our general view, and by that I mean the members of our committee and the people who work with me on the staff, and members of the House in general and our Senate counterparts, is that the problem was non-regulation. And it's very important to stress that it's non-regulation, not deregulation. There was some deregulation; there was the passage of the Graham-Leach-Bliley Act in 2000, a bipartisan product of the Clinton Administration and a Republican Congress. I voted against it. But I do not think that was the major cause of our problem. Our problem was, rather, that of non-regulation. We have a very healthy phenomenon in this free enterprise country in which the private sector innovates, and the innovation is very important. And by definition, only those innovations which provide value added are going to survive because it's voluntary. If someone comes up with a new idea that doesn't work, it doesn't work, it goes away. The only innovations that thrive are those that attract people's money in a free enterprise society. And that's a constant process.

But there are periods when innovation reaches critical mass, when there is such a combination of new things, it often means that with new technology combined with new ideas, that the existing regulatory framework is left behind. And the role of the public sector is to come up with regulations that allow society the benefit of those innovations in the private sector while curtailing some of the abuses. The problem with the current situation, I believe, is that we had for too long a dominant ideological viewpoint that rejected that -- which rejected the notion that innovation of a very, very substantial sort, innovation that just was turning around a whole lot of previous assumptions and that very much changed existing patterns, that that did not require new regulation.

One of the arguments we have today from some people is, "Well, what was the cause of the problem" -- assuming that there were things that should have been regulated that weren't. "Was the cause of the problem regulators who are ideologically opposed to regulating, or an inadequacy of regulatory structures?" And the answer is very clear: yes. It was both. It was both people who did not believe in regulating, and a regulatory structure that facilitated their ability not to regulate.

And it's true, there were two extreme cases. You can have the most complete regulatory powers given to individuals who simply do not believe regulation is ever useful, and it won't work. And frankly, Alan Greenspan, as he has acknowledged, came close to that by flatly refusing to use many of the regulatory powers given to the Federal Reserve. That was in the old days. The Federal Reserve led other bank regulators into becoming born-again consumer advocates. It's been one of the most interesting conversions we have seen recently in the United States.

But, it is made easier for those who believe firmly in never regulating, never to regulate, when no responsibility is fixed on who should do it. The more you disperse responsibility, the harder it is to overcome that aversion. On the other hand, it is true, if you had wonderful regulators firmly committed to trying to propose rules that would stop the bad things, or minimize the bad and let the good go, they could overcome regulatory inefficiency. But, we can't legislate on the assumption that we're going to either have people totally opposed or wonderful super-regulators. We need to regulate for normal human beings, and that's what we hope to do because we think it is important, both that there be regulatory structures that provide focused responsibility for the right side of regulation, and the appointment of individuals to do it. It's best to have both, but it is better to have at least one than to have neither. And we think we can structure it so you do get both, at least for the near term.

Because it is very important when you get new regulations, and this is something that we shouldn't lose sight of, by definition in the political process, that the new regulation is going to come under the aegis of people who believe in it and the first set of regulators will be good ones. And that's very important.

Franklin Roosevelt led the United States into a new set of regulations for finance capitalism, and then appointed people who would run it. By the way, for those who have criticized the Obama Administration because there are people in the administration who had participated in the financial system we are now trying to change and improve and regulate, think of the example that was set by Franklin Roosevelt, when having established the Securities and Exchange Commission, he appointed as its first chair someone who knew what he had to regulate: Joseph P. Kennedy. And Joseph P. Kennedy was a very effective Chair of the SEC precisely because he knew what had been legal, what was no longer legal, what was no longer approved. So, we will be going forward with setting up that kind of a structure.

Now, I mentioned the New Deal. To me, we are in the third iteration of this phenomenon of innovation that is qualitatively different than what had been before in terms of a system, and the need for regulation to catch up. The first example came in the late 19th century when American business created the large industrial enterprises, far outstripping what had been there before. If we hadn't had that, we never would have had the wealth created and spread the way it was. So the late 19th century was a time of large enterprises. People did it in the financial and manufacturing area, in finance and steel and railroads, et cetera.

And then came Theodore Roosevelt and Woodrow Wilson, who spent their time coming up with regulation not to cancel out the innovation, but to try to contain its excesses. And you got the antitrust laws, you got the establishment of the Federal Trade Commission, you got the establishment of the Federal Reserve. And I think that was a very good system.

Then years later, decades later, Franklin Roosevelt confronts the need to do that again and creates a framework for mutual funds, a Securities and Exchange Commission, the Federal Deposit Insurance Corporation. By the way, for those who want to combine history and current events, if you want to read predictions that efforts to regulate innovation, efforts to rein in abuse are foredoomed and will, in fact, deny us the benefits of the innovation and curtail the ability of the financial system to provide benefits, you could either read today's Congressional Record -- come to my markup session tomorrow when we will hear my conservative colleagues say that -- or, you could read what they said about Theodore Roosevelt and Woodrow Wilson, or what they said about Franklin Roosevelt. There is a pattern in which some people argue that any attempt to seriously set rules for these innovations will destroy the economy. We reject that. We think that, in fact, the most pro-market thing Franklin Roosevelt could have done is what he did do; setting up the SEC and setting up rules for mutual funds. Setting up the FDIC, in fact, saved capitalism and allowed it to go forward. And we plan to do the same thing if we are successful, to set rules which provide a framework in which this wonderful, vigorous, capitalist system can go forward.

We have several things that we need to do. And by the way, in that, we do reject one argument, and it comes from many conservatives. And by the way, there's an element of partisanship here. Can I say I do not understand why partisan is always a bad word, or at least it's always been a bad word since the end of World War II when the partisans in Yugoslavia fought the Nazis. But in every other context, if you Google partisan, it's a bad thing. Political parties are necessary for democracy. They have not, in my view, been successful self-governing polities where you don't have parties. Partisanship becomes a problem if it is excessive because there are issues in any democracy which are going to be legitimately partisan where two different parties have two different viewpoints. Remember, the parties are not, particularly in America today, sides randomly picked for a color war at camp. They are not ones and twos. They are people who have different viewpoints.

And in particular on this central issue of whether or not there should be an appropriate regulatory intervention not to cancel out innovation, but to channel it, there are different viewpoints. There were those who thought that Theodore Roosevelt and Woodrow Wilson got it wrong, that Franklin Roosevelt got it wrong, and that we're getting it wrong today, that the best thing to do is to simply leave it at free enterprise with all of the goods and bads. And others of us think that if you do this right, it's tough and it's difficult and you have to be careful and you have to have humility about how you do it and fully listen to everybody, but you can make the system better by reducing the bad while not in any way diminishing the good things that happen.

And the parties differ on that. The Republican Party in the House has a very different view than the Democratic Party. And that's called democracy. And we had an election. Look, we had elections in 2002 and 2004 in which the people who did not believe in regulation won, and they did not give any regulation. Nothing was done in that general area. And then we had elections in 2006 and in 2008 which were different.

And I say that because I want to raise the stakes for myself and my colleagues. We now have for the first time since 1993 a Democratic President, a Democratic House and a Democratic Senate. We have the responsibility as Democrats to come up with a system of rules that allow the free enterprise system to flourish and provide all the benefits it can provide while diminishing the abuses, protecting consumers, encouraging investors to feel safe about investing, and basically to giving us the benefits of the function of the financial system. And it's up to us.

I will tell you that I believe that my Republican colleagues had that responsibility failed. They had four years, 2003, 2004, 2005 and 2006, when they had the Presidency and both houses of Congress, and nothing was done in the regulatory area. Now, I understand there was a theory that says that was my fault, and Chris Dodd's and some others. Apparently, that view is that I had a secret hold on Tom DeLay that I wish I knew about. If I were to have made a list of things I would have deterred him from doing, it would have been a lot larger than simply derivatives.

But in fact, we had a difference of viewpoint. There were some who thought the problem was that we had been too good to poor people, that the problem was a Democratic approach that said, "Let's try to help low income people." Let me be very clear, and measured and balanced. Utter nonsense. The Community Reinvestment Act is what they blame. And in fact, talk to the community bankers, the people who run the smaller, locally-based banks who justifiably object when people denounce banks and they get swept in, getting blamed for things that they were not guilty of doing.

If only financial institutions subject to the Community Reinvestment Act had made mortgage loans, we would not be in the crisis we are in today. The overwhelming majority of those loans were made by institutions not covered by the Community Reinvestment Act, and there was not a regulator who served under the Bush Administration, or the Clinton Administration who will tell you that the CRA--well, you never know, could be one--but there's this consensus: it clearly didn't happen. Again, look at the loans. What happened was an explosion of loans being made outside of the regular banking system. And by the way, that ties in with my thesis because the banks covered by the Community Reinvestment Act who did not cause the subprime crisis were the regulated ones. It was largely the unregulated sector of the lending industry and the under-regulated and the lightly regulated that did that.

We now have our responsibility, and here's what we believe needs to be done. We want to make it very clear that the financial sector is an essential intermediary in our economy. The phrase intermediary is an important one. In fact, in periods when cash has disappeared from the system, or credit has disappeared from the system, it's called disintermediation. Disintermediation means that the financial sector no longer performs its important intermediary function. What's that function? To gather up money in fairly small amounts from large numbers of people, bundle it (a good word, bundling in this context) and making it available to people who will use it for productive purposes. That's the financial function.

Financial activity is not an end in itself; it is a means to an end. It is a means by which we gather up the savings of individuals and their need to invest and provide for their own personal income and make it available to those who will invest it in large amounts and productive activities. And frankly, I believe one of the problems is that over the past 20 years in particular, a certain amount of financial activity became the end rather than the means. Let me be very clear. I do not expect anybody in this society to do very important work for nothing. Obviously, enterprises have to make a profit. Financial activity has to have a profit. But the purpose of that profit is to enable them to be the intermediary. So, I have had people come to us and complain, "Well, if you do that, I can't make any money." The answer is, "That's not our job. We're not here to help you make money." We are here to help have a system in which you will make money as an incident of your providing funds to those who would use it productively.

And to some extent, there's been financial activity that was an end in itself. That's what's behind the denunciation of speculation. Sure, risk-taking is there, and people can call anything that they don't like speculation, but there is an element in which people have been doing things solely to make money on them. And to the extent that is curtailed, the society is no worse off other than for the handful of people there who were doing it, and they can go out and get real jobs and it won't be any loss to anybody else.

We believe, first of all, a large part of this came from innovation --a good thing. Securitization -- thirty years ago, most loans were made by people who expected to be paid back by the borrower. And that meant you had to wait until the borrower paid you back to re-lend that money. Securitization comes, and it means there's money that's outside the deposit-taking system because there are new sources of liquidity, and it means that you don't wait to be paid back. You sell the right to be paid back by other people. And we then had a whole range of instruments involved that took those rights to be paid back and magnified them and cut them up into a whole range of very innovative financial devices.

Now, basically this securitization is a good thing because it means the money turns over more quickly. If I have to wait for everybody to pay me back, I can't make as many loans. So if they're good loans, let's put it this way, the more good loans that are made, the better. The problem is, securitization had two impacts: it allowed more good loans to be made, and it allowed more bad loans to be made. It turns out a very simple human truth got lost. If I lend you money and I expect to be paid back, I'm going to be more careful than if I lend you money and you're going to pay back somebody else. And securitization has weakened that borrower/lender relationship and the discipline.

I think the rating agencies have done, on the whole, a rather poor job, and today it seems to me the rating agencies are trying to overcompensate for weakness by excess. And let me say on behalf of the working press, they may enjoy this phrase, but I'm reminded of a great phrase by one of the great editorial writers of all time, Murray Kempton, who said as an editorial writer, his job was to come down from the hills after the battle was over and shoot the wounded. I think you see some of that with the rating agencies. But in fact, rating agencies, when millions of loans are made by people who don't have the discipline of expecting to be paid back, I don't know how anybody could rate those.

Anyway, here's the lineup we think you need to do. We think you need to put some limits on securitization. People should not be able to lend money without having any risk retention. We think that there needs to be somewhere in the system an ability to limit leverage, to put maximum leverage rules in place so that people do not wind up owing not only much more money than they have, sometimes I think we have in this society as a whole people owing much more money than there is. You have to limit leverage.

You have to come up with a way to put ailing financial entities out of our misery. It's called the resolving power, which is a strange word; it means dissolving. We have a way to do that with banks. We did not have a decent way to do that with AIG or Lehman Brothers or Merrill Lynch, and all of them caused problems as the Bush Administration legitimately, people of good will, Ben Bernanke and Hank Paulson, tried to avoid terrible financial harm from what would happen.

We need to contain derivatives. Yes, they play a very important role, but they have gotten out of hand and we need to do something about it. We need to protect consumers because protection of consumers now has dissipated in ways that result in a lack of activity because there is no way to focus responsibility.

And we need to deal with executive compensation. The problem with executive compensation is essentially from the systemic standpoint, that it gives perverse incentives. That if you are a top decision maker, or maybe even somebody else down the chain, you may have a system in which you are incentivized to take a risk because if the risk pays off, you make money. And if the risk doesn't pay off, you suffer no penalty. Heads you win, tails you break even. It's like selling lottery tickets that only cost you money if they pay off. We'd sell a lot of tickets, we wouldn't raise much money. That's part of it.

Now, there's also a problem with salaries being excessive. Our view is, and we will be working on this tomorrow, that the regulators, the Securities and Exchange Commission, should prevent there from being systems that give perverse incentives. As to the amounts, we think that's up to the shareholders. We have the radical notion on the Democratic side that the shareholders who own the company ought to be able to set outer limits on pay. Because the notion that it will be done by the board of directors, I think, is fruitless because boards of directors and CEOs are inevitably the closest of collaborators. There is not, and should not be an adversarial relationship between the CEO and the boards of directors. I think it's impossible to structure one in a well functioning organization. But given that it's a mistake to think that one day a year, they'll go to arm's length and be labor and management. So we want the shareholders to be involved in setting the pay. That's our package.

Now, I have a challenge to make. And let me tell you, that package has broad support in the Congress, I believe. And I accepted a challenge. I believe as Democrats we have the responsibility to put a systemic risk regulation regime in place that will limit the kind of leverage that got us into trouble with people being overextended. That will allow us in the future to deal with an AIG or Lehman Brothers and put them out of business in an orderly way without either shocking the system or having enormous public funds have to go into them as went into AIG.

I believe we can curtail speculation in derivatives that is excessive without reducing the real economic function that they provide in society. I think we can impose risk retention rules on originators of loans so that we still get the benefit of the higher turnover, but don't lose the lender/borrower discipline. I believe we can protect consumers from abuses without endangering the system. Indeed, if we had protected consumers better from subprime mortgages they shouldn't have gotten, we'd have a sounder system, not a less sound system.

We're going to do those. There is a commitment, as I've said. It's a responsibility for us as Democrats to do them. We are convinced that this is the way to prevent these abuses. And I invite the judgment of failure if we are not able to deliver that. And I will tell you, I am not politically inclined to take on responsibility I don't think I can handle. I am giving us this responsibility because I am confident we are going to meet it. I believe you are going to see during this Congress, I believe by the end of this year, a package that does it.

One last point I want to make, and I want to offer advice, unpaid, to my friends in the financial community, and to the rest of the financial community because that first category--that first category is kind of cyclical, maybe. I think I didn't have that many a few years ago. Then I became chairman of the committee, I made a lot of new friends without getting any nicer. And, we've worked together. We worked together last year. When Ben Bernanke and Hank Paulson came to us on behalf of the Bush Administration and said, "We face serious financial collapse if you can't collaborate," none of us thought this was going to be the most popular thing to do, but we did it in a very bipartisan way. The Democrats in the House and Republicans and Democrats in the Senate worked very closely with the Bush Administration. And yes, there were many in the financial community who were grateful for our help.

But I think some of them have forgotten that. Not everybody, but there are some in the financial community who call to mind what was said of the Bourbons, the restored monarchy in France after Napoleon. "They have forgotten nothing because they learned nothing." And I do think, and let me go back to my youth and to the days when radio had a function other than the spewing of venom, and when fiction on the radio was labeled as fiction, and there were people who in the financial community -- some of the older people here will catch the reference -- want to revert, return, they want to return, to the thrilling days of yesteryear. And let me make one amendment. They want to return to the thrilling days of yesteryear when the "Loan Arrangers" will ride again. And in this view, the loan arrangers will be accompanied by their faithful and submissive companion, government.

And that's not going to happen. We are going to put these rules into effect. And in fact, if they want to stick with that analogy--they don't, I do, but let me just say for the sake of my own metaphorical consistency--there was an old unpleasant joke when I was a kid, and it may be relevant now. We may have to give them a new definition in that context of Kemo Sabe. Older people will explain to younger people what I mean by that.

I am making this response to the financial community. I want them to work with us. They need to understand what I talked about: restricting leverage, having a systemic risk regulator, curtailing the excesses in derivatives, some risk retention, protection of consumers in a single, effective agency -- those are all going to happen. I can guarantee you that the votes are there, not because I want them to be, but because I have had a series of conversations with people and I know that is what is going to happen. And I know if the financial community or people who believe in total deregulation, if they want to make that a national debate, I welcome it. They will lose that debate. It's a good debate to have. I believe just as we had that debate in the early part of the 20th century and in the New Deal, we will have it again and we will win it. We will prove that the best thing you can do for capitalism is to have rules that give investors the confidence to get back into the system, that protect the great majority of decent people from abuses.

That doesn't mean that there's no role for them. I believe we should be containing derivatives. There are a couple of ways to do it. On the table is banning naked credit default swaps; there are alternatives to that, a much tighter regime of openness and price discovery that comes from putting them on exchanges. We will talk to them -- we hope to talk to them about that.

But there are some tests they have to meet. One, tomorrow there will be a meeting called by Secretaries Donovan and Geithner about one of the great failings of my friends in the financial community today: their unwillingness to help us reduce mortgage foreclosures. It's not in their own interest. The cascade of foreclosures -- and to make it worse, by the way, because I'm glad we did unemployment compensation as part of the Economic Recovery Bill and I was very pleased when Ben Bernanke said in testimony last week, in response to a Republican question, that if it had not been for that bill, unemployment would be higher today. But, you cannot pay your mortgage in many cases out of unemployment compensation. So, we face a potential of more foreclosures with disastrous effects for individuals and communities and the whole economy.

The financial community was successful with the community banks and the credit unions in the lead in defeating a bankruptcy reform. Their argument was that we didn't need that to reduce mortgage foreclosures; but so far, that's not been proven right. We need much better cooperation in reducing foreclosures. We need people in the major financial institutions to understand how angry the American people are, that people who were in many cases collectively the causes of a crisis and the beneficiaries of serious economic activity on the part of the government to help them get out of the crisis. Look, we didn't do the rescue plan or the TARP, and I long for the good old days when I thought that TARP is what you used to cover the infield when it was raining. But we're not there anymore.

We didn't do that to help the banks, but helping the banks was the inevitable byproduct of it. You could not restore the credit system of the United States from imminent danger of collapse, as Hank Paulson and Ben Bernanke, I think, accurately said. You could not have done that without helping some of the institutions there. You can't get a whole new set of institutions.

Having done that, though, for them to return to those thrilling days of yesteryear with the level of compensation is a great mistake. And by the way, I do have to say to my friends in the financial community, think about what you say about your character when you tell us that you have to have enormous bonuses to align your interests with those of the people who pay your salary. In other words, you get hired for this very prestigious job and you get a salary, and now we have to give you extra money for you to do your job right? I must say, that does not speak well of the character of the people there. I think they're unfair to themselves. To be honest with you, I'll be their compensation consultant. I think if you cut their bonuses by 90 percent, they'd work just as hard. But, that's not what they've done, so we will have to deal with this in legislation. Not to curtail the overall amount, but to restructure them.

But I am asking the financial community to cooperate with us. Help us figure out the best way to do derivatives. Follow Joseph Kennedy and accept the reality of this regulation and work with us. And that applies to the community banks. The community banks were not the ones who did subprime mortgages; they are not the ones who did credit card abuses.

By the way, another example in the financial sector is salary increases, compensation increases going up, not helping in mortgages. And, we passed a credit card bill and we were told, "Oh, we need more time to work it out so we can do the pricing right." Well, that was the reason for the delay; not so they could jack things up in the interim. And they are inviting a much harsher response if they are not willing to cooperate with us on these. Again, TARP recipients who now tell us that we should not curtail the excessive use of derivatives because it might reduce their profits, they are putting themselves outside of the debate we're going to have. And I would much rather they be in it, because they need to understand they can't stop it.

And to the community banks, yes they have been unfairly traduced because they weren't the problem. But, they have to be careful not to allow themselves to be used by some of their big, big brothers who would like to shelter them. We can set up a consumer protection agency that will respect all of the community banks. They were not the perpetrators of the abuses; they will not be the subjects of the corrections. And they need to work with us to help us do that. So, we are ready to go forward with a set of regulations that respond to these innovations that we believe will give us the benefit of the innovations and diminish the abuses. And our models are Theodore Roosevelt, Woodrow Wilson and Franklin Roosevelt.

We invite the financial community to participate with us given what we believe is necessary and how we do it. But it's going to happen one way or the other, and the debate will be, I believe, in terms of history, as important as the one in the early 20th century, as important as the New Deal, and I believe will end just as beneficially for the American economy. Thank you.