Congressman Barney Frank, who chairs the powerful House Financial Services Committee, delivered the keynote speech at the 9th annual Directorship Boardroom and Economic Leaders Forum in New York in December. With two parts high-powered insight and one part biting wit, the Congressman examined the events that led up to the financial crisis, the outlook for increased regulation, and, from his view, what role corporate directors will play going forward. In this excerpt of his comments, he touches on the debate over executive pay, risk assessment, corporate governance, “say on pay,” and dead vampires.
The major issue for boards of directors will be from the standpoint of financial regulation and legislation. We have a failure of techniques to constrain risk in an era of securitization. Until fairly recently, risk in the debt market was constrained by the fact that most people didn’t want to lend money to people who they thought would stiff them.
There’s a pattern in economic history in which the private sector innovates and these innovations add value to society and they prosper, grow, and become more important. But, by definition, because they are innovations, they operate outside regulation. Eventually, the role of government is to rein in the inevitable abuses that occur because they operate outside of regulation, without losing their innovative structure.
A common view of Congress members is that we need to be more financially wise. But I don’t think a lack of wisdom or financial expertise on the part of Congress caused the problem…I don’t know of a bill that said you are now entitled to money that you don’t have to pay back. I think the problem has been that we [the legislature] have lagged too much in responding and we don’t always respond well.
The Third Wave
The rise of securitization is following pattern. In the late 19th century, there was the formation of the trusts. It was a positive development: If we didn’t have this large industrial base that you need, built by these ruthless people, we would have never become a modern, industrialized society. Ma and Pa Kettle, God bless them, would never have provided the industrial base that the world now enjoys. But these trusts, while they did a lot of good, created some problems—again, because there were no rules governing their behavior. After the trusts were created in the late 19th century, Theodore Roosevelt and William Howard Taft spent their time coming up with rules—antitrust acts, the Federal Trade Commission, and others—to rein them in.
Once you have these large enterprises, the next innovation was the creation of a stock market, which became more important than the trusts. But again it was not well regulated, so the New Deal set up regulations to give us the benefit of finance capitalism. I think we’re in the third wave of that. Securitization rises to that level.
Who’s to Blame?
So we know how securitization turned out, but how did it happen?
First, the rating agencies substantially overrated everything and now substantially underrate a lot of things. We [also] had quantitative models to protect us. Those were the astrophysicists and the mathematicians, and I have come to believe that this whole discipline was somewhere between alchemy and astrology in its scientific inexactitude. It’s clear that they did not work, probably because it’s hard to model when you have no experience. Models are based on taking past experiences and making some order out of them so that experience can be predictive.
“I’ve never been a director…but my own view is this: I get very nervous about being held responsible for things that I don’t have complete control of.”
Then there was diversification. The thinking seemed to be, ‘If we make enough lousy loans and sell them to enough people, they will go away.’ No, they don’t. They multiply. And diversification turned out to be a way to spread the epidemic.
By the way, we spread it with extraordinary skill all over the world, and so when the question arises that America is at a disadvantage because we will regulate too much, remember, there has never been a better time for ‘beggar-thy-neighbor’ regulatory policies because the whole world has gotten badly burned in this crisis.
When bad mortgages made in America bring down banks in Germany and England, as has happened, then…there is a greater inclination to cooperate among the international regulatory communities. There’s not going to be one regulator—we don’t have the sovereignty and I don’t think it’s going to happen. There was a brief period when the Europeans were chortling over America’s problems because of our lack of regulation and within a few weeks, they were in the same boat. I suggested to [Treasury Secretary] Hank Paulson that someone write the short history of schadenfreude, because it didn’t last very long.
It is in this context that I look at the role of directors. Boards of directors, we were told, were one of the mechanisms to prevent companies from taking too much risk. And it didn’t work. It did not work any better than anything else.
I have to tell you: I’ve never been a director and I would be reluctant to be one even after I retire—I wouldn’t take it and no one would offer it to me—but my own view is this: I get very nervous about being held responsible for things that I don’t have complete control of. The notion that there would be very intelligent people doing very complicated things six and a half days a week and I would come in on a periodic basis and tell them how to do it better, I don’t understand how you do that. It’s an inherently difficult task. I don’t think coming to a board meeting occasionally can do that. You need the board of directors to pick the next CEO…and help with risk assessment.
What Congress Will Do
Asking the tough questions about risk assessment— that’s what Congress will be focusing on. The main thing we will be doing next year is trying to find regulatory constraints on risk, because we have very few constraints right now. But these will not be substitutes for decision-making.
There are a couple of possibilities. One, of course, is simply transparency: knowing who’s got what and maybe putting them on an exchange. Credit default swaps are a great example. Credit default swaps are one of the best arguments for regulation. Within AIG, as I understand it, the regulated entities, the insurance companies, are still functioning and making money. The problem is that the people at the top took their regulated money and put it into unregulated entities such as credit default swaps.
Citizens ask me: ‘What are these?’ Well if you sell casualty, life, or other kinds of insurance…my understanding is you have to show the insurance regulator in your state that you have enough money to pay the claims and you’ve got access to reinsurance and…if you’ve got reinsurance, you’ve got risk retention. You can’t lay off all of your risk. Credit default swaps are a form of insurance that requires none of that.
Dead Vampires
How could people get so in over their heads? If you are insuring against something you think will never happen, you can be pretty free with your sales. It’s kind of like going into the business of issuing life insurance for vampires. If you were issuing life insurance for vampires, you would have nothing to worry about. But the point is, the vampires died. Housing prices went down and now we’ve got a lot of dead vampires and people who can’t pay the claims. And that’s called credit default swaps.
“The main thing we will be doing next year is trying to find regulatory constraints on risk, because we have very few constraints right now. But these will not be substitutes for decision-making.”
In terms of finding a solution, let’s be honest with each other. First of all, politicians tell fibs like: ‘Yeah, I love to campaign.’ ‘Yeah, I ran against him and we’re friends now.’ Never. Never remotely true. Well, think about it: you’ve got a job and someone goes to your boss and says: ‘He’s a bum, he’s lousy, and he doesn’t do his job. He’s lazy. I could do his job much better.’ That’s called somebody running against you. Now that’s democracy, but it’s not endearing.
One fib that everybody tells is that they don’t like to say ‘I told you so.’ Everybody likes to say ‘I told you so.’ I have found personally that it is one of the few pleasures that improves with age. I can say ‘I told you so’ without taking a pill before, during, or after I do it. The ‘I told you so’ here is that home ownership is a nice thing, but it is not suitable for everybody.
So there are a variety of things you can do to constrain risk taking. There are people in this society who don’t have enough money to be homeowners and there are people whose lives are not sufficiently integrated for them to take on the responsibility… What I’m saying is this: constraints on excessive risk taking in the era of securitization turned out not to work very well, unless you sort of cut it off at the source. So, there are going to be new ways to disincent people from making the bad loans in the first place. The subprime loans? We are just going to make them illegal. And people will say: ‘Well, don’t you wish everyone could be a homeowner?’ And my answer is yes. And I wish I could eat more and not gain weight. But sometimes when I act on my wishes, it is not a good result. We will shut down those bad loans.
Avoiding Future Bailouts
Now the question is: How do you diminish excessive risk taking elsewhere? There are a variety of ways to do it. One possibility: You can’t buy reinsurance without some risk retention. Another possibility—an open question—do you say that you cannot securitize 100 percent of the loan that you made? If you are the originator, should you have to securitize some percentage of the loan and should you be high up in terms of the risks that are taken? Capital requirements? Banks have them. We could limit the leverage so that you can’t issue many more credit default swaps than you could ever pay off if you bet wrong and the vampires die. We could also put them on an exchange so people can see what they are.
The way to prevent bailouts in the future is to substantially diminish the number of entities that will become indebted with so little ability to pay their debt. Remember, too, that the people who are being bailed out are not the entities themselves but the creditors of those entities. The shareholders of Bear Stearns, Lehman Brothers, and Fannie [Mae] and Freddie [Mac] have not done very well. What we have done is to intervene from them defaulting to prevent their creditors from being drawn into this downward cycle. That’s where I would hope we could see something from boards of directors.
Risky Business
Boards of directors need to prove that the companies they serve are not getting in over their heads. Deal with compensation and deal in particular with that compensation that incentivizes excessive risk-taking. As I understand it, most entities have this set of rules that if you make an investment that pays off well for the company, you get a significant bonus. And if it doesn’t work out so well, you go home to dinner and you come back to work the next day. That’s a one-way ratchet. It’s a perverse incentive.
Without question, the most influential economic spokesman in America today is [CNN anchor] Lou Dobbs. He has successfully articulated the anger that Americans feel. If you do not do a better job of alleviating the anger, then I think that we will continue to see policies that are in our interest not go forward.
If the game is heads I win, tails I break even, then I’m going to flip a lot of coins. And that’s our sense of what’s going on. Also, there’s the sheer volume. We’re talking about some extraordinary numbers. I admire that [Chrysler CEO Robert] Nardelli has said he is only going to take a dollar in salary [but] he got a $230-million severance [package] when he left Home Depot, so living on a buck-a-year salary is perhaps less of a sacrifice than it would be in another context. The point I’m making relates to accumulated stock options —that’s what was voted to him and, at the same time, [Home Depot] announced it would spend $350 million to refurbish the stores. So, I would say you’re talking about boards demanding that people show you how to avoid excessive risk taking and rein in excessive compensation in the interest of having some civility in this society.
“Everybody likes to say ‘I told you so.’ I have found personally that it is one of the few pleasures that improves with age.”
So, we will go forward next year legislatively in trying to come up with ways like the antitrust laws or the SEC—those are models of legislation we have—that put rules and regulations around securitization to curtail the abuses without killing the benefits of the instruments. I believe, by the way, if we do that right, it is pro-market. We have a problem right now that investments that should be made aren’t being made and people can’t get loans that should be made. There has been an overreaction and the overreaction has come from the investor community. Again, I’d go back to the SEC and mutual funds and what FDR did in the 1930s that was very pro-market, because if you don’t give these people assurances that they can invest again, they will stay away from it.
The ‘Hot Stove’ Effect
There’s a story where a little child touches a stove and gets burned and having touched the stove and gotten burned, never touches the stove again. Now, the child is not touching the stove and it’s good that the kid doesn’t want to go near the stove again, but the problem today is that the kid doesn’t want to go near the stove or the refrigerator or the sink or the toilet. He is overreacting to having been burned by [the stove]. Rules that allow people to differentiate between hot stoves and other instruments are a good thing.
Where We Are
So, that’s where we are. We will be working hard and listening to people and we want to do it with international coordination to put some constraints on excessive risk taking that don’t deny us the great benefits of securitization.
As far as boards of directors, you will see some movement in the corporate governance area. I have been somewhat surprised at the reversal of fortune in the opinion of shareholders. When I was growing up, shareholders were considered the salt of the earth. They’re now seen as a bunch of rapacious nudniks that have nothing better to do than prevent these corporations from working. We will be talking about increasing the ability of the majority shareholders, with proper constraints, to set, ultimately, broad policies for corporations. But that will shrink in importance. The major role we will be trying to fulfill is finding a substitute in the era of securitization for the lender/borrower direct relationship in risk taking and we will be doing it with international cooperation.
Finally, you will see a Democratic initiative in trying to increase the social safety net, because until you alleviate the sense that the average American is unfairly being put upon, then you will not see things going forward as they should.