A panel comprised of Emmons, Mary Karr, senior vice president and general counsel, and Steven Manzari, senior vice president, Complex Financial Institutions, Federal Reserve Bank of New York, answer a variety of questions from the audience. Julie Stackhouse moderates.
William Emmons: All right. So we need to get our chairs in place and...
Julie Stackhouse: Okay. We'll get our panel up here. Let's give Bill a round of applause.
William Emmons: Thank you.
Julie Stackhouse: And we'll have our other two panelists join Bill. So that was provocative, Bill, maybe persuasive towards the angle that large institutions have some risks attached to them. You know, in some ways, just to hone in on some points that Bill made, there is some natural transition that occurs in any industry—banking is no exception to it—that as the economy grows and as competitive conditions change, so does the nature of the industry change. And we have seen that in banking. Now, to some extent, and I'm not sure if you connected the dots on this, there was a change in law where institutions that previously operated multiple separate entities under the same holding company were allowed to branch those entities. So in some respects, some of the very large institutions we have today are a sum of parts that they held under the same corporate holding company or corporate format in years past. But there's no doubt that the financial crisis made institutions that were already big bigger. Because when you have a financial crisis and you are looking at ways to shore up the system in short order, sometimes hurried marriages are the best way. Or maybe we could say it's the best option out of the many least attractive options presented to you.
There is certainly a system today that is different than what we had in the 1930s where some of the original banking laws were put into place. In those days financial institutions tended to be very much located in the United States, had very traditional lending and deposit taking operations. And in reality, that changed as our economy changed and we became a very global international economy. So the competitive considerations are a reality as well.
So hopefully we've given you both sides to this story, both the challenges that are out there as well as some of the realities of the change that takes place just through a changing economy. And now we're going to open it up to you to see what questions you have on our presentation tonight. And just to remind everyone, on our panel, first is Mary Karr, general counsel here at the Federal Reserve Bank of St. Louis. Mary is our local expert on the Dodd Frank Act. In the event you'd really want to deep dive into any of those issues, we've got the right person for you. Of course, you know Bill. And then on Bill's right is Steve Manzari, senior vice president at the Federal Bank of St. Louis. And again, Steve has the unique perspective of working with a very large financial firm, Citi, being a part of the team that worked with AIG as its issues were addressed, and now serving as lead supervisor for a number of large financial firms that the New York Fed is responsible for. So what questions might you have? Yes? Please turn on your mic.
Q: My question is to the accountability. It is my understanding that none of the too big to fail banks, no senior executive CEO has been held accountable to the degree that they were prosecuted by federal law. And I'll take the John Thain case in the global, a lot of hearings, a lot of smoke, but, you know, they can't get down to the nitty-gritty of who's responsible and who's going to go to jail.
William Emmons: Let me take that in two parts, in terms of the individuals' financial accountability, and then their legal I'll turn it over to Mary.
Mary Karr: Okay.
William Emmons: Many, many people have lost their jobs because of the crisis. Many of the leaders, some of the institutions have disappeared. And, of course, many of the firms—and this then I'll hand it over to Mary—the prime defense that many of the executives have used is that, look, I lost millions, I lost my fortune, how could I have been acting in a dishonest or purposely deceptive way? I was fooled by this crisis of the century like everybody else. And so, in fact, I think the first answer to your question is many executives have paid dearly financially. And that in turn is one of the reasons—and, Mary, you can comment on that—one of the reasons why there haven't been people go to jail is that they could show that they lost so much money. That's been their defense.
Q: Well, the billionaires are now just millionaires.
Mary Karr: Perhaps. One of the difficulties and there are still—and I'll defer to Steve perhaps on this—but there are still ongoing investigations. But one of the frustrating issues I think for all of us as we think about this kind of a crisis and the aftermath is that the human cost for many people was quite high, and yet many of the people at the tops of the organizations, as you say, you know, they may no longer be billionaires, they're just millionaires now. Having said that, we're a nation of laws. And criminal liability as we want it to requires the very highest standard for a court to find. And these cases are complicated. Usually we have a requirement for intent in criminal statutes and in criminal proceedings. So is it true that no one will go to jail by the time this is all done? Who knows? But again, these are very, very difficult cases to prove and very, very difficult cases for juries to find a conviction for. Because once you really look at what's required, it's hard to lay the blame.
William Emmons: Steve?
Steven Manzari: I would not add anything to that. That was well said.
Julie Stackhouse: Yes, over there. Can you use your mic, please? Thank you.
Q: Referring to a graph that you had on stock prices versus the bank stock index, the first eight years that you saw bank stocks absolutely blow away the S&P 500—of course, that was during all kinds of mergers and acquisitions. I think it was First Chicago did a study on bank mergers and acquisitions and all the financial measures. And they found only one measure went up, and that was CEO salary. Do you think you could extrapolate that to this only on a mega scale? This is a new level of acquisition correlated to CEO salary?
William Emmons: Yeah, the evidence points in the direction that you're pointing out, that one of the primary drivers of mergers appears to be, yeah, incentives to get bigger for purposes of compensation. That's a long, long history of economists confronting bankers and saying, why are you doing these acquisitions? Your stock price goes down when you make the announcement that you're going to make this acquisition. And yet, as you say, the evidence shows that there is a correlation between the size of the bank and the size of the compensation of the surviving CEO.
Mary Karr: But I wouldn't limit that, Bill, just to banking.
William Emmons: No, no.
Mary Karr: I think if you look at corporate America in general, frequently there's a premium for size. You know, I used to be in private practices with my own opinion and not anything official, but you used to see waves of let's create a conglomerate. And maybe the CEOs make money, maybe the law firms make money, maybe the investment bankers who help them put it together make money, and then five years later, let's get back to our core business. And you see that happening in industries other than banking. I think banking is so highly regulated in comparison to many of those other industries and has been so highly regulated that once you create a basket, a financial supermarket, it's a little bit harder to unscramble it sometimes. So for years and years we had—you know, it was Bill's slide show—we had very restrictive laws about what banks could do. We had geographic restrictions, we had business restrictions, we had the Fed charged with deciding what businesses were closely related to banking and you could do that but nothing else. And, you know, the banks were telling us and finding ways in essence to get around those. And so really the law was playing catch-up with what the banks were trying to do anyway in terms of both geography and scope of what they did. And I think one of the things that has happened since the mid-90s is we've seen a tremendous increase in both scale and scope of those institutions facilitated by law. And once that happens it's hard to make those things to shrink those things down, as Bill suggested.
Julie Stackhouse: Steve, there are some rules today on incentive compensation that did not exist until a few years ago. Could you briefly fill our audience in on what those roles do?
Steven Manzari: Yeah, sure. So the banking agencies issued about a year or two ago guidance to financial institutions on incentive comp. I think it was widely accepted that the incentive comp practices at large financial institutions were part of the cause of some of the problems in terms of how the firms were managed. So for a long time most employers usually had a couple of different things they were trying to achieve in terms of how they structured their incentive comp. One was retention. People structured incentive comp in a manner to maintain the ability to keep talented individuals as long as possible. And then second, they designed these compensation programs to really maximize the value to the employee and minimize the value to the firm. So for instance, if I could structure compensation to people in a manner that was very valuable in terms of the type of compensation the employee wanted but had as little cost as possible to the organization, that was obviously what firms were trying to accomplish.
What was missing from that was the creation of what I would say—really an incentive inside the organization for the employees to own the risk alongside the owners of the firm. So the incentive compensation guidance that the Federal Reserve and the FDIC and the Office of the Comptroller of the Currency among others have endorsed is essentially a set of practices that would make the employees of a firm own the risk. The size of the compensation the employees would get would be linked to the amount of risk they take and there would be an opportunity that, if those risks manifested themselves in a way that was inappropriate, there would be an opportunity to take that compensation back from employees. This was generally designed to create the right risk-taking incentives for individuals inside the firm. So while there are a large number of controls that these firms have to stop their employees from taking undue risk, for instance, they have large credit, an underwriting department, so if a loan officer wants to originate a loan, it has to go through a pretty rigorous review to make sure that it's appropriate for the firm. This adds on top of that the ability at some point after a loan officer has built a book of business to say, look, things went wrong with this portfolio of loans that you put together and your compensation, which is vesting over, say, five years—three years in some of those loans turn out not to work out so well. That comes back to the organization. So it really tends to put the employee in a position where they care as much about the long-term outcomes of the firm as the owners do.
Julie Stackhouse: Okay, next question. Oh, my gosh, let's go over here.
Q: So I'm wondering, are we still securitizing mortgages and putting them into tranches? And if we are doing that, which I understand we're doing, have we changed the instrument so that the servicer, if you know this, or the trustee has more control in making arrangements when a default or foreclosure comes into place so that we can work these arrangements out?
William Emmons: The private label residential mortgage securitization business is dead.
Julie Stackhouse: And if I could just add? When Bill says private label, pretty much all of the non-prime mortgages were underwritten by firms that are not the government-sponsored enterprises, private firms. And that's how they got the name private label. So that's the piece that is essentially dead.
William Emmons: There is another part to that. In terms of the practices that we associate with the bad practices with securitization, which as Julie said was the sub-prime and the Alt-A, that is dead. That's gone. But there still is the potential to create risk through securitization, and that's by taking the Fannie and Freddie mortgage securities and creating what we would call CMOs, Collateralized Mortgage Obligation. So it is possible to tranche these even government-guaranteed securities to create, say, interest rate exposures. And I know that the supervisors are concerned about there're still ways to create lots of risk even if you start with these government-guaranteed securities.
Q: Do you know if the GSE is still doing that? And have they changed the...
William Emmons: The GSEs themselves don't do the tranching. They sell into the market plain vanilla.
Q: Right. Is the market doing that?
William Emmons: To some extent. And I think—I don't know if you see it in your organization, some appetite.
Steven Manzari: So broadly speaking, there have been reforms to the securitization market which require, outside of a relatively narrowly defined set of securitizations, requires underwriters to retain risk on their balance sheets. That is in the process of implementation, and that's going to be a pretty significant change to the market. So just in very similar vein to the incentive compensation guidance that is out there for the industry that the agency has put out, there's also this change that says, listen, if you are going to securitize mortgages, you're going to keep some portion of the risk on your balance sheet so that you're not going to be standing sort of on the shore when the boat out in the ocean sinks and you're waving goodbye.
Q: And what about the default issue, to work out the defaults? Is that too much in the weeds here?
Mary Karr: I think it's, well, you know, I don't have a good answer for that yet. And part of it is that this market is changing, and the issues with respect to keeping skin—it's called skin in the game—you know, we just don't know yet. So servicers—there have been actions taken. Again, this isn't—but you're talking about the securitizations. And that I don't know that much about where it's heading right now.
Julie Stackhouse: Yeah. And again, just to make sure everyone is understanding, there's been just a vast number of changes to mortgages, both how they're underwritten and the regulations that guide them, that today some people would say it's really hard to get a mortgage. And we have some more regulations coming down the path. Steve mentioned one. It's called a risk retention rule where securitizers now have to hold part of the instrument, however it's defined, to incent good underwriting. And then there are what will be called ability to repay rules, which are underwriting standards that will be required to create really a safe harbor of what is a good mortgage. The effect of that is going to be that the ability to write mortgages is going to require a strong balance sheet, a good credit history and ability to repay. Which is not to say there won't be defaults, but it does portend a different environment in the future just because the initial underwriting will be so different. Yes. There?
Q: I wanted to go to something Steven said just a minute ago. He said something about retaining risk on the balance sheets. Now, that was kind of already there for a lot of these firms, but then they bought into the credit default swaps which was basically insurance on those risks. So they were exposed because of the investments they made, because they had to carry those on their balance sheets, but then they bought the insurance against them because they were going to fail. So they're exposed twice. How does...
William Emmons: Well, they bought protection to take away...
Q: But they bought protection from themselves, right?
William Emmons: No, we...
Julie Stackhouse: Steve, do you want to talk a little bit about a normal—If we had a situation where we have an investment bank and it's pipelining—a little bit different than risk retention, but it's in the process, creating securities—how then a credit default swap might be purchased to hedge that risk? Can you speak to that a little bit?
Steven Manzari: Well, so if you're talking about the warehousing process and the securitization process?
Julie Stackhouse: Right.
Steven Manzari: Well, there's a number of ways this could work, Julie. But in general, firms, they built a portfolio of loans, underlying credit risk assets that they were going to securitize into pieces. They retained that entire risk during that period of time. They could take certain actions. For instance, if they knew what the credit profile of these assets would look like once securitized, they could buy essentially bond insurance from someone to protect them during that interim period when they owned that risk out of reduced the credit risk of owning those assets. So in that ramp-up period as they're building these securities which they're going to issue, if they understand well enough—which they would—what the credit profile was, they could purchase bond insurance that looked much like that. Now, that's not a perfect risk reduction, but that was possible.
William Emmons: And I think, Steve, when you talked about the risk retention requirement, that's net of any protection they would buy.
Steven Manzari: Yeah. In terms of the rules going forward, that's correct.
William Emmons: Yeah. So they can't eliminate that risk through...
Julie Stackhouse: Yeah. So we might want to handle that one offline because we actually have two different concepts we're talking about, and we probably left you totally confused. So let's go ahead and take a couple more questions here. Yes? Right there.
Q: What are the main differences between the Glass-Steagall Act which was repealed, and the Volcker Rule?
William Emmons: Okay. Glass-Steagall was to keep commercial banking, lending and payments, separate from investment banking—that is, the underwriting part of it—and insurance underwriting.
Julie Stackhouse: Right.
William Emmons: So the Volcker Rule is not that. It's just that a bank is limited, not absolutely prohibited, but limited in how much trading for its own account it can do.
Julie Stackhouse: Steve or Mary, anything to add to that?
Mary Karr: Well, just a brief elaboration. Banks have long acted on behalf of customers and as an agent for a customer in securities transactions. Glass-Steagall didn't stop that. What Glass-Steagall stopped was banks underwriting securities and getting into the major business of being an investment bank as opposed to—we used to talk about investment banks and commercial banks. Investment banks underwrote securities offerings, they underwrote bond offerings; banks made loans. On the side, banks might have a trust department where they managed some assets and invested, and they might buy and sell stock on account for their customers but not for themselves. So that was the old kind of Glass-Steagall world. What Volcker does—or will do if we ever get a rule written that people can understand—is basically go back and say, other than hedging, banks can't trade for their own account. So it's a different approach to a similar issue, I think.
William Emmons: Hm-hmm.
Julie Stackhouse: And, Mary, I'm just curious because I know someone wants to know this. Could we put Glass-Steagall back today? Or are we just so far past those days that that would be impossible to do?
Mary Karr: Well, Congress could do any number of things, including pass a law that looked very much like Glass-Steagall. The implementation would be challenging, just like the implementation of the Volcker Rule is proving to be difficult. Because I think it's, you know, lawyers are fond of quoting the definition of obscenity which is, I can't define it but I know it when I see it. And that's kind of what you hear about the Volcker Rule: I can't define what trading for the bank's own account is, but I'll know it when I see it. Well, if I'm a bank trying to decide what I can and can't do, that's not a very satisfying definition.