Superintendent Neiman Addresses New York Certified Public Accountants Society's Banking Conference
September 25, 2007
Good afternoon. I’m so pleased to be with you here today at this important forum for accounting and financial services professionals. When I read over the agenda for this event, I was impressed by the depth and range of topics that are being addressed, particularly in key risk management areas, such as anti-money laundering, auditing, tax and accounting standards.
That’s quite a list to tackle, and these certainly are challenging times to be tackling them as part of the banking industry. These are issues that we also deal with on a daily basis at the Banking Department. So I’m very happy to see several other representatives from the Department here in the audience and on the agenda. They’re here to share their expertise on these hot topics and participate in what I am sure is a very lively dialogue.
As I said, the present time for the industry is challenging. So challenging, in fact, that I sometimes wonder what I signed on for when I agreed to accept the position as Superintendent. And I know I’m not alone in that thought - many people have asked me why I made this move; why give up a bank presidency to join state government?
That was actually the first question by the Governor’s selection panel, which included former Superintendent Diana Taylor. I will tell you exactly what I told them.
I told the panel that I had indeed thought a lot about it. And that I have a range of experiences to contribute in making meaningful advancements in financial services regulation. I’ve seen the industry from a variety of perspectives - as a regulator, attorney, consultant, and executive - and in each of those roles, I interfaced with internal auditors, quality control experts, and external auditors on a regular basis. I believe that experience has also given me unique insights into the critical work that you perform every day.
And even after a demanding first half year on the job, I have no regrets that I accepted the opportunity - this is truly an exciting time to be a regulator, and perhaps especially so to be a regulator at the state level. I suspect that each of you may feel the same enthusiasm about your work in this time of evolution for the banking industry - the challenges are real, but so is the satisfaction of working to address some of the most pressing issues in recent memory.
But I can’t say I wasn’t warned to expect challenges! Before I accepted this position, I reached out to a number of former superintendents to gather their opinions on what I might anticipate. And virtually every one of them advised me that they had experienced some sort of incident or financial emergency - and not just over the course of their tenure, but during their first few weeks of service.
As for me, the beginning of my term as Superintendent has been shaped by not one, but two, genuine trials for the market and the state regulatory system:
- the turmoil in the mortgage sector, and;
- preemption, as defined by the Supreme Court in Watters v. Wachovia.
And while they are two distinct issues, they are also intertwined. Ensuring that we have the right regulatory structures to effectively respond to the subprime problem necessitates a very frank evaluation of the nature of state-federal supervisory cooperation. And the preemption issue has served as a timely, if somewhat blunt, catalyst for much-needed interagency conversations.
I’m not implying that we have formulated all of the answers. We’re still in the midst of the situation and may see the impact for years to come. The resolution of the uncertainty in the mortgage market and the compounded effect of preemption on the dual banking system are both long-term issues. So while it would be premature to say that we can analyze either situation with the 20/20 clarity of hindsight, I think we can and should be able to identify lessons learned so far. I understand and appreciate the importance for reflection. But as critical solutions are identified on a rolling basis, there is also a need to act on those lessons learned and incorporate those lessons into our strategies and future planning. The goal for a regulator is to be proactive, to anticipate risks and make mid-course corrections as needed to protect consumers and investors and to help the market function most efficiently.
So I’d like to frame my remarks this afternoon around three themes, to aid us in evaluating those mid-term solutions:
- First, an overview of the origins of the subprime problem. Though not the main objective of today’s conference, I believe some initial thoughts on what is behind these market dynamics is instructive and can better frame the preliminary lessons learned.
- Second, a consideration of resulting risk management strategies for the industry. The impact of the subprime problem has been wide-ranging, as there are a variety of roles that financial institutions play within the mortgage market. But I’d like to focus on those issues that impact your accounting-related functions, particularly in the areas of risk management and internal controls.
- Third, a summary of our renewed regulatory approach. The Department has taken several important steps to improve our supervisory method and maximize our effectiveness in responding to the subprime problem, particularly in light of the preemption decision.
1. THE ORIGINS OF THE SUBPRIME PROBLEM
To return to the first theme - I believe the origins of the problem stems in part from increased institutional demand for higher yielding subprime investments. As stock values fell earlier in the decade, real estate became an appealing investment alternative and property values increased in response to renewed investor appetite. As a result there was a significant increase in institutional investor demand for higher yield securities in a time of declining rates and declining risk premiums.
Lenders were quick to respond to this investor interest through the development and marketing of alternative mortgage products. These alternative products contained unique risks, such as the potential for negative amortization and risk of payment shock as adjustable-rate loans with low initial rates reset. These inherent product risks were combined with underwriting risks, such as 100% loan-to-value financing, no income verification and reduced documentation.
These products and underwriting techniques were then applied to consumers with impaired credit histories. The higher fees that originators could obtain through these products may have provided an incentive to place some consumers in products that were not appropriate for their financial circumstances. This created the potential for misaligned interests between the brokers or lenders relationship to their customer and their own profit considerations. Many of these alternative products were originally intended for high net worth customers who could better withstand and understand the unique risks associated with these products, such as the potential for negative amortization. When marketed more broadly and with a reduced regard for the borrower’s ability to pay, however, the tragic result has been a spike in delinquencies and foreclosures across the state - with the associated personal harm to consumers, economic harm to communities, and a real business loss for lenders.
I think there were two primary drivers behind lenders’ willingness to engage in this kind of high-risk lending activity:
- the gross under-appreciation of the true depth of the risk, basically a failure in risk management on the part of some lenders, and;
- a ready mechanism to disperse the risk through the securitization process.
On the second point, regarding the securitization process, I don’t mean to suggest that the secondary market is inherently flawed or that risk dispersal is not desirable. Certainly no one is looking to concentrate risk, and the securitization process has provided a steady stream of capital that has fueled economic expansion. But compartmentalizing risk can have the negative effect of fostering complacency in the absence of vigorous risk management. If the risk is so widely spread that no one really knows where all of the interests lie, then no one has the motivation to invest in a sufficiently robust risk containment infrastructure.
However, I don’t intend to focus my remarks today on securitization. That’s not to downplay either the importance of the securitization process on the mortgage market or the necessity of engaging market participants in designing a lasting solution to the subprime problem. But what I’d like to emphasize is the effect of under-appreciated risk from an institutional perspective. Understanding how you as accountants and we as regulators manage risk is an integral part of building a more robust financial services system in New York. Risk management goals that we both share are prevention and the detection of emerging issues as early in the process as possible.
That leads me to my second theme:
2. RISK MANAGEMENT STRATEGIES FOR THE INDUSTRY
I see accounting and quality control specialists at the vanguard of a bank’s risk management program. So I think it’s appropriate to begin our discussion of improvements to our financial services system with a consideration of several specific risk management strategies in relation to internal and external auditing functions. While these strategies have particular application in the mortgage context, they also serve as examples of the type of comprehensive monitoring that is needed to adequately assess any complex lending activity. So here are just a few action steps for auditors that the subprime problem has identified:
- Ensure that new mortgage underwriting guidance standards are being implemented. The Department, in cooperation with the Conference of State Bank Supervisors, has issued guidance on mortgage lending for subprime and nontraditional products. These guidance statements are available on our website for your review, and they address the core underwriting issues that contributed to the subprime situation. The new standards contain provisions for documenting and calculating a borrower’s ability to pay, especially at the fully indexed rate, not the introductory, interest rate. An important task for quality control specialists is to ensure that the operating business lines are actually applying the guidance in practice and are being reinforced in that behavior by management.
- Perform regular credit model validations. The move away from traditional underwriting standards that prevailed in much of the subprime sector was perhaps facilitated by the use of various predictive credit models or “scorecards.” Such statistical tools are designed to increase objectivity in the loan process, and thereby reduce risk, but they come with their own unique limitations that lenders can easily fail to appreciate. Statistical models are intended to aid in sound decision-making, but there is a potential danger of over-reliance. The precision of a prediction is not a certainty. While there is a proper role for credit modeling, the question remains as to whether the various credit risk models were sufficiently tested, or were even designed to forecast default rates when income and payment capacity were de-emphasized. Internal controls should include vigorous validation testing. The goal is to ensure that models are not biased in the weighting of underwriting criteria and are sufficiently robust to predict consumer behavior across various economic cycles.
- Consider valuation standards. Areas where accounting depends on "fair values" will be tested where market prices cannot be readily obtained or determined. Such areas include trading activity, loans held for sale, and derivatives. The use of models or other forms of estimates will require external auditors to gain comfort with highly-uncertain values. I expect that CPA firms are discussing with each other the best means for determining fair values, and hoping to reach a consensus on approaches.
- Monitor the work quality of employees and third-party services providers. Another disturbing reality of the current subprime problem is the degree to which outright fraud was involved, often perpetrated by industry insiders. Loan officers may have altered or forged qualifying documents. Third-party providers such as appraisers may have provided false valuations. The prudent auditor should perform quality control testing that is designed to cover all employees and third-parties. In a random audit sample, there may not be enough loans from a particular source included to demonstrate a trend - those suspicious files could be “washed out” in the broader sample. Ensure that there is adequate supplementary testing on an individual provider basis.
I’ve just laid out quite an ambitious and complex set of issues arising out of the subprime crisis that you are and your colleagues are addressing. Regulators have also learned from this experience, and that leads to my third theme:
3. THE DEPARTMENT’S RENEWED REGULATORY APPROACH
The Department has always been active in these areas, but the subprime issue and the potential for a foreclosure crisis to develop have been the occasion for us to renew our commitment to the following:`
- Fostering constructive interagency cooperation. This is more important now than ever - the preemption decision in Watters v. Wachovia has further stratified the regulatory landscape. And that necessitates more, not less, state-federal cooperation in order to effectively supervise the diverse mortgage market. And the subprime problem itself dictates closer collaboration. I think we need to acknowledge that there’s enough blame in the subprime situation to go around – and just about everyone involved in this industry shares in the blame for the situation we’re faced with today. There’s no time for regulators to engage in finger-pointing over the current state of the market, or for sour grapes over preemption. But New York is a state with progressive consumer protection laws, and preemption does have real ramifications for us. That’s why I’m advocating a national minimum standard for mortgage lending that would level the playing field and reduce the practical effects of preemption on consumers. But those progressive state standards point to another cherished and timely priority, which is my second point.
- Maximizing the benefits of the dual banking system. Some have wondered whether the preemption decision sounded the death knell for the dual banking system. Far from it - the subprime issue has actually highlighted the important role that the states play, particularly in the supervision of non-depository mortgage bankers and brokers. It is perhaps ironic, but in some ways, preemption may have a positive effect for the states in that it helps to clarify where each regulator should focus their limited supervisory resources. The hoped-for result is that interagency regulatory overlap will be reduced, and each agency will concentrate more deeply on its primary area of supervision - to the end that the market is even more effectively canvassed. And remember that supervision and enforcement are not the regulators’ only purposes. My final point today is another priority that the present mortgage turmoil has highlighted.
- Realizing the value of the regulator in a “convening” role. The subprime issue is so complex, and has so many moving parts, that solutions require engagement from community groups, industry, regulators, and law enforcement. Regulators stand in a unique position, and can serve to bring diverse groups to the same table. Regulators can facilitate dialogue between consumer advocates and industry to design improved lending standards, foster economic development and inclusion, and identify solutions for borrowers facing a mortgage hardship. In the context of the subprime problem, the Department and the Governor’s interagency HALT Task Force to “Halt Abusive Lending Transactions,” have been active in this convener role, particularly in hosting a series of day-long summits across the state to bring stakeholders together. Another important conversation that we are interested in facilitating is between servicers, the securities industry, and accounting professional such as yourselves. Containment of the subprime problem partially depends upon offering at-risk borrowers fiscally prudent work-out arrangements when possible. We’ve issued guidance encouraging lenders to work with mortgage borrowers. But we recognize that issues around modifications remain, and I’m particularly interested in hearing from the accounting community about your ideas for solutions.
And that is one of the reasons that I am here today, to become better acquainted with each other and to identify avenues for further collaboration. In an increasingly global marketplace, risk spreads quickly and risk management strategies and regulatory methods need to keep pace with market evolution. The subprime experience is just one example of the effect that improperly managed risk can have in an interconnected economy. To help ensure that New York regulators are optimally positioned to be an engaged partner in this needed risk management, Governor Spitzer has formed a Commission on Financial Modernization. We want to reduce regulatory burden and overlap, while still upholding the high standards of consumer and investor protection that are part of New York’s success story as a center for international finance. Throughout this process, I look forward to hearing your suggestions for ways in which we can update our regulatory framework to meet future challenges. And I’d be pleased to answer any questions you may have.