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Superintendent Neiman Addresses the Institute of International Bankers at Regulatory Examination, Risk Management & Compliance Seminar

October 29, 2007


Good afternoon. And thank you Larry, for that kind introduction. It’s good to be with you today. Compliance issues that were once considered “back room” have suddenly become front-page news. And rightly so; therefore, I’m pleased that the IIB is hosting this timely seminar on examinations, risk management and compliance.

When I last spoke to the IIB back in July, we were already discussing the initial compliance lessons learned from the unfolding subprime problem. And the effects are continuing to develop; in particular, the broader impact on the capital markets has manifested itself since the summer and is the subject of much discussion.

Just last week I was in Washington, DC during the World Bank meetings and had the opportunity to attend three days of events sponsored by the IIF, the Group of 30, and the IIB.

Participating in these meetings were Global CEOs of the world’s major financial institutions, regulators from around the world, as well as finance ministers and heads of Central Banks.

Almost without exception, the topic most of the global executives and world leaders wanted to address related to current liquidity crisis and turmoil in the subprime mortgage market. The question they kept asking was: “Why did it happen and what have we learned ?”

One lesson is that a crisis can arise where it is not expected.

Ever since the crisis of Long Term Capital in 1998, many observers have predicted that the next major global risk would come from the explosive growth of largely unregulated hedge funds or derivative instruments. Others thought the largest risk lay in emerging markets like China or Russia.

However, this global crisis was born right here in the USA and during a time of continued economic growth, low inflation, and low interest rates. Factors that in reality contributed to the current problem.

It’s fair to wonder both how this credit weakness crept into our economy and how problems in just one sector of the U.S. housing market provoked a potential international liquidity crisis. Attempting to answer that is like trying to unpeel an onion- each new layer reveals yet another level of detail and complexity.

We are continually gaining new insight into this multi-layered problem, and it’s becoming clear that the entire chain of events is driven by changes within the mortgage origination system. To a great degree we have seen mortgage lending shift from buy-and-hold process to an originate-to-distribute model. Where loans are originated and quickly sold, packaged and distributed through the securitization process.

I’m not suggesting that securitization is the real culprit here-- the funding of mortgage originations through the capital markets has expanded homeownership and other consumer opportunities and I don’t want to see that potential cut short. But this transformation comes with its own set of risks, as well as rewards.

With that in mind, I’ll frame my remarks around the following two questions:

  1. What are the continuing lessons learned from the subprime problem?

  2. What action steps are being taken by the States and the Department at the state level to respond to these challenges?

In terms of observations, I’d like to briefly highlight six themes.

1. First is the need for greater transparency regarding the risk associated with complex, structured products like CDOs.

It had become readily apparent by August that the risk imbedded in these products was not thoroughly understood by investors and other market participants. Without that clarity, risk becomes uncertain and the price of such instruments becomes uncertain as well. Repricing was long overdue. But this lack of confidence in the quality and uncertainty regarding the valuation of subprime assets impacted other asset classes.

2. A second lesson is the need to reassess the role of Ratings Agencies.

There was an over-reliance on ratings. There is a need for ratings agencies to more closely monitor the default and delinquency rates of the underlying assets. Just last week one of the ratings agencies instructed servicers to begin providing them with monthly delinquency data on subprime mortgages in pools. Why did it take that long ? There is also a question as to whether the ratings were entirely independent; a conflict of interest can arise when rating agencies are paid by the issuers and not by investors.

3. Third is the importance of strengthening liquidity risk management and supervision.

Effective management requires more emphasis on stress-testing, and I also expect that the Basel 2 implementation process will begin to accelerate banks’ attention on liquidity risk. This effort will require cooperation among international bank supervisors.

4. The fourth lesson regards the use of off-balance sheet vehicles.

A robust risk management program should include an assessment of exposure due to vehicles like SIVs and conduits, and consider residual risk from accounting, financial, and reputational angles. Questions have certainly been raised as to whether many of these vehicles are experiencing trouble due to the classic problem of Asset and Liability maturity mismatch.

5. Fifth is the impact of the subprime problem on valuations.

Areas where accounting depends on fair values are being tested, as market prices cannot be readily obtained or determined. A mature source of data for mark-to-market valuation may not be readily available. If the process turns to mark-to-model, parameters and assumptions used in the model and the ability to manage the results are among the significant concerns. Management needs to have adequate controls in place to compensate, such as internal monitoring and model validation.

6. And finally, increased coordination and harmonization in global supervision is necessary.

Although globalization is a reality, regulatory convergence has yet to catch up. We need to increase the effectiveness and efficiency of coordinated supervision. And it should be countercyclical supervision. When the economy is strong, institutions are more inclined to lessen underwriting standards. Also, in strong economic times, investors may not engage in the same level of due diligence or insist on appropriate underwriting disciplines.

Since this is a global problem, it’s logical to assume that it requires a global solution. And while we do need prudent oversight and macro-economic policies from the Federal Reserve and international central banks, a large part of the solution is still purely local. Remember that the root cause of the subprime problem is poor asset quality, and those assets are mortgages collateralized by homes in the fifty states.

So no matter how complex and widely distributed the resulting investments products become, mortgage lending remains a local matter. And that fact partially explains why the states have historically played a significant role in the supervision of the mortgage market.


And the states remain well-positioned to continue in that role, despite the implications of the new global origination and securitization machinery. State governments are closest to the local conditions that can foretell a downturn in the mortgage market, whether the issue is housing prices, employment, or other economic factors. And states regulate the non-depository mortgage bankers and brokers, whose business accounts for an increasing share of new originations.

There has been much discussion about the role of mortgage bankers and brokers in the present crisis, and I’d like to devote the rest of my time today to my second theme: the action steps that the Department is taking:

These Banking Department initiatives also contribute to the work of the Governor’s HALT Task Force, to “Halt Abusive Lending Transactions. The Governor formed this Task Force, which I chair, back in March to unite the resources of all the state agencies and departments that relate to the mortgage industry.

Let me share with you some highlights of our heightened enforcement and consumer protection efforts.

On the supervision and enforcement side:

All consumers, as well as investors, will benefit from these heightened enforcement activities. But I’d like to highlight additional initiatives that are specifically designed to help existing mortgage borrowers who may be facing a payment hardship:

We’re also taking steps to help the market to work more efficiently and protect future consumers.

I’d be very interested in your feedback on a future legislative and regulatory agenda. What reforms do you think would best protect consumers, investors, financial institutions, and the global economy going forward?

If there really are going to be lasting lessons learned from the pain of the current housing correction, then perhaps we need to make those lessons permanent by putting them into law or practice. Your ideas are an important part of that process. If we want to anticipate and hopefully prevent the next challenge to the global markets, we need to continue to work together.

I thank you for your time and would be happy to entertain any questions.


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