Barney Frank: Create a “Risk” Post

In Boston, the chairman of the House Financial Services Committee says that regulation needs to catch up with financial innovation and trends in securitization.

Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, said Thursday that the United States is in a recession and that Congress should consider a “financial services systemic risk regulator” to combat the causes of the credit crisis.

Speaking before the Greater Boston Chamber of Commerce, Frank blamed years of anti-regulation sentiment and the technical innovation of securitization, dating back to the 1980s, for the meltdown in the subprime mortgage market and the broader economic slowdown.

“Securitization has severely dissolved the discipline of the lender-borrower relationship,” Frank said, arguing that people have put too much faith in mathematical models. “Diversifying bad debt just spreads the poison.

Although Frank laid blame on securitization, which allows all kinds of debt to be chopped up, repackaged and resold as new securities, he acknowledged that it has been a useful tool. However, he said new regulation is needed to diminish its abuses. The fact that mortgages were sold by people who did not need to be repaid is a regulatory problem, he said.

“This is the third wave of regulation needed to catch up with innovation,” Frank said, noting the creation of the Securities and Exchange Commission and the Glass-Steagall Act as previous key moments.

Frank argued that the sentiment of de-regulation from just a year ago, which contended that markets are smart and governments are not, was over. Now, he explained, added regulation is necessary to create the trust required for the market to work. “The right kind of regulation is pro-market,” Frank said. “You’ve got people not buying things.”

A new regulator, Frank suggested, would have the power to assess risk, inspect institutions and report to Congress on the health of the financial sector. The Federal Reserve could potentially take on some of these responsibilities, and anyone that creates credit would be subject to the same supervision that now only applies to banks.

“It’s not form, but function,” Frank told CFO.com, explaining that when the Glass-Steagall Act, which created a distinction between commercial and investment banks, was repealed in 1999, some new protections should have been added. “Now we have competition between commercial banks and investment banks, but with different regulations.”

Frank was reluctant to condemn either party for the credit crisis, acknowledging that even he “was somewhat daunted” by it. Instead he pointed to several culprits, including rating agencies, bond insurers, and executive pay. He scolded the belated downgrades by rating agencies as “shooting the wounded”; he bemoaned a system where bond insurers have lower credit ratings than the municipalities that they insure; and he criticized managers who are rewarded when risks pay off and break even when they do not.

“It’s a perverse incentive,” Frank said. “Those making initial decisions should have a greater stake in failure.”

Invoking the Heisenberg uncertainty principle, a concept from quantum physics that shows how the act of measuring something can change its position, Frank also contended that strict “mark to market” valuations were pushing the market down. “A rigid interpretation could be dangerous,” he said.

Meanwhile, Frank suggested that top priorities include assisting the municipal bond market, keeping the flow of student loans going and reducing foreclosures. He suggested that companies be forthright with their write-downs and that the Securities and Exchange Commission must move forward with mutual recognition of international accounting and auditing systems.

Frank will be holding hearings next month on his proposal to create a $10 billion loan package to slow home foreclosures and his plan to allow the Federal Housing Administration to insure and guarantee refinanced mortgages for those who have suffered significant losses. New legislation is unlikely until next year, he said.

The Securities Industry and Financial Markets Association (SIFMA) was supportive Frank’s proposal of new greater oversight. “We welcome Chairman Frank’s call for a comprehensive review of the regulatory framework for financial markets,” said Scott DeFife, senior managing director at SIFMA. “Recent events have made it critically clear that we must focus on both the evolution and innovation in the financial markets to help reduce the current turmoil.”

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