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Mary J. Miller On OTC Derivatives And the Dodd-Frank Act

Secretary Mary J. Miller at the CFA Institute:  During my time at Treasury, I have come to greatly appreciate the importance of open lines of communication with investors, financial institutions, and other stakeholders.

As the Assistant Secretary for Financial Markets, I view one of my main roles at Treasury as meeting with investors to follow the markets, and bringing the knowledge and experience I gained during my time as an investor to my current responsibilities for managing federal debt issuance, helping to implement the Dodd-Frank Wall Street Reform and Consumer Protection Act, and generally advising the Secretary on financial market developments.

Three years since the financial crisis and just over a year after the passage of the Dodd-Frank Act, this is a good time to take stock of where we are and where we are going. We are focused on implementing the statute in accordance with its requirements. At the same time, we are mindful of the importance of preserving and strengthening the best attributes of the U.S. markets. These include innovation, liquidity, investor protection, efficiency, and transparency.

In the decades before the financial crisis in 2008, the U.S. was among the most desirable places in the world to invest. The reforms we put in place in response to the Great Depression gave investors’ confidence in our financial markets and institutions. Our financial system was not only the envy of the world but also attracted capital from all over the world. Over time, however, the evolution of our financial system gradually eroded the strengths of the Depression-era reforms in the run up to the financial crisis.

The Dodd-Frank Act and other reforms are designed to restore the proper balance between promoting the competitiveness and efficiency of U.S. markets and institutions while making the system safer and more resilient.

Striking the right balance will help our markets remain the strongest and most attractive in the world and remain capable of attracting capital from around the globe to help our economy grow steadily in the years to come.

Entrepreneurs, innovators, and small businesses must have the opportunity to access the financing that they need to grow and to create jobs for Americans. A key purpose of the financial system is to provide efficient and effective means of transferring capital from savers and investors to entrepreneurs and other businesses that drive economic growth.

In order to make sure that the financial system can serve that critical function in the economy, we are committed to getting the details of reform correct so that markets can function effectively with consistent, transparent rules of the road. And, we are committed to moving as quickly as practical to provide the certainty that markets need.

We will not sacrifice quality for speed, however. While we fully understand the importance and benefits of certainty for investors, we also believe that we need to put the best possible structure in place that will solve the problems we are trying to address without creating unintended side effects. I know that some people have expressed frustration about the pace of implementing financial regulatory reform and the uncertainty that creates. But the risks associated with financial instability and lack of confidence in markets and institutions far outweigh the costs associated with taking the time needed to put the right reforms in place to mitigate those risks.

We have taken a pragmatic approach to timing. Wherever possible we are providing clarity to the public and the markets. But the task we face cannot be achieved overnight. Regulators are writing rules in some of the most complex areas of finance, consolidating authority that was previously spread across multiple agencies, setting up new institutions, and harmonizing with countries around the world. While we want to move quickly, our first priority will always be to get it right.

The current level of coordination between independent regulators is unprecedented and will promote harmonized and simplified regulation, which will reduce costs for the market, promote certainty and support further recovery.

In particular, the Financial Stability Oversight Council (or Council), has a mandate to facilitate coordination across agencies. Already, we have worked through the Council to:

  • produce the Volcker report and coordinate the interagency rulemaking on the Volcker Rule;
  • coordinate a six-agency proposal on risk retention; issue a rule on the designation of financial market utilities for enhanced supervision and other requirements; and most recently
  • re-propose a rule and propose additional guidance on the process for designating nonbank financial companies for enhanced supervision.

Our commitment to sensible regulation is demonstrated by our approach to the $600 trillion derivatives market.

Increased transparency and exchange trading will tighten spreads, reduce costs, and increase understanding of risks for market participants. Margin and clearing requirements will not only provide protections for market participants but also prevent losses from spreading more broadly throughout the system and contributing to another crisis. In recent weeks, we have heard from numerous participants in the derivatives markets, including investors and dealers, that Dodd-Frank’s push towards the increased use of clearinghouses for OTC derivatives is already providing an important alternative to bilateral arrangements and helping to mitigate concerns about counterparty credit exposures.

Our work in this area also shows that regulations are not being written just for the sake of increased regulation. Treasury and financial regulators are carefully considering what is most appropriate for each market and not taking a one-size fits all approach. This approach is reflected by the Notice of Proposed Determination Treasury issued in May that would have the practical effect of exempting foreign exchange swaps and forwards from central clearing and exchange-trading requirements. Consistent with the statutory factors, the proposed determination reflects a considered judgment that the unique characteristics and existing oversight of the foreign exchange swaps and forwards market already reflect many of Dodd-Frank’s objectives for derivatives reform – including high levels of transparency and strong settlement practices.

We are also working hard to make sure that other countries put in place regulatory frameworks similar to our own on the key issues where international consistency is essential – such as OTC derivatives. Secretary Geithner has stated publicly and repeatedly his commitment to ensuring international harmonization. In addition to dialogue in international forums like the G-20 and the Financial Stability Board, Treasury and the financial regulatory agencies work every day with our foreign counterparts in Europe and Asia.

The Dodd-Frank Act puts us in a position to lead internationally on reform, set the standards for the rest of the world, and foster a race to the top while working with our counterparts in other countries to ensure international consistency. Substantially delaying reform here in the U.S. would reduce financial stability in our country and around the world. That’s a risk that we cannot take. I expect that most of you share the same experience that I had as an investor and as a fiduciary of clients’ investments – we did not look for the least regulated markets with the lowest transparency, the weakest investor protections, and the greatest risks. We looked for opportunities with expectations of reasonable returns, with appropriate disclosures, and legal and financial protections in place to protect the safety of the investments we made.

The costs of not taking action are too high. Because of the financial reforms we have already begun to put in place, we are in a much better position today than we were in 2008. Our financial institutions have higher levels and quality of capital. Capital has increased at our largest banks by more than $300 billion since 2008. Our financial institutions are also less leveraged and less reliant on short-term funding. My hope and expectation is that investors’ confidence in the strength of the U.S. markets and in some of these reforms that we have already put in place will give us a comparative advantage and allow us to weather this current storm with far less negative consequences than three years ago. Indeed, the relative performance of the U.S. markets this year suggests we are on the right path.

In the absence of the protections that the Dodd-Frank Act puts in place, our system descended into a crisis that has left deep scars on our nation. Unemployment remains unacceptably high, and weakness in the housing market is a continuing headwind to economic recovery. The large drop in home prices erased trillions of dollars of American families’ wealth and continues to cause hardship for millions of families in this country. Additionally, as fixed-income investors, you are well aware that the financial crisis inflicted an additional toll on our nation’s fiscal situation by forcing the federal government to borrow significant amounts of money to stabilize both financial markets and the economy.

A consequence of the financial crisis was the necessary increase in Treasury debt issuance to finance the rescue measures, such as the Troubled Asset Recovery Program (TARP), and to provide economic stimulus to fight the ensuing recession. Our deficits grew from 1.2 percent of GDP in 2007 to10.2 percent in 2009. While borrowing peaked two years ago, and deficits to GDP measures are coming down, our debt continues to grow while economic growth remains modest. The long term trend is unsustainable. This very public fact led to considerable drama over the summer, and ended with a hard won increase in the debt limit.

As a country we need to make some tough decisions. The Congressional “Super Committee”, a bi-partisan group of House and Senate members was given that assignment this Fall. The balancing act that they must achieve is to secure growth in the short term, while finding spending and revenue measures to secure savings in the long term. To improve our debt-to-GDP ratio, we cannot lose sight of the importance of growing GDP.
Since the mid-2009 the Treasury has focused on extending the average maturity of our debt portfolio from about four years to now over five years, no small feat with total marketable debt outstanding of close to $10 trillion. We have also increased our commitment to issuing Inflation Protected Bonds, based on strong investor interest.

All of this has been accomplished in a very low interest rate environment and with strong participation from both domestic and international investors. Even as our debt has grown, interest expense as a percent of GDP has fallen from 1.7 percent to 1.4 percent over the past three years. But we can’t take this favorable environment for granted.

We know that interest rates will eventually rise and that our investors want to know that we have a long-term fiscal plan for bringing deficits down and arresting the growth of debt to GDP.
Another area where the Treasury is deeply invested in policy making is fixing our country’s housing market and the future of housing finance. The housing bubble that burst in 2007-08 left a terrible legacy of mortgage failures for both homeowners and financial institutions. As a result the government currently guarantees over 90% of new loans originated, mainly through the Government Sponsored Enterprises (Fannie Mae and Freddie Mac) and the FHA, a situation that is neither desirable nor sustainable.

In February the Treasury published a white paper which lays out both the principals for reform and three options to consider. Basically we believe that we need to return to private market financing of most mortgage loans, and dramatically lessen the reliance on government support. At the same time we need to make sure that we can provide housing assistance to the most needy with the goal of having a population that is well housed, whether through home ownership or good rental options.

None of these reforms to housing finance can really begin without addressing the legacy problems in the market first. These include high inventories of unsold homes, high loan delinquency and foreclosure rates, and the more than 20% of all mortgage holders who are underwater on their loans, meaning that the appraised value of their house today is less than their mortgage.
We think there is an opportunity to address the backlog of unsold homes by creating a process for moving real estate owned by the government to new private owners, with a particular interest in creating rental options, as we see more demand right now for home rentals than home sales. In August the Federal Housing Finance Agency (FHFA) put out a request for information to solicit the best ideas on how to accomplish this. Within their 30 day comment period they received 4,000 comments. Clearly there is interest here and we look forward to supporting the FHFA as they move ahead.

We also think there is an opportunity to help homeowners who are underwater on their mortgages and therefore unable to refinance into a lower interest rate mortgage. The current level of mortgage interest rates – at or below 4 percent for a 30-year loan – makes this especially timely and important. An existing government program that was introduced in 2009, the Home Affordable Refinance Program (HARP) has seen relatively low take-up due to many obstacles in the refinancing process. The Administration is interested in reviewing all of the barriers to refinancing GSE mortgages to help these homeowners realize savings. While I know that this initiative has generated questions from investors in mortgage-backed securities, we have been clear that the terms of the HARP program have been known to the market since program inception, and should not introduce new issues. The investors in these securities have enjoyed a much longer holding period than historical prepayment levels would have allowed.

The housing crisis has been long and painful and there’s still more work to be done. We think that these two initiatives would help in key areas and allow us to accelerate a recovery in the housing market. With that on track we can move forward with building a stronger housing finance system for the future.

* * * * *
As I previously mentioned, one of the easiest ways for us to work together and one of the most important parts of my job is simply hearing from people like you. Our door is always open, and our work is significantly improved as a result of the constructive input we receive through the formal rulemaking process, through events like these, and from simply listening to the markets and the public.
This audience is filled with gifted and talented people with a close watch on the financial markets. There are a number of ways that you can be helpful at this time as we rebuild the market infrastructure for the 21st century.

First of all, weigh in. Stakeholders have engaged extensively in the financial reform process so far, and that engagement has significantly improved every study and rule that has been issued. To provide just a couple of examples, we received over 8,000 comments in response to the request that we put out before publishing a study on the Volcker Rule earlier this year. I expect that the proposed regulations that the agencies approved earlier this week will receive substantial additional comments. We welcome that input, view it as an integral part of the process, and firmly believe that the final rule will be improved as a result of the additional information, perspectives, and insights we will receive.

Rulemaking agencies have also re-proprosed or re-opened certain rules for comment where the process would benefit from additional public engagement. The risk-retention rule for the asset backed securities market, a rule that is being coordinated by the Treasury Department, is a good example where the six rulemaking agencies decided to extend the comment period to allow additional time for thoughtful input.

In addition to the rulemaking process, however, there is another important way in which we can work together to improve the financial system. You don’t have to wait for the government to act to implement reforms that could reduce risks, improve returns, and strengthen financial institutions. There are many areas where the private sector could make valuable contributions.

A great example of an opportunity for groups like this one would be to develop ideas for alternatives to the use of credit ratings in investment guidelines. As part of the Dodd-Frank Act, federal regulations can no longer refer to or require reliance on the use of credit ratings. The challenge to the private sector is to come up with something to use in their place, not just where federal regulations formerly required them, but for the purposes of your own investment analysis, decisions, and criteria. You are uniquely positioned to provide the best ideas on this topic.

Another area that we are very focused on at the Treasury is improving small businesses’ ability to access capital, in both the equity and fixed-income markets. The President mentioned this in his recent jobs speech, and has proposed exploring ways to address the costs that small and new firms face in complying with disclosure and auditing requirements. While we will continue to aggressively move forward to explore these and other ideas to make it easier for entrepreneurs to raise capital and create jobs, we welcome your input and ideas as well. For example, what could the investment community do to expand research coverage of small companies?

Finally, in the area of debt management, earlier this year we asked our private sector advisors group, the Treasury Borrowing Advisory Committee, to study new instruments we might consider. These include ideas such as floating rate debt and longer-term maturities or even callable debt. Our interest is in developing durable instruments with market demand that help us meet our debt management objectives. We are continuing to work on these ideas and welcome your insights as well in this area.

* * * * *
I’ve covered a lot of ground here today and in abbreviated form. The message that I would like to leave you with is that we will continue to deliver measures to restore integrity and trust in our financial system to ensure that it can, once again, serve as an engine for economic growth and job creation. A pro-growth, pro-investment financial system allows us to help transform ideas into industries, to finance great companies, unleash the next revolution in technology, make key advancements in science, and create jobs and economic prosperity. This can only be accomplished with a stable financial system that encourages investment and does not expose the country to a cycle of collapses and crisis.
We recognize that there is still a lot left to accomplish, and we look forward to working with you over the coming months to implement financial market reforms in a careful, effective manner. I am confident that, over time, there will be much more clarity about the final rules of the road. We will continue to pursue our work to strengthen the financial system to ensure that businesses and investors have the confidence that they need to put their capital to work.

As the founder of my former firm, Thomas Rowe Price, was famous for saying, “Change is the investor’s only certainty.” I have learned during the last two years I have spent in Washington that the same can be said for policymakers as well. Despite our different vantage points, I want to conclude by emphasizing that I think we share a common goal in building strong and competitive markets, creating jobs, and supporting a healthy economy. By continuing to put the right reforms in place, I believe that our financial system will be better positioned to respond well to whatever changes may come.
Thank you very much.

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