(The article featured below is a selection from Federal Securities Law Reporter, which is available to subscribers of that publication.)

D.C. Bar Hosts Subprime Summit

SEC Commissioner Paul Atkins, in a keynote address to the D.C. Bar, discussed the SEC's role in alleviating the situation brought about by the recent rash of defaults on subprime mortgages, which affect not only the housing market, but also other aspects of the U.S. economy, including investors who purchased mortgage-backed securities. Enforcement officials also participated in a panel discussion about the subprime crisis.

Commissioner Atkins outlined what he called "interrelated reasons" for the crisis, including the relaxing of underwriting standards and the "risky" strategy of expecting property values to rise. He said that the subprime crisis resulted in a spillover to the rest of the market because of the securitization of mortgages. He noted that since the 1990s, more than half of the mortgages in the United States are securitized. Although this trend has several positive aspects, such as the expansion of liquidity and home ownership for people who otherwise could not obtain a mortgage, the negatives ultimately had serious effects on the economy, he said.

The commissioner said that when housing prices did not rise as expected, there was widespread delinquency, the effects of which were felt throughout the market. A drop in liquidity affected the valuation of financial instruments, which in turn resulted in even tighter liquidity. Investors became more risk-averse and turned to less risky but lower-yield instruments like U.S. Treasury securities.

Mr. Atkins also called the collapse of Bear Stearns a "tragedy" that led to a "crisis of confidence." He said that regulators, market participants, politicians, academics and lawyers are all working to understand the causes of the crisis. He drew attention to the President's Working Group on Financial Markets, which has made recommendations to increase transparency, risk awareness and management, and oversight. He said that the need for reform was apparent and that the initial shock of the crisis uncovered and exacerbated underlying weaknesses.

Although Commissioner Atkins said that regulators have a role to play in fixing the current situation, he warned against too much government intervention in the market. The market, not the government, is better at pricing risk, he said. In his opinion, the government should ensure adequate transparency and disclosure, but not assess the quality of financial instruments themselves.

He also addressed the role of credit rating agencies, or Nationally Recognized Statistical Rating Organizations, in the subprime crisis. He said that the SEC staff is currently examining NRSROs and would recommend to the Commission reforms based on its findings. He noted that conflicts of interest are inherent in the ratings process because issuers of securities are paying the agencies for a rating. He warned against rushing to judgment with the benefit of hindsight. He said that in some cases, NRSROs were wrong in assigning a particular rating, but in the end it is an opinion protected by the First Amendment. The SEC should have a role in identifying conflicts of interest and requiring transparency, but he said that anything resembling an "official imprimatur" by the government that ratings are accurate would create a "moral hazard." In the end, the government is no substitute for understanding risk and diversifying, he said.

A panel of enforcement officials from the federal government and the Financial Industry Regulatory Authority, also weighed in on the subprime crisis. Cheryl Scarboro, an associate director in the SEC's Division of Enforcement, said that while currently there are no public cases on point, the division is conducting nearly four dozen investigations connected to subprime failures. She outlined several categories into which the cases tend to fall. Many lenders are private companies, but some lenders are public companies and are subject to the SEC's jurisdiction, she said. A second category involves several aspects of the securitization process. Ms. Scarboro described many players in this category, including banks, due diligence firms, credit rating agencies and insurers. The SEC is also looking at issues involving fraud in connection with securitization of mortgages, disclosure in the marketing of complex instruments and accounting problems, she said.

Another category she described is the retail market. She said that the enforcement staff has encountered issues including fraud, material misstatements and suitability of investments. In the last area, she gave the example of brokers encouraging investors to take out equity in their homes in order to buy high-risk instruments. She also described novel instances of insider trading and market manipulation, such as the recent case of a defendant who spread false rumors about a company and then established a short position to his advantage.

John Arterberry, with the Department of Justice, offered the view of the criminal side of enforcement of subprime cases. He said that by the time a case goes through self-regulatory organizations and regulatory agencies such as the SEC, it reaches a very serious stage once it gets to the Department of Justice. Criminal cases tend not to involve mistakes or business judgment, but rather fraud or abuse, he noted. Areas the Department of Justice examines with regard to subprime cases include the failure to disclose and material misstatements. In these cases, sellers of certain instruments might neglect to inform investors about the deterioration of loans behind the instruments, or might lie outright about the quality of the loans that have been securitized.

Penny Rosenberg, the director of the Department of Enforcement at FINRA, described her organization's role in investigating and sanctioning abuses related to the subprime crisis. She said that FINRA typically has no jurisdiction over lenders, but plays an important role due to its jurisdiction over broker-dealers. Broker-dealers are crucial to obtaining investment-grade ratings, and have devised complex instruments using tranches where some tranches are given high ratings while riskier tranches are given lower ratings. She noted that ratings are typically arrived at through a collaborative effort between the underwriter and the rating agency.

Daniel Stipano, the deputy chief counsel of the Office of the Comptroller of the Currency, noted that, although his agency regulates banks, it currently does not have the statutory authority to change its rules to cope with the recent subprime situation. He discussed the use of OCC's guidance documents, such as those prohibiting predatory lending. He said that he felt the OCC's current authority over banks is sufficient and criticized those that would measure the agency's success by "the number of scalps hung on the wall." In his opinion, the OCC has a supervisory role to play, and when there is an enforcement action, supervision has failed. He noted that the OCC has been reaching out to state regulators in an effort to share customer complaint information and has established a working group to cooperate at the state level.