Remarks at the Women in Housing and Finance
Chief Executive Officer, FINRA
Thank you very much—it's great to be here. I'd also like to thank President Rebecca Laird, and also Leslie Woolley, Chair of the Luncheon Committee, for the gracious invitation to meet with you. There is so much going on in our markets that it's hard to know what to talk about.
In my nearly 30 years as a regulator, I have rarely seen a convergence of events that so clearly demonstrates the frailties of our regulatory system and so many proposals for how to fix it.
I know that Secretary Paulson spoke with you last week and talked extensively about current market conditions and the policy issues spawned by all the market turmoil, including those that the Treasury Blueprint seeks to address.
Importantly, he also focused on two markets where practices and financial infrastructure are really in very great need of strengthening—the tri-party repo system and over-the-counter derivatives—an area of our financial markets that has long been in need of greater standardization, transparency and risk reduction through a centralized clearinghouse or other mechanism.
The attention being paid by regulators to these transactions is well-deserved and long overdue.
You heard from Secretary Paulson, I understand, about the systemic risks that are threatening our markets, but I would actually like to talk about another set of risks that are growing daily in our markets.
And while their impact may not yet be systemic—yet—the impact on investors is very real and the economic stability of a generation is being called into question.
When I look at the unsteady nature of today's financial environment, I'm reminded of that very famous scene from Charlie Chaplin's The Gold Rush—which premiered in Hollywood on this very day in 1925.
In the movie, Chaplin's character has made his way to Alaska to strike it rich. After a fierce winter storm blows his cabin off its foundation, Chaplin and a fellow gold prospector wake up with their house teetering on the edge of a snow-covered cliff.
At first, they aren't sure why the house is rocking back and forth like a see-saw. But soon they realize their dire predicament—that if they make the wrong move, it's all over.
They both begin scrambling back and forth, from one side of the house to the other, struggling to find balance and safety, only to jump out seconds before the house tumbles off the mountain into the canyon below.
To put it bluntly, even though we're experiencing the aftermath not of a gold rush, but a housing and credit boom, too many investors today find themselves teetering between financial survival and financial destruction, looking for balance and safety, and solid ground to stand on.
While Chaplin got out of the cabin in time, and he and his friend struck it rich in the end, today's investors haven't been so lucky. Many can't afford to make the wrong move, and many are not financially agile enough to find stability and balance.
Rising costs of food and fuel, declines and volatility in the housing and financial markets, and an ever-tightening credit crunch have gathered to form the proverbial perfect storm that is leading some Americans to make very poor financial choices.
Not so long ago, those who faced a temporary financial setback, such as the loss of a job, a health emergency or an unexpected expense, could borrow or use credit to get by—and many still do. Recent data from the Federal Reserve show consumer use of credit cards and revolving lines of credit are at an all-time high.
But while some Americans use credit as a safety net to weather life's occasional storms, and we understand that necessity, others rely on it as a way to finance a lifestyle they otherwise could not afford. Debt has become a norm in the U.S.—and, according to the Center for Responsible Lending, households are finding it difficult to break that cycle.
Similarly, personal bankruptcy filings are rising—as is the age at which consumers declare bankruptcy. A recent study by AARP found that in 2007 more than 1 in 5 debtors were over the age of 55, compared with 1 in 10 back in 1991. The study also found that the rate of personal bankruptcy filings among those ages 45 to 54 had jumped by more than 48 percent from 1991 to 2007. For those ages 55 to 64, the rate rose by 150 percent—and for those ages 75 to 84, by 433 percent.
These are very disturbing numbers by any measure. But they represent the hard realities of today's financial environment for many Americans. And they represent the challenge for policy makers, legislators and regulators.
In tough financial times, many investors feel pinched for cash—and some may search for different, often risky ways to make ends meet, or to maintain a certain lifestyle. Troubling trends include investors leveraging or prematurely depleting their retirement savings, trading in their insurance policies in transactions known as "life settlements," and tapping their home equity through reverse mortgages.
We are concerned that some investors may be risking their most valuable assets in an effort to raise cash—including those in or near retirement, who may not have time to recover their losses.
And unfortunately, some unscrupulous financial professionals—many of them unregistered—feed into this investor anxiety, pushing strategies and products that promise to provide balance and safety, but that often end up haunting an investor for a lifetime.
Using a 401(k) as an ATM machine is a great example. Fidelity Investments reported a 17 percent increase in 401(k) hardship withdrawals last year, and T. Rowe Price reported a 10 percent increase.
The number of 401(k) loans is also on the rise. In 2006, 11 percent of investors took loans from their plan. In 2007, the number of loans jumped to 18 percent.
These numbers serve as a warning sign, demanding extra vigilance on the part of regulators. But from FINRA's perspective, protecting investors today is made more complicated because there are many products that may be suitable for some investors, but very unsuitable for others.
If it were simply a matter of banning certain products, our job would be very easy. But we know that even products like variable annuities, which create issues when sold to the wrong people, can have legitimate value for some investors.
At FINRA, we've taken a two-pronged approach to help protect investors in these unsteady times.
First, we use our surveillance and enforcement tools to detect and deter abusive sales practices, especially those aimed at seniors.
And second, we do everything we can to educate investors to help them make the best financial decisions for their unique situation. They need to know which direction to go and the right products to invest in, to keep their financial house from falling off the cliff.
FINRA is paying particularly close attention to several types of transactions that involve giving investors easy access to retirement savings, home equity and insurance policies—the very financial assets upon which we all build our long-term financial security.
The products I'd like to talk about may offer valuable access to cash at a time when an investor has no other source of liquidity—but these are complex, expensive products that may offer short-term relief in exchange for long-term pain. At a minimum, the trade-offs need to be understood.
Life settlements are a good example.
A life settlement involves selling an existing life insurance policy to a third party—a person or an entity other than the company that issued the policy—for more than the policy's cash surrender value, but significantly less than the death benefit. They're generally only available to policyholders over the age of 65.
Certainly, life settlements can be a valuable source of liquidity for people who would otherwise surrender their policies or allow them to lapse—or for people whose life insurance needs have changed.
But they are not for everyone.
Life settlements can have extremely high transaction costs, as well as some unintended consequences—including unexpected taxes, the inability to purchase a new insurance policy and the potential loss of eligibility for Medicaid or other state or federal benefits.
In addition, investors may not be aware that the purchaser of their life insurance policy will have access to a great deal of personal information about them, including their health status. After all, the buyer is acquiring a financial interest in their death.
Despite these drawbacks, the life settlement industry is growing dramatically, in large part because of the growing number of eligible individuals and the high commissions associated with these transactions.
One analysis predicts that the life settlement industry, which now stands at 12 to 15 billion dollars, will grow more than tenfold to 160 billion dollars by the year 2030.
FINRA's primary goal is to bring as much transparency to the life settlement industry as possible, so that investors who do decide to sell their policies are able to get a fair price—and fully understand the consequences of their decision.
We're also focusing examination and enforcement resources in this area.
Because life settlements can involve both variable and fixed insurance policies, and because variable insurance policies are securities, life settlements involving variable policies are securities transactions, and subject to FINRA's rules, including our suitability, markup and best execution requirements.
We've issued guidance to the life settlement industry and released an Investor Alert highlighting important issues individuals should consider before entering into a life settlement.
Another product we're concerned about is the reverse mortgage.
Reverse mortgages may benefit some senior investors by unlocking their home equity, but they should only be entered into carefully and with a complete understanding of the consequences.
As we well know, the sting of the recent sub-prime mortgage crisis extends not only to Wall Street, but to Main Street as well. An estimated 2 million homeowners could face foreclosure this year, up from about 1.5 million last year.
Borrowers who can no longer afford to pay their mortgages when the low teaser rates adjust to higher levels have limited choices: sell, refinance, seek a modification from the lender or face foreclosure.
With negative equity, refinancing may not be an option; and in an area with depressed housing values and a glut of homes on the market, selling may not be possible.
As a result, some homeowners who owe more on their mortgages than their house is worth are simply walking away, wreaking havoc on their credit profiles and their financial futures.
For homeowners over the age of 60 who want to stay in their homes—and have equity in them—but are having trouble making their mortgage payments, a reverse mortgage might seem appealing.
Like a home equity loan, a reverse mortgage allows a homeowner to convert home equity into cash that can be used for any purpose. Unlike other home loans, however, homeowners make no interest or principal payments during the life of loan. The interest is added to the principal, which is why reverse mortgages are often called "rising debt" loans.
Yet, as more Americans near retirement age, some financial institutions are aggressively marketing reverse mortgages as an easy, cost-free way for retirees to finance lifestyles—or to pay for risky investments.
Despite the fact that this product can jeopardize their financial futures, more and more people are buying them. Currently, the federal government insures about 350,000 reverse mortgage loans. Nearly one-third of these loans—about 107,000—occurred in 2007 alone. And two-thirds of these mortgages have been insured since 2005.
Because home equity is often a homeowner's most valuable asset—and the most precious source of retirement security—entering into a reverse mortgage is a very serious decision.
Not only can they be costly, but just as in the case of life settlements, there may be serious unintended consequences if the homeowner doesn't fully understand the terms of the transaction, including the possibility of becoming ineligible for Medicaid or other benefits.
Moreover, since reverse mortgages typically come due when the homeowner moves for any reason—including going into a nursing home—some homeowners may be surprised to find that they have very little left over to pay for long-term care just when they need it most.
The bottom line is that reverse mortgages are an expensive option that may prematurely deplete home equity that will likely be needed in the future.
In an effort to help prevent investors from being harmed, FINRA's enforcement and examinations departments are paying close attention to brokers who actually recommend that a homeowner use the proceeds from a reverse mortgage to invest in other financial products and potentially do further harm to their financial position.
In both of these cases—life settlements and reverse mortgages—investors need to take their time and ask themselves: Will these products put my financial house back on solid ground or will they just move the cabin closer to the edge of the cliff?
That same question needs to be asked about some other financial strategies. FINRA is very concerned that some financial advisers have started advocating the use of retirement accounts as a way to address their clients' current cash problems.
Two examples come to mind.
The first involves early retirement account withdrawals. The second is the relatively new phenomenon of 401(k) debit cards. Both are troublesome because they may make it easy—too easy—for investors to unlock retirement savings before they really need it.
Section 72(t) of the IRS code permits penalty-free early withdrawals from company-sponsored plans before the age of 59 ½. What we are seeing is that some financial advisers tout Section 72(t) as a "loophole" that allows investors to retire early by withdrawing assets through a series of substantially equal periodic payments and reinvesting in products that offer higher rates of return.
In some cases, the financial advisers may promise that the investments will generate returns high enough to allow the investor to maintain a standard of living that is equal to or even higher than they have while working.
However, the promised rate of return is often unrealistically high, and investors are often not told about the potential downside to these investments, including the potential for total depletion of their retirement savings.
Many times victims entrust a broker with the entire cash proceeds of their retirement accounts—forfeiting their right to receive a lifetime monthly benefit under their company's pension plan.
In recent cases involving Exxon and BellSouth employees, FINRA fined two firms $5.5 million and ordered them to pay $26 million in restitution related to this type of early retirement investment scheme.
Given the aging U.S. demographic, this is a problem that is likely to grow and we are watching firms very closely to make sure investors are treated properly.
Finally, I'd like to highlight a relatively new way investors are accessing funds from their retirement plans—the 401(k) debit card, which is like a debit and credit card rolled into one.
It acts like a debit card because it allows investors to access and spend their own money, rather than someone else's. But it also acts like a credit card because investors can repay their balances over time.
FINRA published an Investor Alert outlining the pros and cons of 401(k) debit cards last month—and we hope investors heed our warnings. The pitfalls of theses debit cards are many.
Investors use a 401(k) debit card to borrow directly from their 401(k) account. It is one of the most frightening financial innovations I have ever seen.
Consumers can use the funds for any purpose and usually don't have to explain why they need the money or how they intend to spend it. But as they spend it, the potential is very high that they may wipe out a good portion of their retirement savings in the process. There can be significant tax liabilities, lost opportunity costs and exposure to creditors if the investor ultimately has to declare bankruptcy.
If that weren't enough of a deterrent, the cards also charge interest and fees. Like traditional credit cards, the interest rate is usually tied to the prime rate, but the debit card also carries a charge based on the amount borrowed, which is paid to the card vendor.
In addition to these finance charges, there may be set-up fees, annual fees and cash advance fees—so individuals should think long and hard before they sign up.
The bottom line is that these cards are very easy to use, but carry a high price. Borrowing against retirement savings should be a last resort, done only in a true emergency—certainly not for a flat-screen TV with surround sound or to fund a lifestyle that's out of reach.
Well, they certainly didn't have surround sound back in Charlie Chaplin's day, yet they still found a way to get their message across to the audience.
Back then, they used title cards—the printed text that was spliced into a silent movie to explain a critical scene or convey important character dialogue.
One of the title cards at the beginning of The Gold Rush explains that many of the prospectors headed to Alaska were quote "ignorant of the hardships before them." In other words, they didn't realize what they were up against.
Times may have changed, but the exhausting search for financial stability remains just as demanding—and the dangers just as daunting. In 2008, too many investors don't realize what they're up against either.
Thank you all for listening. I'd be happy to take some questions.