FOMC20080130meeting--3 1,MR. POOLE.," Thanks, Mr. Chairman. I came here 10 years ago with a boom. I'm going out with a pause. [Laughter] " fcic_final_report_full--96 The Boom and Bust  6 FOMC20060510meeting--100 98,MR. POOLE.," Okay. Anyway, he said that their construction costs—for a store, I guess—have come in 27 percent above expectations. Their construction costs are even higher in the Gulf Coast area. He also said that Wal-Mart is in the process of raising starting wages in about 700 stores. This is the first time in eight years of talking with him that I’ve heard any comment like that. He said that some of the raises are part of the Wal-Mart, I’ll call it “social/political,” agenda because of all the controversy about Wal-Mart. But he said about 125 of these were market driven, that they have plenty of labor in rural areas and in urban areas, but they are developing a labor supply problem for their stores in suburban areas. Suburban areas are strong. I have received some unsolicited e-mail messages—well, I guess to be fair they’re sort of solicited. [Laughter] These are from two directors: “Heavy construction industry is really hot. In the past month, I have received reports of a second round of capital cost increases of 25 to 40 percent in the refining industry, and the same for construction of large power plants. These estimates follow similar increases last summer.” Another message discussed pressures on the cost of construction materials. I won’t read the whole thing. It says, “We believe we are now on the front side of a real surge in prices that will mainly affect highly volatile commodity building products—steel, copper, aluminum, and zinc. However, if it is sustained, it will ripple across a broad range of more-manufactured products.” Now, very briefly, I’ve made a list of what I think are classic inflation warning signs, and I’ll just rattle these off very quickly. Inflation expectations—we’ve talked about that. Dollar depreciation. Commodity prices are really breaking out of a trading range that has prevailed for about fifteen years— if you look at the chart in the Greenbook Part 2, you’ll see that. The surge in construction costs—I think there is a building boom indicating business confidence, and, of course, a direct source of aggregate demand. Relatively low risk spreads, making it easy for firms to raise capital. Strong stock market. Strong corporate profits. From our anecdotal information, some increase in pricing power. And a worldwide boom. There is growth in almost every region of the world, and, of course, that translates to some extent into price pressures everywhere, including goods that we import and goods that we export, at least eventually. I’ll stop there. Thank you." CHRG-111shrg57319--595 Mr. Killinger," I believe we were talking about back in the housing boom period? Senator Levin. Yes. And you were talking about your high-risk products? " CHRG-111hhrg54868--85 Mr. Scott," I know my time is running out. It is about to run out, too. But I did want to get to, why are so many banks closing, especially in the State of Georgia? What is there? Is there something we can point to that is going on in Georgia to explain why so many of these banks are closing? Ms. Bair. There are a lot of banks in Georgia. It was a boom area. Now, many of the boom areas are bust areas. There is residential mortgage distress and a lot of commercial real estate distress as well. In Georgia, like other parts of the country, it is broader economic problems that are feeding losses on bank balance sheets, which is driving closures as well. One of the best things you can do for the banking system, especially community banks, is to get the economy going again quickly, keep the unemployment rate down, get those retailers back in business, and get those hotels full again. Those are the kinds of things that will help banks as well. In Georgia, bank closures were a symptom of a lot of banks existing in the State, plus it was a great boom area. And as in other areas, like Florida, southern California, and Nevada, Georgia is having a severe bust now. " FOMC20050809meeting--109 107,MR. WILCOX., I can point to two main factors. One is simply the aging of the population. The baby boom cohorts are moving into an age of lower participation rates. CHRG-111shrg57319--452 Mr. Killinger," Yes, that is right. I just wanted to be sure that we understood the primary cause was that the refinancing boom from 2002 and 2003 subsided in the other period. Senator Levin. Now, you also changed your strategy. What year was that? " CHRG-109hhrg22160--215 Mr. Greenspan," I did not use it yesterday in the Senate. I consider the problem a very serious one, one that has to be addressed, in my judgment, quite soon, and certainly to be in place well before the 2008 leading edge of the baby boom generation retiring. " FOMC20060131meeting--54 52,CHAIRMAN GREENSPAN.," In other words, whether that bill passes or not, the pressures to fund these liabilities are going to increase, especially after the baby-boom generation starts to retire and fund managers look at the size of it." CHRG-111hhrg55809--40 Mr. Bernanke," There are tough questions there. I guess I would--it is not just a question of specialization. Unfortunately, financial crises, booms and busts are a long-standing problem of capitalism; and they have, I think, a special role in the broader-- " FOMC20080130meeting--148 146,MR. PLOSSER.," So are these ""extra channels""-- if you want to call them that--typically part of the forecast change and how you evaluate? That is to say, in the fall, when the stock market booms 10 percent, are we going to get another kicker upward in r* due to these same factors? " CHRG-111hhrg55809--58 Mr. Royce," Let me ask you another question. Some economists are arguing that the Fed not only lost control, but its policy actions have unintentionally become procyclical--encouraging financial excesses instead of countering the extremes. And this gets to the point that has been argued by many economists. In fact, Friedrich Hayek won the Nobel Prize in 1974 for arguing that artificially low interest rates lead to the misallocation of capital and the bubbles which then lead to bursts. Looking back, do you agree that the negative real interest rate set by central banks from 2002 to 2006 had a dramatic impact on the boom and the subsequent bust, especially when you take into consideration what was already an inflating housing bubble with the drastic steps taken by the Federal Government to encourage less creditworthy borrowers to get into loans they could not afford? Do you think those combinations could have had an impact on that boom-bust? " CHRG-109hhrg28024--240 Mr. Pearce," Looking 10 years into the future, when we're in the depth of the baby boom retirement and the number of skilled workers available, and again setting aside skilled versus unskilled on immigration, do you see enough reason that we'd need workers to come into the country, or do you think we can solve our internal problems with the people who are available in the next generations? " CHRG-111hhrg55814--158 Secretary Geithner," Congressman, there is one part of that quote you omitted, which is, I said, monetary policy around the world was too loose, too long. But I think it's very, you're right to say that this crisis was not just about the judgment of individuals to borrow too much or banks to lend too much. It wasn't just about failures in regulation supervision. It was partly because you had a set of policies pursued around the world that created a large credit boom, asset price boom. And I think you're right to emphasis that getting those judgments better in the future is an important part of the solution. Dr. Paul. Okay. On the issue that it's worldwide and we don't have the full responsibility, there's a big issue when you are running and managing the reserve currency in the world and other countries are willing to take those dollars and use those as their asset and expand and monetize their own debt, so it's all, we're not locked in a narrow economy, it's a worldwide economy and it's our dollar policy and our spending habits and our debt that really generated this worldwide crisis. That's why it's not a national crisis; it's a worldwide crisis. " CHRG-109hhrg31539--55 Mr. Bernanke," Our concern, Congresswoman, is to achieve a sustainable growth path. We don't want to get into a situation where we get into a boom and bust. We don't want to get into inflation, because inflation also detracts from the buying power of workers and the consumers. So we are looking to try and achieve a sustainable growth path. We are aware of the risks to that, and we are going to do our utmost to achieve that. " CHRG-109hhrg28024--90 Chairman Oxley," The gentleman yields back. The gentlelady from Indiana, Ms. Carson. Ms. Carson. Thank you very much, Mr. Chairman, and thank you, Mr. Chairman, for being here today. I have a quick question concerning the housing market. At one point it was just skyrocketing and booming, and now it seems to be on the decline. Could you anticipate what kind of effect, impact that's going to have on the domestic economic growth? " CHRG-111hhrg54867--161 Mr. Lucas," Because, after all, Secretary, in my region, we went through both an agricultural and energy property boom, bust, and bubble in the 1980's. We were slaughtered economically. We did not receive capital injections. Our industries were not propped up. It took us, 10, 15 years in some segments to recover from it. We do not wish that on anyone else, but by the same token, let us not make the matter worse because the feud back home is, it was the big boys that damn near killed us all, not the little players. " CHRG-111shrg54533--33 Secretary Geithner," Our plan does not address a range of other causes of this crisis, including policies pursued around the world that helped produce a long period of very low interest rates and a very, very substantial boom in asset prices, housing prices, not just in this country but in countries around the world. And I think you are right to underscore the basic fact that a lot of things contributed to this crisis. It was not just failures in supervision and regulation. And as part of what the world does, major countries around the world, in trying to reduce the risk we have a crisis like this in the future, it will require thinking better through how to avoid the risk that monetary macroeconomic policies contribute to future booms and asset prices and credit bubbles of this magnitude. Senator Bunning. Your plan puts a lot of faith in the Federal Reserve's ability to spot risk and exercise its power to prevent the next crisis. However, if the Fed and other regulators have been doing their jobs and paying attention to what the banks and other firms were doing earlier this decade, they almost certainly could have prevented the mess. And the Fed has proven it is unwilling to use its power it has. Let me give you an example. Just look how slow it addressed the credit card abuses, and it took 14 years for the Fed to write one regulation on mortgages after we gave them the power to do that. So giving them the power and making them act are two different things. What makes you think that the Fed will do better this time around? " CHRG-111shrg55739--116 Mr. Coffee," I think that what some of us are saying is that you could certainly have alternatives that did not involve the use of an NRSRO agency. But to the extent that there already is this reputational capital out there in the public's mind and they are going to want you to have an NRSRO rating, some of us want to make that real and not illusory by insisting on due diligence. And that due diligence, to answer your earlier question, would probably be paid for by the underwriters. If the underwriters could get this market jump-started again, they would be happy to pay the cost of due diligence. Senator Corker. Thank you all. I appreciate it. Senator Reed. Thank you, Senator Corker. Senator Bunning. Senator Bunning. Thank you. Five minutes turns into 10 in a big hurry up here, and that is the only reason--since some of us have another meeting to go to. This is for anyone who would like to answer it. During the housing boom--the boom--rating agencies rated mortgage-backed securities without verifying any of the information about the mortgages. If they had, maybe they would have detected some of the fraud and bad lending practices. Do you think rating agencies should be required to verify the information provided to them by the issuer? And I am going to give you a caveat. The first mortgage that I ever took, I had to take three of my Federal tax returns in with me to verify that I had the income that I wrote on my application. You do not have to do any of those things right now, and I am asking if you think we ought to have a little more verification of what is on the list that the person who is looking for the mortgage at the time--and that is how we got into all this mischief with mortgage-backed securities being sold into the market without any verification, even though they were AAA rated. " CHRG-111hhrg51698--50 Mr. Gooch," Yes. I think that there is a danger in doing something drastic with a marketplace that exists now that is very liquid, and has actually functioned very well throughout the credit crisis. I would just like to point out that the taxpayer, in any case, in the United States of America, 50 percent of the country doesn't even pay taxes under Obama's tax plans; and so they are not picking up the tab. During the boom, when things were going very well and profits were being made, the government was taking a 35 percent corporate tax, the government was taking 38 percent, 35 percent taxes on incomes, and 15 percent capital gains. So, during the boom times, the government was taking more than 50 percent of the upside. And when you go through a cycle, which this one happens to be extremely severe, the government needs to then become involved in stepping in and paying their fair share in stabilizing the marketplace. But to step in now and kill the credit derivative market at this point in time where we are very delicately trying to get banks to lend, and they won't lend until they get these bad assets off their balance sheets. All this money that is sitting on the sidelines is willing to sell credit derivatives, which reduces cost of borrowing; and they won't be willing to sell them if they can't buy them naked. You will kill the credit derivative market and, in my opinion, extend the recession, possibly even creating a deeper recession for a very, very long period of time. " CHRG-109hhrg28024--247 Mr. Bernanke," The share of GDP that took the form of revenues in 2000 was about 21 percent, which was the post-war high, and certainly in retrospect, we can say that a good bit of that was due to the unsustainably high level of the stock market, in particular, capital gains, bonuses, and stock options, and the fact that firms did not have to contribute so much to their pension plans because their valuations were rising with the stock market and, therefore, they reported higher profits. So a significant portion of the tax collection clearly was related to the stock market boom of that period. " FOMC20070321meeting--58 56,MR. POOLE.," Dave, I have a question related to housing. I gather that a good part of the projection that the drag from housing will work off by the end of this year comes from the belief that sales will gradually clean out the inventory of unsold homes and, once that happens, construction can return to the rate of sales. That’s the unsold inventory of recently built new homes that I guess have never been occupied. If you take the housing boom over, say, the three years ending in the middle of last year, was there an accumulation of houses that ran beyond the underlying demographics and income—and the financing costs, too? I’m interested in those longer-run determinants of the equilibrium stock of housing. Did we end up with a stock of housing that outran the underlying long-run determinants and has to be worked off—in the sense that the underlying determinants have to catch up to the stock that has already been constructed?" FOMC20080625meeting--82 80,MR. BULLARD.," Thank you, Mr. Chairman. The District economy continues to be sluggish. Severe weather, combined with a very wet spring, is hampering agriculture in some areas. Major flooding has caused significant damage already, and the situation continues to develop. Many business contacts in the District emphasize energy costs along with some other high commodity prices as an overriding concern. Most of the descriptions I have encountered concern businesses and consumers scrambling to adjust to new pricing realities. Many contacts are reporting skittishness over the inflation outlook, fueled by dramatic increases in key commodity prices. Many contacts with deep experience in the commodities markets remain convinced that market manipulation or speculation is behind the run-up in commodity prices across the board over the past several years. This belief is widespread and deeply held. Many predict a crash in market prices of these commodities once the bubble bursts. My assessment is that this very strong belief may, by itself, have important macroeconomic implications. Businesses and households may be reacting very differently to price increases that they see as temporary, as opposed to their reaction if they view price increases as permanent and unlikely to reverse. Reports on the level of economic activity are decidedly mixed. The housing sector remains in a deep slump and subject to a widespread shakeup. Business in the energy sector continues to boom. High energy prices are affecting the logistics business, which has to try to be profitable at higher prices with reduced demand. Still, a very large retailer reports brisk activity, and a large technology firm is essentially unaffected by the macroeconomic slowdown. Recent data on the U.S. economy have been stronger than forecast, keeping economic performance weak but avoiding a particularly sharp contraction. The worst outcomes stemming from financial market turmoil have failed to materialize thus far. There is, to be sure, still some potential for additional upheaval, depending in part on the managerial agility among key financial firms. However, the U.S. economy is now much better positioned to handle financial market turmoil than it was six months ago. This is due to the lending facilities now in place and to the environment of low interest rates that has been created. Renewed financial market turmoil, should it occur during the summer or fall, would not now be as worrisome from a systemic risk perspective. In addition to this lessened risk from financial markets, I see the drag from housing dissipating during the second half of the year. Most likely we will also see a moderation in energy price increases. Output growth is, therefore, likely to be moderately stronger going forward. Policy was very aggressive during January and March of this year. This was, in part, a preemptive action, insurance against a particularly severe downturn brought on by financial contagion. This was a very real possibility, but it did not materialize. This has created a situation with more stimulus in train than would have been intended had we known the outcome in advance. This is putting upward pressure on inflation and inflation expectations in the second half of this year. Policy has to turn now to face this situation. On the long-term projections, I think it is a good idea to put down long-term projections. I am happy with any of the options. I have a slight preference for option 3. I think a trial run would be good. If the objective is to name these numbers, such as an inflation target or the potential growth of the economy, another way to do it would just be to name those numbers and not have it tied to any projection or any particular year. We could just say, ""This is what I think the inflation objectives should be. This is how fast I think the economy could grow in the absence of shocks. And this is what I think the unemployment rate would be if output were growing at potential and inflation were at target."" You could just name those numbers. You wouldn't have to say five years away or ten years away, which kind of brings in new long-run factors that you might not want to get into. Thank you. " CHRG-111hhrg55809--59 Mr. Bernanke," We are actually looking very carefully at this question because it is very important for policy going forward, and I think we need to keep an open mind. Having said that, I think that the very strong way you stated it is probably an overstatement. I think there are a lot of reasons to think that there were other factors involved in the housing boom and bust besides monetary policy. And I would say secondly that a strong, well-regulated financial system should not have been crashed by an increase and decrease in house prices. I think the failures of regulation, supervision and oversight allowed this to become as big a deal as it was. So I think that is a very high priority right now. " CHRG-111hhrg53245--133 Mr. Watt," Thank you, Mr. Chairman. Ms. Rivlin, I confess I am having a little trouble understanding what you would do. You talk about a ``macro system stabilizer'' and then you talk about a ``systemically important'' or somebody who is over--I thought that what you were proposing was akin to what the Obama Administration has proposed, that the Fed be put in charge of the kinds of things that you indicate a ``macro system stabilizer'' would do, but you seem to have some concerns about that. Can you clarify what it is you are proposing? Ms. Rivlin. Yes. I am proposing the exact opposite of what the Obama Administration is proposing. We both recognize that there are two kinds of tasks here. One is spotting problems in the system that might lead to excessive boom or a crash. " CHRG-111shrg57319--481 Mr. Killinger," Again, that product or that feature has been around for many years. I think what we are all dealing with is the housing crisis, or the housing boom grew and as competition grew, the use of limited documentation and no documentation kind of loans certainly expanded. And as we were commenting earlier, as we became more concerned that the housing market had increased in risk, I think that is one of the elements we all started to take a look at. So in our case, we started to cut back on our originations. We eliminated some of the product offerings. We tightened underwriting. As I heard from David Schneider earlier this morning, at one point, we also decided that limited documentation loans were not appropriate. Senator Kaufman. And what size mortgages were stated income loans used for at WaMu? " CHRG-110shrg50369--69 Mr. Bernanke," Well, and from a fiscal perspective in the longer term--and by longer term, I means only a few years from now because we are coming very close to the point where the baby-boom generation is going to begin to retire in large number. By far, the biggest issue is entitlements, particularly the Medicare part, but Social Security as well. Senator Allard. Yes, I appreciate those comments. The other thing, you talk about, you know, inflation being pushed by energy and food costs. What is offsetting that? There must be some--to come out with an average of 2 percent, a little over 2 percent, there must be somewhere over here where we are getting a lesser amount that is offsetting those increases. Where do you see that happening? " FOMC20081216meeting--153 151,MR. AARONSON.," Housing and construction always go down, so we take that out, and then we say, okay, so now there are these atypical movements that are greater than we usually see. That is what we would consider the sectoral reallocation. That is what is left over. You can see, as I mentioned in the briefing, that actually during recessions there is a lot of sectoral reallocation, even once you take out the usual declines in employment that differ across industries. That is because each recession has different causes. Different industries have grown a lot during the boom--like finance recently or, say, communications during the late 1990s--and those sectors are going to shrink more than usual during the recessions and get back to more of an equilibrium state. That is what is going on here. " CHRG-110hhrg44901--202 Mr. Perlmutter," First, Mr. Chairman, just thank you for the time that you have given to us. Thank you for rolling up your sleeves, working with the Secretary of the Treasury, and working with our chairman to try to deal with a lot of tough problems you have out there. There is no minimizing what those problems are. Like I said, I found a wealth of information in your report, some of it pretty disturbing. I don't know if you have it in front of you, but on page 25 of the report, there are several graphs there, and I just ask you about on the commercial paper it looks like everything is going along hunky-dory, and then boom, there is an earthquake in the summer of 2007. That same thing applies in the graph below it. What happened in the summer of 2007 that just has caused this tremendous upheaval right now? " fcic_final_report_full--117 The origination and securitization of these mortgages also relied on short-term fi- nancing from the shadow banking system. Unlike banks and thrifts with access to de- posits, investment banks relied more on money market funds and other investors for cash; commercial paper and repo loans were the main sources. With house prices al- ready up  from  to , this flood of money and the securitization appara- tus helped boost home prices another  from the beginning of  until the peak in April —even as homeownership was falling. The biggest gains over this pe- riod were in the “sand states”: places like the Los Angeles suburbs (), Las Vegas (), and Orlando (). FOREIGN INVESTORS: “AN IRRESISTIBLE PROFIT OPPORTUNITY ” From June  through June , the Federal Reserve kept the federal funds rate low at  to stimulate the economy following the  recession. Over the next two years, as deflation fears waned, the Fed gradually raised rates to . in  quarter- point increases. In the view of some, the Fed simply kept rates too low too long. John Taylor, a Stanford economist and former under secretary of treasury for international affairs, blamed the crisis primarily on this action. If the Fed had followed its usual pattern, he told the FCIC, short-term interest rates would have been much higher, discourag- ing excessive investment in mortgages. “The boom in housing construction starts would have been much more mild, might not even call it a boom, and the bust as well would have been mild,” Taylor said.  Others were more blunt: “Greenspan bailed out the world’s largest equity bubble with the world’s largest real estate bubble,” wrote William A. Fleckenstein, the president of a Seattle-based money management firm.  Ben Bernanke and Alan Greenspan disagree. Both the current and former Fed chairman argue that deciding to purchase a home depends on long-term interest rates on mortgages, not the short-term rates controlled by the Fed, and that short- term and long-term rates had become de-linked. “Between  and , the fed funds rate and the mortgage rate moved in lock-step,” Greenspan said.  When the Fed started to raise rates in , officials expected mortgage rates to rise, too, slow- ing growth. Instead, mortgage rates continued to fall for another year. The construc- tion industry continued to build houses, peaking at an annualized rate of . million starts in January —more than a -year high. As Greenspan told Congress in , this was a “conundrum.”  One theory pointed to foreign money. Developing countries were booming and—vulnerable to financial problems in the past—encouraged strong saving. Investors in these coun- tries placed their savings in apparently safe and high-yield securities in the United States. Fed Chairman Bernanke called it a “global savings glut.”  CHRG-111hhrg56776--58 Mr. Bernanke," Congressman, interest rates are very low right now, and I do not think building too many houses is really a problem. Dr. Paul. That makes a very important point. In the boom part of the cycle, the low interest rates cause people to do things that might not be proper and best for the economy, and then when the bust comes, we resort to the same policy of keeping interest rates extremely low for too long. What are the chances--do you think there is any chance in a year or two or three from now we will look back and say well, not only were they too low for too long in the early part of the decade, they were too low for too long in the latter part of the decade? When the prices start to go up, it is sort of a little bit too late, and then you have the job of reigning that all in. " CHRG-111hhrg48873--268 Mr. Lucas," Thank you, Mr. Chairman. Let us continue to look at the process of cleaning up behind this parade. In Oklahoma, in the 1980's, we went through a twin agriculture and energy resource boom and bust. And it was fascinating after the FDIC got done stomping through the arena how 5 and 10 and 15 years later, amazingly there were some millionaires made of dealing and disposing of these assets. Could we talk for a moment about the public-private investment fund? And if you could, just let me give you a real world--from a perspective of the real world. For a typical investor who might participate in this kind of a thing, this effort to clean up the legacy assets, the toxic assets, for $100, it could be $100 million, it could be $100 billion, but for $100, how many dollars' worth of assets, Secretary, do you envision that controlling or being worth? " CHRG-111hhrg67816--79 Mr. Rush," The chair thanks the chairman. The chair recognizes himself for 5 minutes for the purposes of questioning our witness. Chairman Leibowitz, during the housing boom the FTC had clear jurisdiction over many of the worse predatory lenders with the most objectionable practices, but the Commission arguably didn't do much to address any of these activities. As a matter of fact, it was the states that successfully brought actions against lenders such as Countrywide and AmeriQuest when there are abusive lending practices in the sub-prime mortgage market. In the second panel Attorney Jim Tierney will talk about these and other issues a little more. But to begin with, I want to ask a simple question to you. What happened at the FTC? Why did the FTC not take aggressive action against mortgage lenders in the earlier part of this decade? " CHRG-110shrg46629--107 Chairman Bernanke," We, of course, had many areas of rapid innovation in the past and it is just one of the long-standing economic irregularities that the share of capital and labor tends to stabilize over time. We saw in the 1990s, for example, that capital went ahead of labor for a while during the productivity boom and then labor began to catch up again. So, I do think that we will see a more normal---- Senator Bayh. I do not want to use all my time on this question and I apologize for interrupting. We are not for redistributing wealth overtly. But to judge at least by the first part of your answer, if the economy is rewarding more highly skilled parts of the labor force better, then perhaps a focus on education, access to college, and those kind of things might empower the middle class to enjoy a larger share of the wealth. " CHRG-111hhrg48873--293 Mr. Bernanke," Congressman, I certainly do not reject capitalism. I don't think this was a failure of capitalism per se. And I also think the free market should be the primary mechanism for allocating capital. Markets have shown over many decades that they can allocate money to new enterprises, to new technologies, very effectively. And so we want to maintain that free capital market structure. It is nevertheless the case that we have seen over the decades and the centuries that financial systems can be prone to panics, runs, booms, and busts. And for better or worse, we have developed mechanisms like deposit insurance and lender of last resort to try to avert those things. Those protections, in turn, require some oversight to avoid the buildup of risk. Dr. Paul. May I interrupt, please? " FOMC20080130meeting--180 178,MR. HOENIG.," Thank you, Mr. Chairman. Let me talk a bit about the region. The Tenth District is generally moving forward at a fairly steady pace, but there are some mixed data. The obvious wide variances are in real estate. Housing is weak--not as weak as some parts of the country but still weak. Also, it is interesting that commercial real estate in each of our major cities right now continues to do well. I recently talked with several developers. They are all doing well but are very concerned, and they are beginning to cut back on their plans and move away from them. So you can see the worry carrying forward in terms of what actions they are taking. In the agricultural area and in the energy area, real estate is a different story. It is booming. Land values have gone up in the ag part--non-irrigated land, something like 20 percent over the past year. If you are near an ethanol plant, it has gone up 25 to 30 percent. It is also interesting that the ag credit system is helping to fund that. Their increase in lending was about 12 percent this past year. That is up from about 9 percent the year before, so they are providing that. They are also now involved in lending to these ethanol plants in a very significant way, helping to carry that boom forward. That gives me some pause in terms of what is going on in some of the rural areas. Related to that, the energy and lease values are also accelerating at a fairly high rate. I found it reminiscent and somewhat disturbing in talking to a couple of individuals when they noted that the land values have about doubled over the past two or three years in some areas, and they said that I should relax because on current ag prices they should have tripled. [Laughter] Where have I seen that before? On the other side, actually, manufacturing in our region has held steady. We have a lot of aircraft manufacturing, which is really strong, and some other smaller manufacturers providing support in both ag and energy, and they seem to be doing well. Technology is also doing well in the region, especially in the mountain areas--the Colorado and Denver areas. Engineering firms are still very strong--the strong demand for engineers and the unfilled positions continue. They are supplying that service across the globe and see continued demand there. So it is mixed, but overall probably our region is doing better than average relative to the rest of the nation. On the national level, my projections suggest that we are going to grow below our potential growth rate. I am not as pessimistic as the Greenbook. I also have inflation coming down, but that is on the assumption that we are able to reverse our monetary policy at a fairly quick pace as we move through this year and into 2009. I will leave it there. Thank you. " CHRG-110shrg46629--47 Chairman Bernanke," It is not our expertise to directly say that this deal is a good deal and that deal is a bad deal. What we try to do is make sure that the banks and the investment banks themselves have good controls, have good models, have good approaches, have good risk management so that they can make what we believe to be, in general, appropriate decisions about these instruments. Senator Reed. Let me shift gears again, Mr. Chairman, to try to cover a lot of ground. We have witnessed all a booming housing market until very recently. As your predecessor, Chairman Greenspan, opined in many homes their increasing equity valuation was an ATM that they could go to without leaving the house. Current estimates are that equity withdrawals are down precipitously, 70 percent from 2005. What is your view of the macroeconomic effect as people can no longer essentially use their equity as a quick source of cash? " FOMC20080130meeting--330 328,MS. YELLEN.," I wanted to support President Poole's comment. I remember very well back at Jackson Hole in 2005 that Raghuram Rajan presented a paper in which he emphasized the misalignment of incentives between investors and managers and the fact that almost everyone down the line right up to the investors themselves should have had incentives here. I don't know what they were thinking, but everybody was rewarded for the quantity and not the quality of originations. He warned us before any of this happened that this could come to no good, and I think he did have some suggestions about compensation practices. These were not popular suggestions. So I think this is worth some thought. I don't know what the answer is in terms of changing these practices. Maybe the market will attend to them, but it seems to me that we have had an awful lot of booms and busts in which this type of incentive played a role. Your presentation and the paper started from the fact that you note the deterioration in underwriting, but we should go one step backward. I suppose another issue here is what we saw in our supervision and whether we acted appropriately given what we saw. That raises a number of issues that I won't go into at the moment but that I think we need to be sensitive to. " CHRG-111hhrg49968--18 Mr. Bernanke," Mr. Ryan, I certainly am concerned about that. I think we face a double challenge. One is that we have to restore ourselves to a more balanced fiscal path after addressing the financial and economic crises that we currently are facing. But, in addition, that is complicated by the fact that with the retirement of the baby boom and the increase in medical costs that we are facing rising entitlement costs, which--this is no longer a long-term consideration. This is something that has got to happen in the next 5 or 10 years. So that is extraordinarily challenging. My rough rule of thumb to the Congress would be, given that we have seen this increase in the debt-to-GDP ratio, that we should hope to try to at least stabilize it at the higher level and over time to try to reduce it. But certainly we cannot allow ourselves to be in a situation where the debt continues to rise, that means more and more interest payments, which then swell the deficit, which leads to an unsustainable situation. So it is very, very important that we---- " fcic_final_report_full--173 As one recent study argues, many economists were “agnostics” on housing, un- willing to risk their reputations or spook markets by alleging a bubble without find- ing support in economic theory.  Fed Vice Chairman Donald Kohn was one. “Identification [of a bubble] is a tricky proposition because not all the fundamental factors driving asset prices are directly observable,” Kohn said in a  speech, cit- ing research by the European Central Bank. “For this reason, any judgment by a cen- tral bank that stocks or homes are overpriced is inherently highly uncertain.”  But not all economists hesitated to sound a louder alarm. “The situation is begin- ning to look like a credit-induced boom in housing that could very well result in a systemic bust if credit conditions or economic conditions should deteriorate,” Federal Deposit Insurance Corporation Chief Economist Richard Brown wrote in a March  report. “During the past five years, the average U.S. home has risen in value by , while homes in the fastest-growing markets have approximately doubled in value.” While this increase might have been explained by strong market fundamen- tals, “the dramatic broadening of the housing boom in  strongly suggests the in- fluence of systemic factors, including the low cost and wide availability of mortgage credit.”  A couple of months later, Fed economists in an internal memo acknowledged the possibility that housing prices were overvalued, but downplayed the potential im- pacts of a downturn. Even in the face of a large price decline, they argued, defaults would not be widespread, given the large equity that many borrowers still had in their homes. Structural changes in the mortgage market made a crisis less likely, and the financial system seemed well capitalized. “Even historically large declines in house prices would be small relative to the recent decline in household wealth owing to the stock market,” the economists concluded. “From a wealth-effects perspective, this seems unlikely to create substantial macroeconomic problems.”  fcic_final_report_full--170 ALL IN CONTENTS The bubble: “A credit-induced boom” ................................................................  Mortgage fraud: “Crime-facilitative environments” ..........................................  Disclosure and due diligence: “A quality control issue in the factory” ................  Regulators: “Markets will always self-correct” ...................................................  Leveraged loans and commercial real estate: “You’ve got to get up and dance” ...................................................................  Lehman: From “moving” to “storage” ................................................................  Fannie Mae and Freddie Mac: “Two stark choices” ...........................................  In , the Bakersfield, California, homebuilder Warren Peterson was paying as lit- tle as , for a ,-square-foot lot, about the size of three tennis courts. The next year the cost more than tripled to ,, as real estate boomed. Over the pre- vious quarter century, Peterson had built between  and  custom and semi-custom homes a year. For a while, he was building as many as . And then came the crash. “I have built exactly one new home since late ,” he told the FCIC five years later.  In , the average price was , for a new house in Bakersfield, at the southern end of California’s agricultural center, the San Joaquin Valley. That jumped to almost , by June .  “By , money seemed to be coming in very fast and from everywhere,” said Lloyd Plank, a Bakersfield real estate broker. “They would purchase a house in Bakersfield, keep it for a short period and resell it. Some- times they would flip the house while it was still in escrow, and would still make  to .”  Nationally, housing prices jumped  between  and their peak in ,  more than in any decade since at least .  It would be catastrophically downhill from there—yet the mortgage machine kept churning well into , apparently in- different to the fact that housing prices were starting to fall and lending standards to deteriorate. Newspaper stories highlighted the weakness in the housing market— even suggesting this was a bubble that could burst anytime. Checks were in place, but  they were failing. Loan purchasers and securitizers ignored their own due diligence on what they were buying. The Federal Reserve and the other regulators increasingly recognized the impending troubles in housing but thought their impact would be contained. Increased securitization, lower underwriting standards, and easier access to credit were common in other markets, too. For example, credit was flowing into commercial real estate and corporate loans. How to react to what increasingly ap- peared to be a credit bubble? Many enterprises, such as Lehman Brothers and Fannie Mae, pushed deeper. CHRG-111hhrg54867--240 Mr. Royce," I just look at the way in which--when we look at the GSEs, Fannie Mae and Freddie Mac, I just look at the way in which that bifurcation between the mission over at HUD and then OFHEO, with safety and soundness, I just look at the goals that were stressed at one end obviously in conflict with safety and soundness, and all of the overleveraging that went on and the, sort of, the mandates for the portfolio that half of it had to be subprime in the portfolio or Alt-A loans. I look at that and I see why the regulators are nervous. And that, also, is a chapter that we have experience with. But let me ask you another question, because I was going to ask if you believe the perceived government safety net under our financial system distorted market incentives and contributed to the financial collapse, especially in the housing boom and bust. Can the moral hazard from the perceived safety net itself, in other words, have something to do with the ballooning of the housing market? I am thinking of Fannie and Freddie there. That could be a contributor. " fcic_final_report_full--88 Residential Mortgage-Backed Securities Financial institutions packaged subprime, Alt-A and other mortgages into securities. As long as the housing market continued to boom, these securities would perform. But when the economy faltered and the mortgages defaulted, lower-rated tranches were left worthless. 1 Originate Lenders extend mortgages, including subprime and Alt-A loans. Pool of RMBS TRANCHES Low risk, low yield 2 Pool Securities firms Mortgages AAA SENIOR TRANCHES purchase these loans and pool them. First claim to cash flow from principal & interest payments… 3 Tranche Residential mortgage-backed securities are sold to investors, giving them the right to the principal and interest from the mortgages. These securities are sold in tranches, or slices. The flow of cash determines the rating of the securities, with AAA tranches getting the first cut of principal and interest payments, then AA, then A, and so on. next claim… next… etc. A AA MEZZANINE TRANCHES These tranches were often purchased by CDOs. See page 128 for an explanation. BBB BB EQUITY TRANCHES High risk, high yield Collateralized Debt Obligation Figure . CHRG-111shrg57319--557 Mr. Killinger," And, Senator, the one point I want to be crystal clear on is that 2002 and 2003 were very unusual years for fixed-rate products because the country was going through a massive refinancing boom, and that is where so much of the origination was. If I went back to a more normalized time, like 2 years before that, you would have seen a balance that was more reflective of 2004 and 2005 and 2006 than it was of 2003. It is the only point I wanted to make there. Senator Levin. June 12, 2006, I am going to read this again: ``Finally, our Home Loans group should complete its repositioning within the next 12 months''--that is your strategy, June 2006--``and will be in a position to profitably grow its market share of ''--you are trying to grow your market share of high risk in June 2006. That is your plan. Option ARM, home equity, subprime, Alt A loans, that is your plan, right, in June 2006. I know that it changed after that, but that was still your strategy. I am just reading your words. " CHRG-111shrg61651--119 Mr. Johnson," Senator, we also have to remember that the ``too big to fail'' is a form of implicit subsidy from the taxpayer, which lowers the cost of funding for these derivative transactions. So one reason the massive banks were able to dominate this market is because they are viewed by the credit markets themselves as too big to fail. That gives them an unfair advantage that enables them to scale up and create even more risk for the taxpayer. The Bank of England financial stability people are calling this entire structure a ``doom loop'' because it is a repeated cycle of boom, bust, bailout, and we are just running through this again. Senator Reed. We have talked about interrelatedness, and I think that is a theme that everyone agrees to. But, Mr. Johnson, in terms of derivative trading, to what extent is that a key factor in this interrelatedness? I know there is no magic one thing, but it strikes me, given the notional size of derivative trading, given the fact that it inherently is staking your future to somebody else's future, would be one of the key drivers in some of these interrelated issues we have. " CHRG-111shrg49488--106 Mr. Green," A mixture. There is also no interest deductibility in the United Kingdom, though that has not stopped a boom in house prices. There has been no regulation of the terms of lending, and one of the issues that has arisen in the review that the FSA has undertaken of what went wrong and what might need to change--which I commend to you, it is a very detailed review covering many of the issues we have talked about today--is whether there should be some kind of mandatory loan-to-value ratios or loan-to-income ratios. So they were not in place, but that is seriously being considered. What has now been agreed at the European level is that there will be skin in the game and that the originator in securitization will have to maintain 5 percent. And I think I am right in saying that has now been legislated across the European Union because of a rather widespread perception that this was a problem that needed fixing. You may say 5 percent is only symbolic, but, of course, it will concentrate the minds of the management to all the issues that Dr. Clark has mentioned. Senator Collins. Thank you. Thank you, Mr. Chairman. " fcic_final_report_full--63 Nonetheless, just weeks later, in October , Congress passed the requested moratorium. Greenspan continued to champion derivatives and advocate deregulation of the OTC market and the exchange-traded market. “By far the most significant event in finance during the past decade has been the extraordinary development and expan- sion of financial derivatives,” Greenspan said at a Futures Industry Association con- ference in March . “The fact that the OTC markets function quite effectively without the benefits of [CFTC regulation] provides a strong argument for develop- ment of a less burdensome regime for exchange-traded financial derivatives.”  The following year—after Born’s resignation—the President’s Working Group on Financial Markets, a committee of the heads of the Treasury, Federal Reserve, SEC, and Commodity Futures Trading Commission charged with tracking the financial system and chaired by then Treasury Secretary Larry Summers, essentially adopted Greenspan’s view. The group issued a report urging Congress to deregulate OTC deriv- atives broadly and to reduce CFTC regulation of exchange-traded derivatives as well.  In December , in response, Congress passed and President Clinton signed the Commodity Futures Modernization Act of  (CFMA), which in essence deregulated the OTC derivatives market and eliminated oversight by both the CFTC and the SEC. The law also preempted application of state laws on gaming and on bucket shops (illegal brokerage operations) that otherwise could have made OTC de- rivatives transactions illegal. The SEC did retain antifraud authority over securities- based OTC derivatives such as stock options. In addition, the regulatory powers of the CFTC relating to exchange-traded derivatives were weakened but not eliminated. The CFMA effectively shielded OTC derivatives from virtually all regulation or oversight. Subsequently, other laws enabled the expansion of the market. For exam- ple, under a  amendment to the bankruptcy laws, derivatives counterparties were given the advantage over other creditors of being able to immediately terminate their contracts and seize collateral at the time of bankruptcy. The OTC derivatives market boomed. At year-end , when the CFMA was passed, the notional amount of OTC derivatives outstanding globally was . tril- lion, and the gross market value was . trillion.  In the seven and a half years from then until June , when the market peaked, outstanding OTC derivatives in- creased more than sevenfold to a notional amount of . trillion; their gross mar- ket value was . trillion.  Greenspan testified to the FCIC that credit default swaps—a small part of the market when Congress discussed regulating derivatives in the s—“did create problems” during the financial crisis.  Rubin testified that when the CFMA passed he was “not opposed to the regulation of derivatives” and had personally agreed with Born’s views, but that “very strongly held views in the financial services industry in opposition to regulation” were insurmountable.  Summers told the FCIC that while risks could not necessarily have been foreseen years ago, “by  our regulatory framework with respect to derivatives was manifestly inadequate,” and that “the de- rivatives that proved to be by far the most serious, those associated with credit default swaps, increased  fold between  and .”  CHRG-110shrg50369--104 Chairman Dodd," Fine. Senator Tester. Thank you, Senator Schumer, and thank you, Mr. Chairman, and thank you, Chairman Bernanke. I appreciate your forthrightness today and always. I want to talk about commodities for a little bit. I am a farmer. I am happy when commodities go up. But as was earlier pointed out today, oftentimes this can end up potentially like it was in the 1970s when we saw a big commodity raise; we saw the inputs that went into agriculture go through the roof; we saw food prices on the shelf go up because commodity prices were higher; and then commodity prices fell back. Those inputs that went into production agriculture stayed up, and the food on the shelf stayed up, too, because they said there was not enough wheat in a loaf of bread to make a difference after they raised the prices because commodities went up. My question to you is: Do you see that playing out the same way? I mean, we are going to see food prices go up probably, it would be my guess. We already have. And we have already seen inputs go up on the farm for production agriculture. I anticipate this commodity price will not stay where it is at forever. They usually do adjust, and they usually adjust down. And food prices will stay up, inputs will stay up. Do you see that same thing happening again? And is there anything we can do if it is that way? " CHRG-110shrg50409--55 Mr. Bernanke," Well, a part of what has been happening--and this goes back to Senator Menendez's question about the role of the subprime crisis and so on--is that there was, if you will, a credit boom or a credit bubble where there was an overextension of credit in a lot of areas. There has been a big reversal of attitudes. Banks and other financial institutions are scaling back on their credit risk. They are deleveraging. They are raising capital. And that adjustment process is part of what is happening now that is creating the drag on economic growth. So it is harder to get a mortgage, it is harder to get a business loan. And until we come to a more stable situation where banks are comfortable with their credit standards and their balance sheets, the leveraging process is going to continue and is part of what we are seeing here. Senator Tester. And very quickly, because my time is over, do you--I mean, we have heard figures of 150 banks potentially going down because, I assume, of this adjustment that you just talked about. Do you guys have any projections on what kind of impact banking institutions going down, how many there potentially could be in the next year or do you not want to comment on that? " CHRG-111hhrg56778--5 Mr. Posey," Thank you very much, Mr. Chairman. To help protect our citizens in the future, I think we probably need to glance at least a little bit on some of our previous failures. And I understand the Office of Thrift Supervision is responsible for supervising 35 holding companies that include both thrifts and insurance operating entities. And it has come to my attention through a news clip actually, just this morning, some revelations I had not previously been aware of and we might possibly clarify in some of our testimony this morning. This was ``Dateline Washington.'' It says, ``Banks weren't the only ones giving big bonuses in the boom years before the worst financial crisis in generations. The government was also handing out millions of dollars to bank regulators rewarding `superior' work, even as an avalanche of risky mortgages helped create the meltdown. The payments detailed in the payroll data released to the Associated Press under the Freedom of Information Act are the latest evidence of the government's false sense of security during the go-go days of the financial boom. Just as the bank executives got bonuses, despite taking on dangerous amounts of risk, regulators got taxpayer funded bonuses despite missing or ignoring signs that the system was on the verge of a meltdown. ``The bonuses were part of a program, little known outside the government. Some government regulators got tens of thousands of dollars in perks, boosting their salaries by almost 25 percent. Often, though, rewards amounted to just a few hundred dollars for employees who came up with good ideas. During the 2000 306 boom, the three agencies that supervised most U.S. banks, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the Office of the Comptroller of the Currency, gave out at least $19 million in bonuses, records show. ``Nearly all that money was spent recognizing superior performance. The largest share, more than $8.4 million, went to financial examiners, those examiners and managers who scrutinize internal bank documents and sound first alarms. Analysts, auditors, economists, and criminal investigators also got rewards. After the meltdown, the government's internal investigators surveyed the wreckage of nearly 200 failed banks and repeatedly found that those regulators had not done enough. ```OTS did not react in a timely or forceful manner to certain repeated indications of problems,' the Treasury Department's Inspector General said of the Thrift Supervision Office following the $2.5 billion collapse of Net Bank, the first major bank failure of the economic crisis. `OCC did not issue a formal enforcement action in a timely manner and was not aggressive enough in the supervision of A&B in light of the bank's rapid growth,' the Inspector General said of the currency comptroller after the $2.1 billion failure of A&B Financial National Association. ```In retrospect, a stronger supervisory response at earlier examinations may have been prudent,' FDIC's inspector general concluded following the $1.8 billion collapse of the New Frontier Bank. `OTS examiners did not identify or sufficiently address the core weaknesses that ultimately caused a thrift to fail until it was too late,' Treasury's Inspector General said regarding IndyMac, which in 2008 became one of the largest bank failures in history. And they believed their supervision was adequate. We disagree. ```OCC's supervision of Omni National Bank was inadequate,' Treasury investigators concluded following Omni's $956 million failure. Most of the bank inspection records are not public and the government blacked-out many of the employee names before releasing the bonus data. It is impossible to determine how many auditors got bonuses, despite working on major banks that failed. Regulators say it's unfair to use those missteps seeing it's a benefit of hindsight to suggest any bonus isn't proper.'' Thank you, Mr. Chairman. I yield back. " CHRG-111hhrg51698--253 Mr. Slocum," Well, the difference in commodities markets is, if I have information about the movement or storage levels of a commodity---- " CHRG-111hhrg51698--436 Mr. Masters," Sure. In the bill, in terms of defining what position limits should be, there is a sort of principle that was really developed by Franklin Roosevelt in the first Commodity Exchange Act, and that was there is something called ``excessive speculation.'' There is not just manipulation, there is excessive speculation. And that only applies to commodities futures markets, it doesn't apply to other markets. The reason it applies to commodities futures markets is because these markets used to be dominated by physical hedgers, and they are there for them to price risk. That is why we have commodity futures markets. We have a different regulator. We have a different way of looking at the markets, because these are commodities. They are not interest rates. Nobody goes home and eats a bowl of interest rates. " CHRG-111shrg50814--20 Mr. Bernanke," Well, we have seen a very broad-based weakness. Housing is very central. At this point, the housing market has reversed the boom that we saw earlier in the decade. In fact, we are now at levels of construction and price declines that we have not seen for a very long time, if ever, and so I would anticipate some stabilization in the housing market going forward and eventually demographic trends, household formation, economic growth will begin to create recovery in the housing market. Likewise, people are very reluctant right now to make commitments to consumer durables like automobiles. I think the current rates of auto sales are below what we will see once the economy begins to normalize. So I think those sectors will be part of the recovery. But in general, as we see confidence coming back, particularly consumer spending on discretionary items, those areas will begin to strengthen and we will see a broad-based recovery. " CHRG-110hhrg38392--128 Mr. Mahoney," As we go through this, we may want to continue to have these discussions with your Board and with Congress as far as what policies. We can promote some of its communication and promotion of educational understanding of savings. That is a segue to a second question; in your speech today, you mentioned that consumer spending has advanced vigorously over the last number of quarters. Sort of looking at the trend over the last number of years, savings have been going down, as you have said. Many people during this boom of real estate started with a lot of home equity loans, taking equity out of their home to support consumer spending, building up more debt that way. And now with the real estate market in many parts of the country very flat, interest rates having gone up, adjustable rates, that is not available for many people, so they have debt on top of that. And then a lot of the consumer spending is on the backs of more consumer debt in terms of credit cards. Congresswoman Pryce mentioned that as well. Again, what impact do you see that having on the long-term basis of the stability of the economy when people are borrowing more and more and more and not saving? And again, what can we do through your offices or through the Congress? " CHRG-111hhrg51698--546 Mr. Weisenborn," Thank you. Mr. Chairman, Ranking Member Lucas and Members of the Committee, thank you for the opportunity to share my views on the important questions of OTC commodity market regulation that you are now considering. Before addressing the substance of my testimony, let me place my views in context by saying a few words about Agora-X and my background. Agora-X is a development stage company located in Parkville, Missouri. It is dedicated to bringing efficiency, liquidity and transparency to the over-the-counter commodity markets by means of advanced, regulatory compliant electronic platforms for OTC transaction. Agora-X was founded by FCStone, a commodities firm headquartered in Kansas City. Agora-X is now also partially owned by NASDAQ OMX. I have been a member of both the Chicago Board of Trade and the Kansas City Board of Trade. I also have self-regulatory experience of the NASDR, now renamed FINRA. OTC markets play an important role in market innovation. They provide an alternative venue for contract formation, price discovery and risk mitigation. For institutional participants, these markets can provide substantial public benefit if they are required to be transparent, reportable, clearable, and to function within the bounds of an electronic platform. Well-organized OTC markets can dramatically improve efficiency of commodity markets. By doing so, OTC markets can reduce the cost that consumers ultimately pay for commodities. When the markets are transparent, liquid and open, transaction costs fall and spreads contract. In transparent markets, there is much less room for manipulation. With broad, transparent OTC markets, the likelihood of devastating speculative bubbles is significantly reduced. Thus, well-regulated OTC markets can contribute to the integrity of U.S. financial markets as a whole. Of course, we must not ignore the lessons taught by the current crisis, but we should be careful to identify the true nature of these problems. In my view, the major problems have been in the misuse of certain commodity contracts and have not been in the means by which they are traded. This brings me to the major point I wish to make. I urge the Committee to preserve the existing OTC commodity markets, but to modify the existing law to improve them. The present financial crisis has demonstrated the need to reform to the OTC commodity markets. Clearly these markets can be improved by means of mandatory reporting, clearing, and by moving these markets to transparent electronic facilities. In addition, an important issue for this Committee is the treatment of OTC contracts on agricultural commodities. Contracts on agricultural commodities deserve the same treatment as contracts on non-ag commodities. Existing law and regulation discriminate against these commodities by making it difficult or impossible to create OTC agricultural contracts electronically, or to clear them. These restrictions, which do not advance any regulatory goal, make no sense today. An example may help to illustrate my point. Last summer, grain prices in the United States reached a very high level, but many producers who wanted to lock in those prices with cash-forward contracts were unable to do so. The country elevators who ordinarily offer such contracts could not do so because they could not finance the margin required for offsetting future positions. I think clearable, structured OTC contracts could have emerged to bridge that gap if it were not for the restrictive regulations. We currently face a time when agricultural markets desperately need liquidity. Allowing cleared, structured OTC contracts can help facilitate and accelerate liquidity. With the safeguards this Committee will add to protect the OTC markets, it is time for eligible agricultural commodity producers, processors, and users to have full access to the OTC markets. I think four things are essential to the OTC commodity markets' reform agenda. First, all physical commodities, including agricultural commodities, should be treated equally. Second, OTC commodity markets should be transparent and reportable to the CFTC. Third, OTC markets should be clearable and less narrow. CFTC-crafted exemptions should apply. Fourth, all OTC contracts should be established on or reported to an electronic facility. Accordingly, I generally support the language of the draft bill, but propose that it be improved to allow a quality of treatment of agricultural commodities, establish electronic documentation and audit trail, trading and clearing requirements, and to give CFTC authority to craft exemptions. Finally, the bill should appropriately define and authorize electronic trading facilities. Thank you for giving me the opportunity to share my views on the draft bill. [The prepared statement of Mr. Weisenborn follows:] Prepared Statement of Brent M. Weisenborn, CEO, Agora-X, LLC, Parkville, MO Mr. Chairman and Members of the Committee, My name is Brent Weisenborn of Parkville, Missouri. I am CEO of Agora-X, LLC. Thank you for the opportunity to share my views on the important questions of regulation of the OTC commodities markets that you are now considering in the proposed bill (draft bill) to amend the Commodity Exchange Act (CEA).(1) Background. Agora-X, LLC is a development stage company that is dedicated to bringing efficiency, liquidity and transparency to over-the-counter (OTC) commodity markets by means of state of the art, regulatory compliant, electronic platforms for OTC contract negotiation as well as trading and transaction execution. Its initial focus is on cash-settled OTC contracts related to physical commodities, such as energy and agricultural commodities. Agora-X, LLC was founded in 2007 by FCStone Group, Inc, which is a commodities firm with deep roots in agricultural commodities markets. FCStone originated as a regional cooperative in the Midwest offering traditional hedging services to cooperative grain elevators, and has grown to offer commodity trading and price risk management services throughout the nation and beyond. In addition to FCStone, Agora-X is now also partly owned by The NASDAQ OMX Group, Inc. I am tremendously excited about the opportunity that exists to improve the functioning of the commodities markets by means of innovations such as the electronic platforms offered by my company and by adjustments to existing regulatory systems that you are now considering. I feel qualified to comment on these points, not only because of my role with Agora-X, but also because of years of experience in both the securities and commodities markets. I have been a member of both the Chicago Board of Trade (CBOT) and the Kansas City Board of Trade (KCBT). I traded futures and was an option market maker as a proprietary trader. I served on the Board of Directors of the KCBT from 1996 to 1998. I was a founder and served from 1987 until 2001 as President of Security Investment Company of Kansas City, an institutional only Broker-Dealer and NASDAQ Market Maker. Security Investment Company specialized in proprietary trading and wholesale market making. I was elected to the NASDR (renamed FINRA), District No. 4 District Committee in 1998 and was elected Chairman in 1999. I served as Chairman until January of 2001 and as co-Chairman of the District 4 & 8 (Chicago) Regional Committee. The NASDR (FINRA) District No. 4 covers seven states: Missouri, Kansas, Iowa, Nebraska, North Dakota, South Dakota and Minnesota. At that time I was responsible for the regulatory oversight of approximately 55,000 stockbrokers in 2,500 offices. I also served on the NASDR National Advisory Council for the year 2000. In June of 2000, I was elected to the NASDR National Small Firm Advisory Board. As a result of my experience I have observed at close hand the evolution of the electronic markets for securities, and I see strong parallels with electronic markets for commodities that are just now emerging.(2) Need for Regulatory Change. OTC markets play an important role of market innovation. They provide an alternative venue of contract formation, price discovery and risk mitigation outside the rigid and restrictive regulatory framework for ``designated contract markets'' that applies to commodity exchanges. OTC markets can provide substantial public benefit without creating systemic risk of the kind that precipitated last September's financial crisis if they are required to be transparent, reportable, clearable, and to function within the bounds of electronic communication networks (ECNs) or exempt commercial markets (ECMs). Well organized OTC markets also dramatically improve efficiency of commodity markets and by doing so OTC markets reduce the costs that consumers ultimately pay for commodities. When the markets are transparent, liquid and open, the spreads that swaps dealers can charge shrink and as a result, transaction costs fall. Efficient markets also inevitably attract liquidity and become broader. If these markets become clearable, they will also bring increased liquidity to clearing houses and registered commodity exchanges. In addition, in open markets there is much less room for manipulation and the possibility of committing fraud. Because of the transparency and breadth of these markets, the likelihood of devastating speculative bubbles is also significantly reduced. These markets will help bring interests of traders and sound market fundamentals into balance. Thus, well regulated and well managed OTC markets will contribute to the integrity of U.S. financial markets as a whole. Of course, we must not ignore the problems that have emerged from the current crisis, but we should be careful in identifying the sources of these problems. In my view, the major problems have been in the misuse of securities and commodities contracts, and have not been in the means by which they are traded. This brings me to the major point I wish to make. I urge the Committee to preserve the OTC commodity markets, but to modify the existing law to derive improvements in them. The present financial crisis demonstrated that there are inefficiencies in the regulation and functioning of the OTC commodities markets and that these markets can be improved by means of electronic audit trail and reporting, by clearing and by moving these markets to a transparent ECN or ECM facilities, where possible. In addition, an important issue for this Committee is the treatment of OTC contracts on agricultural commodities. We believe that agricultural derivatives, such as commodity swaps and options, deserve the same treatment as the non-agricultural commodities under the draft bill. Existing law and regulation discriminate against these commodities by making it difficult or impossible to create OTC agricultural contracts electronically or to clear them. Harmonization of regulation for OTC contracts on agricultural commodities with other contracts will provide the same public benefits to agricultural commodities as are available to all other commodities. In addition it will eliminate existing regulatory anomalies such as prohibitions of clearing and electronic trading that arose in the evolution of the OTC markets and were discarded over time for other commodities, but retained without critical analysis for agricultural commodities. An example may help illustrate the point. Last summer grain prices in the United States reached very high levels, but many producers who wanted to lock in those prices with cash forward contracts were unable to do so because the country elevators who ordinarily offer such contracts did not do so because of inability to finance the margin required for offsetting futures positions. I think clearable, structured OTC contracts could have emerged to bridge that gap if it were not for restrictive regulations. We currently face a time when agriculture desperately needs liquidity. The agricultural OTC market is a significant existing market that is developing entirely outside of registered commodity exchanges. Allowing cleared, structured agricultural OTC contracts on ECNs can help facilitate and accelerate liquidity, while adding transparency and efficiency. With the safeguards that this Committee will add to protect the OTC markets it is time for agricultural commodity producers, processors and users to have full access to such regulated markets.(3) Conclusions and Recommendations. During the last few decades the securities markets have been truly revolutionized by innovative electronic trading methods. Now, the commodities markets are following the same path of innovation. Based on my experience I think four things are essential to the OTC commodity markets reform agenda: (A) The OTC commodity markets should be retained, but improved; (B) Unless exempted by the CFTC, all OTC commodity contracts, agreements and transactions must be reportable to the CFTC; (C) Unless exempted by the CFTC, all OTC commodity contracts, agreements and transactions must be clearable; and (D) Unless exempted by the CFTC, all OTC commodity contracts, agreements and transactions must be negotiated on an electronic communication network (ECN) via the request for quote process (RFQ) or traded or executed algorithmically on an exempt commercial market (ECM) or posted by means of give-ups to such electronic trade reporting facilities. Accordingly, I generally support the language of the draft bill, but propose amending the draft bill as follows: 1. Clearing of all OTC commodity contracts, agreements and transactions. Repeal existing laws and regulations which prohibit electronic trading and clearing of OTC contracts on agricultural commodities and provide that agricultural commodities should be given equal regulatory treatment with non-agricultural commodities by amending section 2(g) of the CEA. The draft bill implies some of this, but it should be further clarified to assure that agricultural commodities fully benefit from the reforms enacted. 2. Electronic Documentation. Require that all OTC commodity contracts, agreements and transactions be electronically documented, whether or not cleared, to assure transparency and to facilitate the reporting of these transactions. 3. Negotiation, Trading and Execution on ECNs or ECMs. Require that unless certain limited CFTC-defined exemptions and exclusions apply, all OTC commodity contracts, agreements and transactions be negotiated, traded and executed on an ECN or ECM or posted by means of the give-ups to such electronic facilities. 4. Definition of ECN. The definition of ``Trading Facility'' in the CEA should be amended to explicitly not include the ECNs. A new definition of the ECN should be drafted and added to the CEA. Thank you for giving me the opportunity to share my views on the draft bill. I look forward to offering any assistance with drafting this proposed legislation as you may request.Brent M. Weisenborn,CEO, Agora-X, LLC.[Redacted]cc:Richard A. Malm, Esq.,Dickinson, Mackaman, Tyler & Hagen, P.C.,[Redacted];Peter Y. Malyshev, Esq.,McDermott, Will & Emery, LLP.,[Redacted]. " CHRG-109hhrg31539--4 The Chairman," The gentleman's time has expired. The Chair now recognizes the gentlelady from Ohio, the subcommittee chairwoman. Ms. Pryce. Thank you, Mr. Chairman. And thank you, Chairman Bernanke, for being with us here today. I was pleased to read in your testimony that you believe that even though the economy is currently in a transition period, that it will continue to expand even under the pressure of increased oil prices, consumer spending, and a slowing housing market. I would like to talk about that just briefly. Studies have shown that housing accounted for more than one-third of economic growth during the previous 5 years. The robust housing market had enabled homeowners to reduce their debt burdens and maintain adequate levels of consumer spending by tapping into the equity of their homes. Unfortunately in research done by the National Association of Home Builders, they show a serious downtrend in housing demand that many believe correlates with the rise in interest rates by the Federal Reserve. As I have said in the past, I am concerned that this house price boom has been driven far more by investors than ever before, and could lead to a series of mortgage failures, and as the Federal Reserve tries to balance rising rates with fluctuations in the markets, I don't need to remind you that your actions have a trickle-down effect to local communities, and losses on housing investments are just one example. A study by the Mortgage Bankers Association puts my own State of Ohio at the very top of the list of foreclosures, and so we are very concerned in the Midwest. Although we would sometimes like to think of our economy as one that stands apart from the rest of the world's sociopolitical issues, the effect of volatility overseas is reaching into our economy more than we might realize. Just yesterday I held a hearing in my subcommittee on currency issues. We had representatives there from the Federal Reserve and the Mint discussing with us the rising cost of the commodities and materials that make up our coins. We heard these commodities are affected by the volatility in the world or through rising demand in other markets, and are also themselves affecting our inflation here in the United States. The more they cost, the more they drive up the cost to make our currency, and the more it drives up costs overall. In your remarks at the Senate yesterday, you touched upon a number of issues concerning citizens, such as rising rates, gas prices, and wage earnings. One of the issues that has been important to me, and a number of other members on this committee, is the ratio of consumer debt to consumer savings in America, and the effects that a slowing economy could have on a more local level. I agree with your statement yesterday that we must be forward-looking in our policy actions, and I would appreciate hearing your thoughts on what Congress can do about low savings rates, especially coupled with rising consumer costs. Some of us, Mrs. Kelly, Mrs. Biggert, Mrs. Maloney, and myself, have worked to bring this issue to a national focus for a number of years, and we mentioned it repeatedly, working with the Administration to highlight increasing financial education in the United States, but much more needs to be done. You also talked about an international savings glut that I believe we have here in America, a credit glut. I believe we can say it is almost a national epidemic. Consumer spending is key to our continued growth, but I believe we also need to send a message that consumer savings is just as important, and I appreciate hearing from you what the Federal Reserve and the rest of us can do to help consumer savings become a priority in this Nation. And I want to thank you once again, Mr. Chairman, for your appearance. I look forward to your testimony, and I yield back. Thank you. " CHRG-110hhrg38392--98 Mr. Sires," Thank you, Mr. Chairman. Thank you, Mr. Bernanke, for being here with us today. I just want to follow up on the housing issue. I represent a district that is across from New York, the northern part, the Jersey City area, which has seen a boom of housing over the last few years. With that, the prices really went up high. A lot of people had to resort to subprime lending to get housing, and it created a lot of jobs, a lot of good-paying construction jobs. I do not know whether this is regional, but I have seen the prices of the houses not really going down when we are losing a lot of those jobs that were created. I would just like to know the impact on these construction jobs. I know that approximately 10 percent of the jobs created in this country are through construction. What effect is this going to have on the economy? Do you see it as regional? Because I know they are going to--I have friends in Florida, and they are going through the same process, the same things where good-paying jobs are being lost. Do you see this trend changing? I know mortgages are getting tighter. Subprime is very difficult to get. Home equity loans to create these jobs are impossible in some cases. Do you see this trend changing anytime soon? " CHRG-111hhrg63105--144 SPOKESMAN, COMMODITY FOMC20070321meeting--59 57,MR. STOCKTON.," That’s possible. We have not taken that view. Overall housing construction had some unexplained strength over the past year, not from a bottom-up demographic addition but just in terms of what we would have expected given the growth in employment, income, and wealth. Admittedly, the evidence is still very tentative, but we think we see some signs of demand stabilizing around current levels so that, in our starts forecast, we’ll be able to drive the months’ supply of homes back down relative to the low level that it had actually been running from the mid-1990s to the middle of the housing boom. So I don’t think we’re seeing an excess supply of homes that people just won’t want at current prices, or roughly current prices, but that is a considerable risk. Adding up household formations and demolitions—there’s a lot of uncertainty about that, and there’s a lot of cyclical sensitivity as well to the overall household formation rates. So whether the housing stock outran the long-run determinants is kind of hard to nail down. We see that as a risk, but it’s not incorporated in this forecast. If that were the case, there could be a bigger drag on housing activity than we’re anticipating." CHRG-111hhrg51698--338 Mr. Masters," I would just like to put out the idea that more and more people now, especially the American public in general, have come to the conclusion that there was no doubt that there was a significant amount of speculation in crude oil markets, and indeed, most of the commodity markets over the last 9 months. You will notice in my testimony we put out a report on that in which we calculate that the excessive speculative activity over the last 6 months cost the average American $850 per capita, per household, in excess of $110 billion over that period of time. And it is interesting to me that dealers from Wall Street and other folks can come up and say, well, money moves markets in everything but commodities. Of course money moves markets in commodities. We had money coming in. We had $70 billion come in, and we had $70 billion come out. Let me just read you a couple of statements that have come out subsequent to our initial testimony about excessive commodity speculation. One of them is from Paul Tudor Jones, who is probably considered one of the greatest commodity traders of all times. He said, ``There is a huge mania, and it is going to end badly. We have seen it play out over hundreds of times over the centuries, and this is no different. It is just the nature of a rip-roaring bull market.'' I will give you another example, Dr. Bob Aliber from the University of Chicago. He is a distinguished professor. He said, ``You have got speculation and a lot of commodities, and that seems to be driving up the price. Movements are dominated by momentum players who predict price changes from Wednesday to Friday on the basis of the price change from Monday to Wednesday.'' Since our testimony, organizations such as the World Bank, the United Nations, MIT, the Austrian Ministry of Finance, the Japan Ministry of Trade and other organizations and academics around the world have come out and said there is no doubt that excessive speculation was a primary cause for the movements we saw in commodities markets over the last year. So, to your question, I would say that the speculation absolutely had a role, and could continue to have a role in prices in the commodity futures markets. " FOMC20080130meeting--110 108,MR. SHEETS.," Right. Just a word of background. The rationale for the falloff is the expected decline in these commodity prices and the expected slowing of global demand. Now, thinking about the risks, I am reasonably convinced that global demand is going to slow, which I believe will translate into reduced demand for many of these commodities that have driven up inflation. However, that says something only about the demand side of these commodity markets. There is also a lot going on on the supply side. At the last FOMC meeting, we talked about ethanol and the fact that many of these emerging-market countries are wealthier, that they want to eat better than they used to, that the relative price of energy has risen, and that it takes a lot of energy to raise these crops. So there are supply factors as well as demand factors at work in driving up these commodity prices. It is very hard for us to forecast the supply side of these markets. It is driven by things like weather and geopolitical developments and so on and so forth. On the commodities, my sense is that demand is going to shift in to some extent. As long as the supply doesn't shift in as well, we should be able to see a decline, or at least a slower rate of increase, in these prices. A very important point here is that, in order to get less of an impetus coming from commodity prices and inflation in these countries, we don't necessarily need oil prices to come down in level terms. We just need them to stop going up at such rapid rates. If we get slower rates of price increases, that will be disinflationary relative to where we have been. That is how I would characterize the risks around this forecast, mainly on the supply side of these commodity markets. " CHRG-111hhrg51698--440 Mr. Masters," The nice thing about position limits is we have 7 years of experience with them. Before the CFTC excluded some broker dealers, it basically exempted them from position limits. Before the Commodity Futures Modernization Act, which allowed swaps and other over-the-counter derivatives to be created that would allow broker dealers to trade off-exchange in significant fashion with other speculators. That is the loophole we have talked about in the past, before we had those issues, we had a very solid, working commodity futures market that served the needs of producers for years and years. In fact, in 1998, producers, physical hedgers, and consumers of commodities were the dominant force of the market. They were 70 percent of the market. Speculators were about 30 percent. " FOMC20080625meeting--41 39,MR. SHEETS.," Yes. The spike that we have seen is driven particularly by commodity prices. The depreciation of the dollar has played a secondary role, so the decline in core import price inflation to below 2 percent next year is conditioned crucially on commodity prices flattening out and the dollar not depreciating as rapidly as it has over the past few years. " CHRG-111hhrg55811--164 Mr. Gensler," I share the Congressman's view that there is a highly concentrated market here, and probably 5 or 10 years from now, it will be even more concentrated. This happens in the airline and other industries as well. But I do think on the non-bank dealers, people holding themselves out in dealing in these, that there is an appropriateness to have capital; that we don't want to have something outside the system. These are generally in the commodity swaps area, the oil and natural gas and commodity areas, and many of them have capital. It is not to be additional capital, what they currently have, but just to make sure they have a minimum amount of capital if they are holding themselves out and making markets in these commodity swaps or other swaps as a non-bank dealer. " FOMC20080805meeting--56 54,MR. KAMIN.," Sure. As I mentioned, core import price inflation shot up very rapidly to over 10 percent in the second quarter, and our approach toward modeling and predicting core import price inflation focuses on three main sources of increase. First are increases in foreign cost pressures, which we proxy by CPIs, which have not been a particularly important driver of core import prices as of late, though they are not negligible. Then the other two, which are more important, are declines in the dollar, which push up our prices, and finally increases in commodity prices because a lot of our imports, even core imports, which exclude oil and high-tech products, still have a lot of commodity input into them. For the past few years, our experience has been that the pass-through of declines in the dollar into core import prices has been relatively moderate. It has definitely contributed materially to the increase in core import prices but not as much, we feel, as the run-up in commodity prices, which has had a pretty substantial effect. One way that we can sort of confirm that impression is that we know that the prices of imported material-intensive products that have the most commodity input have gone up much more rapidly than prices of finished goods, and that has been true over the past year as well. So for all of those reasons, we feel that commodity prices have been the prime impetus for the run-up in core import price inflation. Going forward, we take our guidance from the futures markets, which indicate that oil prices and other commodity prices will flatten out. As a result, we anticipate that, relatively shortly, core import price inflation also should start to decline. At the same time, our anticipation is that, compared with the past few years, the dollar will fall less rapidly going forward than in the past, and that should be another factor supporting our view that core import price inflation should diminish. " CHRG-111hhrg74855--39 COMMODITY FUTURES TRADING COMMISSION CHRG-111hhrg63105--20 COMMODITY FUTURES TRADING COMMISSION, CHRG-111hhrg63105--15 COMMODITY FUTURES TRADING COMMISSION, FOMC20071211meeting--43 41,MR. STOCKTON.," Food is important. In fact, we devote, I would imagine, a surprising amount of resources to it. We have an agricultural economist whose job is to follow those developments and report on them. It is his view—and based on both the futures prices and some of the modeling that we have done—that we will see a deceleration going forward in retail food prices. As you know, futures prices basically are projecting a flattening-out. I assume that is part of what is in Nathan’s forecast as well. We are not trying to outguess the markets in that regard, and the reports that we have received on agricultural production look relatively favorable for the coming year. Now, most of that is a bit of winter wheat at this point and not much more in terms of production, although we have seen some significant rebuilding of both flocks and livestock herds that suggests that we are on the right track in terms of an output response to the higher prices that we have seen in the past year. Markets are tight, and I think there probably is some asymmetry in the risk surrounding the food price forecast, in that it is easier to see some possibility of stock-out problems if there is any shortfall in production over the coming year, than that there would be some massive boom in agricultural production that will depress prices sharply. But I do think—and in the Greenbook Part 2 quite often, especially in the autumn, when we are actually doing a more careful accounting of the harvest—we devote a fair amount of attention to resources to it. We can certainly do even more going forward." fcic_final_report_full--490 III. THE U.S. GOVERNMENT ’S ROLE IN FOSTERING THE GROWTH OF THE NTM MARKET The preceding section of this dissenting statement described the damage that was done to the financial system by the unprecedented number of defaults and delinquencies that occurred among the 27 million NTMs that were present there in 2008. Given the damage they caused, the most important question about the financial crisis is why so many low quality mortgages were created. Another way to state this question is to ask why mortgage standards declined so substantially before and during the 1997-2007 bubble, allowing so many NTMs to be created. This massive and unprecedented change in underwriting standards had to have a cause—some factor that was present during the 1990s and thereafter that was not present in any earlier period. Part III addresses this fundamental question. The conventional explanation for the financial crisis is the one given by Fed Chairman Bernanke in the same speech at Morehouse College quoted at the outset of Part II: Saving inflows from abroad can be beneficial if the country that receives those inflows invests them well. Unfortunately, that was not always the case in the United States and some other countries. Financial institutions reacted to the surplus of available funds by competing aggressively for borrowers, and, in the years leading up to the crisis, credit to both households and businesses became relatively cheap and easy to obtain . One important consequence was a housing boom in the United States, a boom that was fueled in large part by a rapid expansion of mortgage lending. Unfortunately, much of this lending was poorly done, involving, for example, little or no down payment by the borrower or insuffi cient consideration by the lender of the borrower’s ability to make the monthly payments . Lenders may have become careless because they, like many people at the time, expected that house prices would continue to rise--thereby allowing borrowers to build up equity in their homes--and that credit would remain easily available, so that borrowers would be able to refinance if necessary. Regulators did not do enough to prevent poor lending, in part because many of the worst loans were made by firms subject to little or no federal regulation. [Emphasis supplied] 59 In other words, the liquidity in the world financial market caused U.S. banks to compete for borrowers by lowering their underwriting standards for mortgages and other loans. Lenders became careless. Regulators failed. Unregulated originators made bad loans. One has to ask: is it plausible that banks would compete for borrowers by lowering their mortgage standards? Mortgage originators—whether S&Ls, commercial banks, mortgage banks or unregulated brokers—have been competing for 100 years. That competition involved offering the lowest rates and the most benefits to potential borrowers. It did not, however, generally result in 59 Speech at Morehead College April 14, 2009. 485 or involve the weakening of underwriting standards. Those standards—what made up the traditional U.S. mortgage—were generally 15 or 30 year amortizing loans to homebuyers who could provide a downpayment of at least 10-to-20 percent and had good credit records, jobs and steady incomes. Because of its inherent quality, this loan was known as a prime mortgage. FinancialCrisisInquiry--709 ZANDI: Well, first, let me say that one of the hallmarks of the Great Recession was how broad- based it was across industries and regions of the country. I mean, in past recessions, you always had a large region or two that avoided the recession, and that was a safety valve. People could move from Michigan and go to Florida or move from California to Nevada, and that wasn’t the case in this downturn. Now, having said that, obviously, there are some areas that are harder hit than others and those that suffer— well, were in the housing boom and bubble and now suffered the housing bust are the most severely hit, and that would include Nevada, Las Vegas, Arizona, California, particularly the Central Valley of California, Florida, Rhode Island, interestingly enough, for various reasons, and, obviously, parts of the industrial Midwest. And it will take much, much longer for an economy like Nevada and Florida to turn because its economic base is much less diversified. Obviously, it’s related to leisure and hospitality, which is a discretionary purchase and will not turn, and migration flows. And as I mentioned earlier, migration is going to be significantly impaired because one-third of homeowners with first mortgages, by my calculation, are underwater and can’t move or won’t move as easily. So Nevada’s problems are very severe and will be very long lasting. FOMC20060808meeting--12 10,MR. POOLE., Maybe we’ll see what happened there during the break. My argument is that we have very generalized inflation pressure across regions of the world and across commodity and service sectors. The pressure is not isolated. Could you comment on that observation? CHRG-110shrg50409--44 Mr. Bernanke," Well, it cuts two ways. On the one hand, it might weaken to some extent the contribution of exports and trade to our growth. But, on the other hand, if these other economies cool down, it might reduce commodity prices or flatten out commodity prices, which would be very beneficial. Senator Tester. Do you anticipate overall negative, positive, or pretty static in its effect? " CHRG-111hhrg53021--278 Mr. Thompson," Thank you, Mr. Chairman. Thank you, Mr. Secretary, for being here, for answering these questions. With your proposal, I wanted to just seek some clarification. Is it your intent to force private commodity pool operators to register with the SEC as a hedge fund instead of the CFTC? And, if so, why? " CHRG-111hhrg53021Oth--278 Mr. Thompson," Thank you, Mr. Chairman. Thank you, Mr. Secretary, for being here, for answering these questions. With your proposal, I wanted to just seek some clarification. Is it your intent to force private commodity pool operators to register with the SEC as a hedge fund instead of the CFTC? And, if so, why? " CHRG-111shrg50814--153 Mr. Bernanke," Well, I think the Fed was a very active and conscientious regulator. It did identify a lot of the problems. Along with our other fellow regulators, we identified issues with non-traditional mortgages, with commercial real estate, with leveraged lending and other things. But what nobody did was understand how big and powerful this credit boom and the ensuing credit collapse was going to be, and routine supervision was just insufficient to deal with the size of this crisis. So clearly, going forward, we need to think much more broadly, more macroprudentially, about the whole system and think about what we need to do to make sure that the system as a whole doesn't get subjected to this kind of broad-based crisis in the future. Senator Shelby. Does that include insurance, too, because insurance has been regulated under the McCarran-Ferguson Act by the States, but then you had AIG, which caused systemic stress, to say the least, to our banking system, and they were regulated primarily by the New York State Insurance Commission. " Mr. Bernanke," AIG had a Financial Products Division which was very lightly regulated and was the source of a great deal of systemic trouble. So I think that we do need to have broader-based coverage, more even coverage, more even playing field, to make sure that there aren't--as our system evolves, that there aren't markets and products and approaches that get out of the line of vision of the regulators, and that was a problem we had in the last few years. Senator Shelby. Thank you, Mr. Chairman. " CHRG-111hhrg51698--134 Mr. Cota," Congressman Thompson, you also asked the question about how much liquidity is liquidity. Talking about very dull commodities like energy, the heating oil market is about 8 billion gallons per year in the United States, 7 or 8 billion gallons. That amount in regulated U.S. exchanges is traded multiple times per day. There is no lack of liquidity in those markets. Now, it is a little bit more complex than that, because those trades also trade other types of commodities, but there continue to be huge amounts of commodities in these markets. The only time that they seem to be illiquid is when you have extreme volatility within these markets, and the last remaining portion of the floor-traded aspects, which are purely floor traded, are options trade. Options trading, because of the volatility, did dry up, and to me that meant that there was too much volatility in the markets because too much money was coming in and coming out. So I kind of argue the other side of that. " FOMC20050630meeting--321 319,MR. FERGUSON.," I’ll continue to plow that ground just for one minute. I’m struck a bit by the fact that the stories on the run-up in commodity prices and oil prices are all about China and India. You have a forecast here where China’s growth falls off fairly dramatically. Growth in the rest of the world I would describe as maybe more of a downside risk. You point out the uncertainty in Europe and Japan and you’ve even marked down economic growth in the United States. Yet your commodity prices tend to be rather flat. All this run-up was associated with China, India, and global growth. You have global growth dampening, but we don’t seem to recover much in the way of these commodity prices—oil being one, but others in general. I’m obviously missing something. What is it?" CHRG-111hhrg51698--439 Mr. Costa," You believe that the transparency of this commission would suffice in determining what would be viewed as an acceptable risk versus an excessive risk, because, unlike the commodities exchange that we are talking about, whether it be pork bellies or whether it be other future markets in agricultural commodities, in these instruments that we are talking about here, as you said, you can't eat a bowl of derivatives, I guess. And so, where has this worked in a way that there is previous practices that we could draw from experience on? " FOMC20070509meeting--43 41,MS. MINEHAN.," This works as an intervention as well as a question because it is exactly along the lines of President Plosser’s questions. First, the assumption about inventory and where is normal—the past ten years through the housing boom have created a normality, if you will, of very low inventories, as compared with the longer-run inventories. So the question is, Where is normal, and where do builders want normal to be? How much do they have to do to get back to the level where they were for the past ten years versus the level that you could figure over a twenty-year or thirty-year period? I talked to a group of builders about this a couple of months ago and did not get a whole lot of feedback from them on where they thought they might like to be, although all of them, I am sure, are making that calculation for themselves in one way or another in their business on a day-to-day basis. But I think it is hard to say that any given level of inventory—seeing how much it changed between the past ten years and the ten or twenty before that—is “normal” with any confidence. Second, I have been taking a bit of confidence, and maybe this is wrong, from the fact that, if you smooth through sales of existing homes, which of course are a much bigger volume than sales of new homes, on a three-month or a six-month moving average, you do see a dip at the beginning of this year and then you see it come back a little in the environment of reasonably low interest rates for prime borrowers and decent interest in terms of mortgage originations and so forth, but obviously not as high as it was. I am thinking that that maybe says something about the demand side, but maybe this is just cockeyed optimism on my part." CHRG-111hhrg53021Oth--180 Mr. Costa," Thank you very much, Mr. Chairman. I thank both Chairmen for holding this important hearing. And thank you, Mr. Secretary. I want to focus my questions in the area of commodities. I represent a large agricultural area, and obviously commodity trading is very important. You have spoken about a good way to avoid the future AIG situations as to ensure that all parties have a stake in the game, or skin in the action, or whatever you want to call it--skin in the game, I guess. I think that is more achievable in terms of the financial institutions, but commodity hedgers don't generally have the same access to cash and capital in order to be a player in these markets. Their assets oftentimes tend to be tied up in reinvestments and their own company growth. What sort of impact do you think this is going to have on capital requirements on nonfinancial entities that have an appropriate role to be engaged in this market and to have the access to it? " CHRG-111hhrg53021--180 Mr. Costa," Thank you very much, Mr. Chairman. I thank both Chairmen for holding this important hearing. And thank you, Mr. Secretary. I want to focus my questions in the area of commodities. I represent a large agricultural area, and obviously commodity trading is very important. You have spoken about a good way to avoid the future AIG situations as to ensure that all parties have a stake in the game, or skin in the action, or whatever you want to call it--skin in the game, I guess. I think that is more achievable in terms of the financial institutions, but commodity hedgers don't generally have the same access to cash and capital in order to be a player in these markets. Their assets oftentimes tend to be tied up in reinvestments and their own company growth. What sort of impact do you think this is going to have on capital requirements on nonfinancial entities that have an appropriate role to be engaged in this market and to have the access to it? " fcic_final_report_full--45 These funds differed from bank and thrift deposits in one important respect: they were not protected by FDIC deposit insurance. Nevertheless, consumers liked the higher interest rates, and the stature of the funds’ sponsors reassured them. The fund sponsors implicitly promised to maintain the full  net asset value of a share. The funds would not “break the buck,” in Wall Street terms. Even without FDIC insur- ance, then, depositors considered these funds almost as safe as deposits in a bank or thrift. Business boomed, and so was born a key player in the shadow banking indus- try, the less-regulated market for capital that was growing up beside the traditional banking system. Assets in money market mutual funds jumped from  billion in  to more than  billion in  and . trillion by .  To maintain their edge over the insured banks and thrifts, the money market funds needed safe, high-quality assets to invest in, and they quickly developed an ap- petite for two booming markets: the “commercial paper” and “repo” markets. Through these instruments, Merrill Lynch, Morgan Stanley, and other Wall Street in- vestment banks could broker and provide (for a fee) short-term financing to large corporations. Commercial paper was unsecured corporate debt—meaning that it was backed not by a pledge of collateral but only by the corporation’s promise to pay. These loans were cheaper because they were short-term—for less than nine months, sometimes as short as two weeks and, eventually, as short as one day; the borrowers usually “rolled them over” when the loan came due, and then again and again. Be- cause only financially stable corporations were able to issue commercial paper, it was considered a very safe investment; companies such as General Electric and IBM, in- vestors believed, would always be good for the money. Corporations had been issuing commercial paper to raise money since the beginning of the century, but the practice grew much more popular in the s. This market, though, underwent a crisis that demonstrated that capital markets, too, were vulnerable to runs. Yet that crisis actually strengthened the market. In , the Penn Central Transportation Company, the sixth-largest nonfinancial corpora- tion in the U.S., filed for bankruptcy with  million in commercial paper out- standing. The railroad’s default caused investors to worry about the broader commercial paper market; holders of that paper—the lenders—refused to roll over their loans to other corporate borrowers. The commercial paper market virtually shut down. In response, the Federal Reserve supported the commercial banks with almost  million in emergency loans and with interest rate cuts.  The Fed’s ac- tions enabled the banks, in turn, to lend to corporations so that they could pay off their commercial paper. After the Penn Central crisis, the issuers of commercial pa- per—the borrowers—typically set up standby lines of credit with major banks to en- able them to pay off their debts should there be another shock. These moves reas- sured investors that commercial paper was a safe investment. CHRG-111hhrg51698--561 Mr. Weisenborn," To this point in the OTC commodity space, because of the prohibitions, we are a development-stage company. We have not begun trading. Our software is complete, and that is why we are here to urge a level playing field for agricultural commodities, so that they can be cleared and traded electronically. But from what we know, this would be the first application of ECN technology, such as BATS and some of the other things that have developed in Kansas City in this asset class. " CHRG-111hhrg63105--152 Mr. Newman," Chairman Boswell, Ranking Member Moran, and Members, thank you for the opportunity to testify before you today. The American Feed Industry Association is the largest organization devoted exclusively to represent the business, legislative, and regulatory interests of the U.S. animal feed industry and its suppliers. AFIA applauds this Subcommittee, its Members, and the full Committee for calling today's hearing. AFIA members manufacture more than 70 percent of the animal feed in the United States, which amounts to over 160 million tons annually. Feed also represents roughly 70 percent of the cost of producing meat, milk, and eggs. With the majority of our industry input supplies priced directly on, or in reference to, regulated commodity markets, we depend significantly on an efficient and well-functioning futures market for both price discovery and also risk management. Agricultural commodity markets were established to provide an efficient price discovery mechanism and a hedging risk management tool for producers and end-users. While this system encourages and requires speculative participants to provide liquidity, the significant increase of financial investors, as well as the special exemptions from speculative position limits that have been granted over time to Wall Street banks and others who are not end-users, has distorted the function of these markets. The agriculture commodity markets functioned effectively for over 60 years after the 1936 Commodity Exchange Act first implemented speculative position limits. However, this changed in 2000 when Congress codified earlier CFTC regulatory actions granting Wall Street banks and other financial institutions an exemption from speculative position limits for hedging over-the-counter swaps and index transactions. While there are several factors that have led to increased volatility and price swings in agricultural commodities, excess speculation by index funds is certainly one of these factors. As you are aware, the size and influence of these large financial players was never contemplated during the development of the original Commodity Exchange Act. Most of the index speculators tend to hold their positions rather than sell. This allows them to create artificial demands through their long-only positions and in essence really are bets on higher prices. The magnitude of this scenario is clear in the numbers. In 2003, index speculator investment in 25 physical commodities was $13 billion. In 2008, these investments jumped to $260 billion, an 1,800 percent increase in 5 years. In 2010, these investments remain at $265 billion, with three index funds representing 94 percent of that amount and one fund representing 52 percent of those investments. Earlier this year, we applauded the work by Congress to include provisions in the Act that would authorize CFTC to set reportable position limits on commodity contracts, as well as for aggregate and exchange-specific position limits. Within this process, AFIA members support the following items: First, speculative position limits that enhance market performance and the appropriate narrowing of cash and futures market values as they near contract delivery period; the retention and equal application of the existing speculative position limits for agricultural commodities; retaining the current bona fide hedge definition which is in place; the removal of speculative position limit exemptions for financial institutions and other nontraditional participants in agricultural commodity markets. While CFTC now has this authority, without removing these exemptions the speculative position limits will have a much more limited effect when they are put in place. Given the strong relationship between crude oil and corn futures markets brought on by the dramatic and rapid expansion of the ethanol industry, establishing and enforcing energy speculative position limits is also important to secure the reliability of the entire agricultural commodity complex. We support effective speculative position limits that work for both the bona fide hedger and the speculator. However, there is rarely a perfect solution to complex issues and waiting for a perfect solution before setting speculative position limits or taking other actions will only delay that much-needed transparency and controls required in these commodity markets. Therefore, we support implementation of interim limits where data is available and which can also be adjusted by CFTC with further data to confirm and support those changes. I would be remiss if I didn't express AFIA's appreciation to Chairman Gensler, Commissioner Chilton, and the other CFTC Commissioners for their extensive outreach during this entire process. Thank you for inviting me to participate in today's hearing. AFIA and its members stand ready to assist you in these efforts. I look forward to any questions. [The prepared statement of Mr. Newman follows:]Prepared Statement of Joel G. Newman, President and CEO, American Feed Industry Association, Arlington, VA Chairman Boswell, Ranking Member Moran and Members, thank you for the opportunity to testify before General Farm Commodities and Risk Management Subcommittee as you review implementation of provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 relating to speculation limits. I am Joel Newman, President and Chief Executive Officer of the American Feed Industry Association (AFIA), based in Arlington, Virginia. AFIA is the world's largest organization devoted exclusively to representing the business, legislative and regulatory interests of the U.S. animal feed industry and its suppliers. Founded in 1909, AFIA is also the recognized leader on international industry developments with more than 500 domestic and international members, as well as nearly 40 state, regional and national association members. Our members are livestock feed and pet food manufacturers, integrators, pharmaceutical companies, ingredient suppliers, equipment manufacturers and companies that provide support services to the industry. AFIA members manufacture more than 70% of the animal feed in the U.S., which amounts to over 160 million tons annually. Because feed represents roughly 70% of the cost of producing meat, milk and eggs, AFIA members are major contributors to food safety, nutrition and the environment, playing a critical role in the production of healthy, wholesome meat, poultry, milk, fish, eggs and pets. AFIA is a member of the Commodity Markets Oversight Coalition, which was formed in 2007, and is a broad coalition of organizations committed to protecting the interests of bona fide hedgers and derivatives end-users. We thank the Subcommittee for including Jim Collura in this hearing to speak on behalf of CMOC. His leadership has been invaluable to the Coalition. Your review of implementation of the Dodd-Frank Act by the Commodity Futures Trading Commission (CFTC) is both timely and appreciated by the men and women of the feed industry. As I have stated, feed represents approximately 70% of the on-farm cost of raising livestock and poultry. With the majority of our industry's input supplies priced directly on or in reference to regulated commodity markets, we depend significantly on an efficient and well-functioning futures market for both price discovery and risk management. Agriculture commodity markets were established to provide an efficient price discovery mechanism and a hedging/risk management tool for producers and end-users. While this system encourages and requires speculative participants to provide liquidity, the significant increase of financial investors, permitted by special exemption from speculative position limits, has distorted the function of these markets. Speculators are an important part of the commodity markets--without them there is no market. The agriculture commodity markets functioned effectively for 64 years after the 1936 Commodity Exchange Act first implemented speculative position limits. With these limits in place, the process of physical commodity customers using the futures markets as a price discovery and risk mitigation tool were able to rely on traditional speculator participation to provide a clear buyer/seller relationship and market liquidity. However, this changed in 2000, when Congress codified earlier CFTC regulatory actions granting Wall Street banks an exemption from speculative position limits for hedging over-the-counter swaps and index transactions. While there are several factors that have lead to increased volatility and price swings of agriculture commodities, excessive speculation by index funds is certainly one of these factors. As CFTC has recognized, speculator participation in these markets without position limits does have an impact on prices. These banks, which represent institutional investors, used the guise of ``hedging'' their invested capital to take advantage of the exemption. But in fact, their initial investments were speculative and were not hedging future needs or commitments for the underlying commodities. AFIA strongly supported ending this exemption, and we were very pleased when Congress took steps to address our concerns. Over the past few years, as the volatility and instability in the stock and financial markets exploded, speculative activity in the agricultural commodity futures markets grew substantially. In some crop contracts, there were times when the daily speculator trading volume was nearly equal to, or in the case of wheat, was more than the entire U.S. annual production volume of these same crops. This not only added to extreme price volatility as bona fide hedgers scrambled to mitigate their risks, but in many cases it pushed end-users out of the market. In at least one situation, this speculator activity pushed an organization into bankruptcy when the impact of margin calls caused by the extreme price run-ups drained the company's liquidity to unsustainable levels. As you are aware, from the Committee's analysis, when considering reforms for the futures markets and products, the size and influence of these very large financial players was never contemplated during development of the original Commodity Exchange Act (CEA). The recent dramatic increases in nearly all physical commodities values actually increased speculator demand, with the net result of commodity prices reaching unrealistic levels relative to true demand. Most of the index speculators tended to hold their positions rather than sell, which exacerbated the situation by producing artificially high demand accompanied by higher prices that negatively impacted nearly all end-users of the physical commodities. The magnitude of this scenario is clear in the numbers: In 2003, index speculator investment in 25 physical commodities was $13 billion; in 2008, these investments jumped to $260 billion--an 1,800% increase. In 2010, these investments remain at $180 billion, with three index funds representing 92% of these investments and one fund representing 61% of these investments. (Illustration 2) As a result, the feed industry was forced to pay higher prices for grains and other inputs, which were passed along to livestock, dairy and poultry producers and feed costs soared. Farmers, although receiving substantially higher prices for their commodities, were also hit by soaring costs for fertilizer and fuel, as similar speculator activities artificially further drove up oil prices. Simply put, agriculture, from farm to retail, had to deal with extreme price volatility on a number of fronts without the effective support of our primary risk mitigation tool--the futures markets--because those markets were severely compromised by Wall Street banks ability to avoid speculative position limits and invest substantial levels of monies in the physical commodity markets. This not only allowed them to avoid the volatility of the dust storm on Wall Street, it provided them a significant return on those speculative ``hedges'' because of their ability to influence the escalation of market prices by creating artificial demand. Earlier this year, we applauded the work by Congress to include provisions in the Act that would authorize the CFTC to set position limits on commodity contracts, as well as for aggregate and exchange specific position limits. Also, when commenting on CFTC's proposed position limits for energy contracts in March of this year, AFIA encouraged the Commission to consider such actions for other hard commodities to similarly protect agricultural commodities from the very large financial speculators that were masquerading as hedgers, parking their resources in physical commodity markets to ride out the extreme volatility then present in the stock and financial markets. By including clear authority for the CFTC to set a variety of reportable position limits, Congress took a solid and welcomed step toward our mutual goal of ensuring these commodity markets and products effectively serve their primary role of providing bona fide commercial hedgers reliable tools to manage their economic risks. With the expanded authority in place relative to speculation limits, AFIA is anxiously waiting for the CFTC to finalize its regulations and to put speculative limits into effect. We know this will take time and are hopeful the combination of the various categories of speculation position limits, combined with full implementation of the Act's other provisions, such as enhanced transparency and expanded regulation of nearly all derivatives, will assure bona fide hedgers of the viability of their futures-based risk management strategies. I would be remiss if I did not extend AFIA's appreciation to Chairman Gary Gensler and his fellow CFTC Commissioners for their openness and diligence in addressing our concerns, particularly during the time Congress was developing its package of reforms. Through frequent meetings, they provided frank and candid overviews of their established authorities. When Congress was deliberating its reform legislation, the CFTC team also provided regular updates on progress toward the reform goals we and others were supporting. Just as important, they helped us understand how certain provisions in the Act addressed our concerns while approaching them in a different manner than we had proposed. Importantly, the CFTC has been aggressive in its outreach over the past few months as it works to implement the Act. Like most supporters of reform in the futures industry, particularly as it relates to the topic of this hearing, AFIA would very much like to have speculation position limits set and in place today, as well the additional regulatory and transparency provisions. But we need the CFTC to ensure that when it sets limits, they also are ready to monitor and report trading activity, and ready to ensure compliance with and enforcement of the new law. It is critical for all bona fide end-users to know we are on a level playing field with speculators and each other. Modern production agriculture is complex. The linkages between producers, end-users and uses of physical commodities are constantly evolving. The feed industry, for example, is still adjusting to the dramatic and rapid expansion of ethanol and other bioenergy industries. The intersection of corn, soybeans and other oilseeds for feed, food and energy--not mention other industrial uses for these crops--is our new reality, one that poses additional competition and risk management challenges for each of our respective industry sectors. This has also had the effect of linking corn futures to crude oil futures, adding further volatility to the entire commodity complex. We are confident the CFTC is prudently moving as efficiently as it can to implement the speculative limits and other provisions of the Dodd-Frank Act under its existing and new authorities while making sure it clearly and fully understands the complexities of the derivatives markets. While being patient with the rulemaking process does produce certain levels of stress, we remain confident in and appreciative of the CFTC's efforts to date, and hope to remain so. This brings me back to the beginning of my testimony. AFIA again applauds the Subcommittee, its Members and the full Committee for calling today's hearing to check in on the CFTC's progress on speculation limits. Your individual and collective interest in making sure progress toward implementation is both steady and correct does a great deal to reduce stress levels among AFIA's members. I urge you to consider additional hearings on the Commission's progress toward implementing all provisions of the Act. Thank you for inviting me to participate in today's hearing. AFIA and its members stand ready to assist you in these efforts. I look forward to answering any questions you may have. Attachment Marshall [presiding.] Thank you, Mr. Newman.Mr. Sprecher. CHRG-111hhrg52406--10 Mr. Royce," Thank you, Mr. Chairman. Well, beyond the problems with bifurcating consumer protection and solvency protection, a fundamental question remains. And that is, would a consumer financial products agency have stopped the issuance of subprime mortgages to consumers or Alt-A mortgages to consumers? I think it is fair to say the regulators we had in place, many of whom were responsible for consumer protection, were assisting in rather than hindering the proliferation of these subprime products, the proliferation of what are now called ``liar loans.'' In fact, it was because of regulators in Congress that these various products came into existence and thrived in the manner that they did. Subprime mortgages came out of CRA regulations, according to a former Fed official. And Fannie Mae and Freddie Mac purchased subprime and Alt-A loans to meet their affordable housing goals set by their regulators and by Congress. They lost $1 trillion doing that. The consumers frequently lost their homes as a result of the collapse of the boom and bust that was thus created. Instead of adding another government agency, and unwisely separating solvency protection from consumer protection, we should take a step back and look at the artificial mandates we place on financial institutions that inevitably distort the market which ends up in the long-term walloping the consumer and creating the kind of housing problem that we have today. Thank you, and I yield back, Mr. Chairman. " CHRG-109hhrg28024--37 Mr. Bernanke," Congresswoman, with respect to the Federal Reserve's policies, of course our mandate is maximum sustainable employment. We will strive for that mandate by maintaining a level of employment which is not only high but is also sustainable. In that way, we make it possible for better jobs to be created because we don't have seasonal and fluctuating jobs as we would in a boom/bust kind of cycle. So that's the contribution that the Federal Reserve will make. With respect to the relationship between productivity and real wages, I have some confidence that there will be some catch-up. During the late 1990s in the previous episode when productivity surged ahead, there was a period where labor's share declined below its long-term average and real wages fell somewhat behind productivity gains. After a couple of years, as the labor market strengthened, we saw that those gains translated into overall real wages. And I believe that as the market continues to strengthen now that we'll see real wages rising as well. That's a statement about overall real wages. It doesn't necessarily address the entire distribution of wages, and we've already discussed some of those issues. With respect to your question about education, I think an important point to make is that education is much more than K-12 and university. It involves continuing education. Community colleges play an important role. So does job training, on-the-job training. I think we need to promote those kinds of activities, and the Government has some role in assisting on that. " CHRG-111hhrg63105--27 The Chairman," I understand. So are you saying that you kind of expect to be on schedule for the agricultural commodities in April? " CHRG-110hhrg46591--402 Mr. Ellison," Are you familiar with this piece of legislation, the Commodities Futures Regulations Act? " FOMC20050322meeting--9 7,MR. KOS.," “Softs,” as they are called—things like agricultural commodities and metals." CHRG-111hhrg51698--31 Mr. Damgard," I would yield to Mr. Gooch on that. I think he is really the expert on the commodities defaults. " CHRG-111hhrg63105--146 Mr. Collura," Chairman Boswell, Ranking Member Moran, and Members of the Committee, thank you for the opportunity to testify on the importance of speculative limits for commodity dependent businesses and consumers. I currently serve as the Vice President of the New England Fuel Institute, which represents more than 1,200 mostly small, family owned and operated home heating companies. In 2007, in response to what was perceived as unpredictable and volatile commodities futures markets, and out of concern over possible excessive speculation in these markets, we partnered with the Petroleum Marketers Association of America and other business and consumer groups to form the Commodity Markets Oversight Coalition, or CMOC. I am delivering testimony today on behalf of this coalition, and I have submitted a list of supporting groups for the record. CMOC is comprised of an array of commodity dependent bushiness and industries, as well as faith-based organizations and groups representing average American consumers. We favor policies that promote stability and confidence in the commodity markets and that preserve the interests of bona fide hedgers and consumers. Our coalition endorsed title VII of the Dodd-Frank Act, which includes the most substantial reforms of the derivative markets in more than a decade. Members of this Committee, under the leadership of Chairmen Peterson and Boswell, and Ranking Members Lucas and Moran are to be commended for their years of hard work that resulted in the passage and enactment of this monumental piece of legislation. The Dodd-Frank Act includes various regulatory initiatives necessary for market transparency and to prevent fraud and manipulation and excessive speculation, including a requirement the CFTC establish speculative position limits for regulated and currently unregulated markets. The law requires that the CFTC establish position limits for energy commodities by January 17, 2011. However, we are disappointed that the Commission has recently come under pressure to delay the imposition of these limits by the deadline as required by law. Our coalition opposes any such delay. Some argue that the CFTC has not had enough time to thoroughly vet and consider the potential effects of such limits. However, the Committee should note that the Dodd-Frank Act does not provide the CFTC with the authority to establish limits. It actually expands existing authority. The Commodity Exchange Act of 1936 requires the CFTC to set position limits in order to prevent a single market participant from controlling price movements. The law sought to prevent undue burdens on interstate commerce resulting from excessive speculation and, as a consequence, cause sudden or unreasonable price fluctuations or unwarranted changes in the prices of commodities. However, the U.S. exchanges have abandoned hard energy speculation limits in favor of softer accountability limits. Under the leadership of Chairman Gensler, the CFTC in 2009 acknowledged that accountability limits were insufficient to prevent traders from taking controlling positions. Many traders were violating them with little or no action by the exchange. The CFTC held a round of hearings in the summer of 2009 and introduced a proposal in January. In the 4 months between January and April of 2010, the CFTC received well over 8,000 comments on the proposed rule, the vast majority urging strong and meaningful limits in speculation. During that time, some argued against the CFTC's proposed action out of fear that it would drive market activity from regulated exchanges under so-called dark markets; those that reported little or no data or were subject to little or no oversight. The CFTC should not act, they argued, until it was granted authority over the OTC and foreign markets and could implement limits across the board. The CFTC under the Dodd-Frank Act enjoys this authority. Once fully implemented, the Act will bring dark OTC markets to light by requiring exchange trading or clearing. It requires that foreign boards of trade that seek U.S. access first prove that they are subject to comparable oversight and regulation, including the imposition of position limits. In addition, many overseas regulators are drawing up their own plans to impose speculation limits. If the CFTC were to delay implementation of these limits here in the United States, the impetus for regulatory reform in other jurisdictions overseas could be jeopardized. The CFTC must act. Excessive speculation is real and it hurts. When prices surge to unjustifiable levels, consumers are left with higher food, gasoline, and home heating costs. Vital U.S. businesses, including manufacturers, airlines, truckers, and other transporters are hurt as well. Even still, some continue to believe that speculation can never be a bad thing. Despite ample evidence that excessive speculation has been destructive to commodity markets, some continue to doubt, question, or outright deny that speculation was ever or could ever be excessive. Make no mistake, we believe in open, transparent, and competitive markets and that new regulation must not excessively burden market participants or unnecessarily impede market liquidity. Speculators provide the market with this liquidity. But excessive speculation drives commodity prices to levels unjustified by market forces and results in price bubbles that harm commodity hedgers and users in the broader economy, as we saw in dramatic fashion with the commodity bubbles in 2007 and 2008. Establishing and imposing timely and meaningful limits will send a signal of confidence and stability, and help create more transparent, orderly, and functional commodities markets. Thank you again for the opportunity to testify. I look forward to any questions you might have. [The prepared statement of Mr. Collura follows:] Prepared Statement of James M. Collura, Vice President for Government Affairs, New England Fuel Institute; Founding Member and Spokesman, Commodity Markets Oversight Coalition, Washington, D.C. Honorable Chairman Boswell, Ranking Member Moran and Members of the Committee; thank you for the opportunity to testify before you today on the importance of position limits for commodity dependent businesses and consumers, and the broader economy and market stability. I currently serve as Vice President of New England Fuel Institute (or ``NEFI''), a not-for-profit home energy trade association that represents more than 1,200 mostly small, family owned- and operated-businesses. In 2007, in response to what was perceived as increasingly unpredictable and volatile commodities futures markets, and out of concern over possible excessive speculation in these markets, NEFI partnered with the Petroleum Marketers Association of America (or ``PMAA'') to form the Commodity Markets Oversight Coalition.\1\ I am delivering testimony today as a spokesman for this coalition.--------------------------------------------------------------------------- \1\ The Petroleum Marketers Association of America is a national federation of 47 state and regional trade associations representing over 8,000 independent petroleum marketing companies, including convenience store/gas stations, gasoline and diesel fuel retailers and suppliers, and home heating oil dealers.--------------------------------------------------------------------------- The Commodity Markets Oversight Coalition (or ``CMOC'') is an informal coalition whose participating members represent an array of business interests, including commodity producers, processors, distributors, retailers, commercial and industrial end-users, as well as groups representing average American consumers. The CMOC advocates in favor of government policies that promote stability and confidence in the commodity markets and that preserve the interests of bona fide hedgers, consumers and the broader economy.\2\--------------------------------------------------------------------------- \2\ The coalition, when formed in August of 2007, was referred to as the ``Energy Markets Oversight Coalition,'' but was changed to the ``Commodity Markets Oversight Coalition'' to reflect its members' interests in reforming derivative trading in a broad range of commodities, including agricultural and energy commodities.--------------------------------------------------------------------------- On July 21, 2010, President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act.\3\ Title VII of the Dodd-Frank Act, which was endorsed by members of the CMOC, included the most substantial new regulations of the U.S. derivatives markets in more than a decade. Members of this Committee, under the leadership of Chairman Peterson, Chairman Boswell and Ranking Members Lucas and Moran, are to be commended for their years of hard work that resulted in the passage and enactment of this monumental piece of legislation.--------------------------------------------------------------------------- \3\ Pub. L. 111-203.--------------------------------------------------------------------------- Obtaining the consensus necessary to assemble and retain support for Title VII of the Dodd-Frank Act was certainly no easy task. Many proposed reforms of the U.S. derivatives markets were met with great skepticism, if not outright opposition, from various special interests. Many market participants and stakeholders, from small businesses, farmers and energy end-users to massive Wall Street banks and trading houses, got involved in the debate. Despite efforts by opponents to misrepresent or create doubt about many of the derivatives reforms in the bill, Congress included various regulatory initiatives necessary for market transparency and accountability and to prevent fraud, manipulation and excessive speculation. But rather than taking a detailed and proscriptive approach to the most controversial provisions, the Congress ceded much discretion to financial regulators such as the Commodity Futures Trading Commission (or ``CFTC''). One clear example of this delegation of Congressional authority is the law's directive to CFTC to establish speculative position limits for regulated and currently unregulated markets such as over-the-counter swaps markets.\4\--------------------------------------------------------------------------- \4\ Ibid, 737.--------------------------------------------------------------------------- The Dodd-Frank Act requires that these limits be established ``in the spot month, in each other month, and in the aggregate across all months'' and provides the CFTC with discretion in defining exemptions for bona fide hedgers. The new law requires that the CFTC establish speculative position limits for what are defined by statute as currently ``exempt commodities,'' such as energy and metals, within 180 days of enactment, and for agricultural commodities within 270 days of enactment.\5\--------------------------------------------------------------------------- \5\ The Commodity Futures Modernization Act of 2000 (Pub. L. 106-554) created a new classification for commodities to be exempt from many trading rules under the Commodity Exchange Act, called ``exempt commodities,'' which includes any commodity other than an excluded or agricultural commodity.--------------------------------------------------------------------------- We commend CFTC Commissioner Gary Gensler and his fellow Commissioners for their commitment to timely enactment and enforcement of new regulatory initiatives under this Act and for engaging stakeholders in a thoughtful and transparent rulemaking process. Tomorrow, the CFTC will hold the eighth in a series of public meetings on the implementation of the Dodd-Frank Act. Tomorrow's meeting will include discussion and review of proposed rulemakings for position limits. Despite this transparent and inclusive process, the Commission has recently come under pressure to delay the formulation and imposition of position limits by the deadline required by law. Our coalition opposes any such delay.1. Imposition of Position Limits Is Not a New Idea The Dodd-Frank Act does not provide the CFTC with the authority to establish speculative position limits; it actually expands existing authority under the Commodity Exchange Act of 1936. Section 4(a) of that Act required the CFTC to set limits on market positions that traders can take in any commodity in order to prevent a single market participant from controlling price movements. The goal was to prevent an ``undue burden on interstate commerce'' that would result from excessive speculation and, as a consequence, cause ``sudden or unreasonable fluctuations or unwarranted changes in the price'' of commodities. Like the Dodd-Frank Act, the 1936 statue was enacted following a time of crisis for the economy, a catastrophic upheaval in U.S. financial markets, volatility and uncertainty in commodity futures markets and a debate over prudent regulation to remedy these problems and their causes. Farmers, arguing that speculation can indeed become excessive and manipulative, and therefore distort fundamentals and the price discovery function of futures markets, fought hard for position limits authority and won the day. In 1936, Federal regulators acted quickly to impose position limits on agricultural markets that resulted in sixty years of relatively reliable and orderly commodities futures markets for agricultural, and eventually, energy commodities. However, in the 1990s the commodity markets began to change dramatically as a result of digitalization, globalization and the Internet. Traditional open-outcry exchanges on LaSalle Street in Chicago and Wall Street in New York found themselves in competition with new electronic and off-shore trading platforms. In an effort to remain competitive in energy commodity futures, options and swaps, many exchanges abandoned hard speculation limits in favor of softer ``accountability limits.'' Shortly after his confirmation as CFTC Chairman, Gary Gensler acknowledged that accountability limits have time and time again proved insufficient in preventing traders from taking large positions in violation of these limits and with relative inaction by the exchange. In fact, the CFTC found that in the 12 months between July 2008 and June 2009, individual month accountability limits were exceeded for crude oil, gasoline, heating oil and natural gas by 69 different traders. Some traders even exceeded limits every day during the trading period.\6\--------------------------------------------------------------------------- \6\ Statement by CFTC Chairman Gary Gensler, Public Meeting on Establishing Position Limits, CFTC Headquarters, Washington, D.C., January 14, 2010.--------------------------------------------------------------------------- There are well documented cases in which individual traders violated accountability limits and their actions had major consequences for market hedgers and consumers. This includes the $6 billion collapse of Amaranth Advisors in 2006, one of the largest hedge fund collapses in U.S. history. A Senate Permanent Subcommittee on Investigations report in June 2007 found that ``Amaranth controlled 40 percent of all outstanding contracts on NYMEX for natural gas in the winter season (October 2006 through March 2007), including as much as 75 percent of the outstanding contracts to deliver natural gas in November, 2006.'' \7\--------------------------------------------------------------------------- \7\ Excessive Speculation in the Natural Gas Market, Senate Permanent Subcommittee for Investigations Staff Report, June 25, 2007.--------------------------------------------------------------------------- Amaranth occasionally held five or more times the ``accountability limit'' for natural gas, and according to the report, the NYMEX failed to take immediate action and in many instances where traders violated limits, never took any action. When the NYMEX finally ordered Amaranth to draw down its position, they simply moved their holdings onto an off-shore exchange where the CFTC and the U.S. exchanges had access to little or no data. But the size of the Amaranth position relative to the market eventually came back to haunt it, when in September, 2006 its position collapsed. The record surge in natural gas prices at the height of the Amaranth position and the subsequent collapse demonstrated that without hard position limits one trader alone can move these markets. This event led many industries to recognize the problems associated with exempting energy commodities from position limits and catalyzed the establishment of our coalition in August of 2007. It also proved that ``too big to fail'' exists in the commodities derivative markets and that commodity speculation can be at times excessive. It also exposed in dramatic fashion the inadequacies of so-called ``accountability limits'' and lack of oversight and transparency in the commodity markets. More frightening still was evidence that a growing majority of trading was now occurring on so-called ``dark markets,'' or markets that reported little or no data and were subject to little or no oversight and regulation. As policy makers deliberated on appropriate reforms, the market continued to deteriorate for end-users. The following year, energy prices surged to unjustified levels. In the summer of 2008, and despite declining demand and historically high inventories, crude oil topped $147 per barrel. Consumers faced unprecedented gasoline and home heating costs. Food prices similarly surged to record levels. As food became unaffordable and aide declined, riots broke out in at least 30 food important dependent countries. Manufactures, airlines, truckers and other transporters saw fuel prices surge, which caused inflation in the cost of goods and services for every American. But like almost every speculative bubble, this one eventually burst, leaving many farmers, manufacturers and other end-users stuck with unaffordable commodity pricing contracts. Shortly after his confirmation as CFTC Chairman last year, Gary Gensler acknowledged the need for immediate action to restore confidence and stability. The Commission began drafting proposed rules to address trading loopholes and exemptions, and to establish position limits for energy and metals. The Commission held a round of hearings in the summer of 2009 to solicit input from commodity hedgers, speculators, consumers and academics. Several members of this coalition delivered testimony before the Commission at this time.\8\--------------------------------------------------------------------------- \8\ Held on July 28 and 29, and August 5, 2010. (www.cftc.gov/PressRoom/Events/Events2009/index.htm)--------------------------------------------------------------------------- In January 2010, the CFTC proposed a rule for the establishment of speculative position limits for energy contracts, modeled largely after existing position limits that existed for agricultural commodities.\9\ During the comment period ending April 26, 2010, the CFTC received an unprecedented number of submissions, well more than 8,000 in all, the vast majority of which indicated support for strong and meaningful limits on speculation. Several CMOC member groups were among those comments, and many expressed reservations at the relatively ``high bar'' formul# recommended by the Commission.--------------------------------------------------------------------------- \9\ Notice of Proposed Rulemaking for Federal Speculative Position Limits for Referenced Energy Contracts and Associated Regulations, Commodity Futures Trading Commission, 75 FR 4143, Washington, D.C., January 26, 2010.--------------------------------------------------------------------------- Understandably, several Commissioners expressed reservations about establishing limits that could be considered too aggressive in light of the Commissions lack of authority over certain trading environments. At least two Commissioners feared in April that position limits would drive trade to ``dark'' over-the-counter and off-shore environments. The CFTC repeatedly called on Congress to give it authority over these markets, so that broad and uniform limits could be placed on all speculative positions and in all markets. On July 21, 2010, the agency got its wish when the Dodd-Frank Act became law. The CFTC has enjoyed 75 years of authority to establish speculation limits in commodity markets. After nearly 2 years of debate and passage of the most sweeping reforms in the history of the U.S. derivative markets, they now have the authority to establish said limits across the board to all traders and in all markets. We see little merit to the argument that the CFTC has not sufficiently considered the imposition of such limits. We are discouraged that, despite ample evidence of excessive speculation in commodities markets that some continue to doubt, question or outright deny that speculation was ever and could ever be excessive.2. Hard Speculation Limits Will Not Disrupt Markets Many CMOC participating groups represent vital commodity-dependent industries that have a steadfast belief in open, transparent and competitive markets. We believe that any new rules and regulations must be well reasoned, justified and not excessively burden market participants, or unnecessarily impede market liquidity. Speculators provide the market with this liquidity, but excessive speculation drives commodity prices to levels not justified by the market forces of supply and demand, results in pricing bubbles that harm commodity hedgers, end-users and the broader economy. We also believe that the commodity derivatives markets, when they were first established more than 150 years ago, did not have as their primary constituents Wall Street speculators and investors looking to make a fast buck, nor was the CFTC established by Congress to serve such constituents to the detriment of hedgers and consumers. Commodity exchanges were established to provide legitimate commercial businesses and end-users with a means to hedge risks associated with commodity prices. When unrestrained speculation is allowed to dominate markets and their hedging and price discovery functions, as we have clearly seen, it violates the Commodity Exchange Act's prohibitions on such activity. The CMOC rejects the contention of some in the financial services industry that limits to prohibit excessive speculation could be more disruptive to our markets more than excessive speculation itself. Last week, the IntercontinentalExchange (ICE), the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX) denied that timely imposition of limits would disrupt markets. Reuters reported on December 8th that the ``top U.S. futures exchanges expressed confidence that a revised plan to clamp down on commodities market speculation will not unduly burden the market'' if it uses the previous (January, 2010) proposed rule as a starting point.\10\ We believe the earlier proposed rule was insufficient to address ``the burdens of excessive speculation'' due to its very high limits. However, it is a starting point and because the CFTC now has authority to apply limits to previously exempt markets and participants, our coalition would be supportive of lower limits.--------------------------------------------------------------------------- \10\ Wallace, John and Steve Orlofsky, ``ICE, CME More Optimistic on CFTC Position Limits,'' Reuters News Service, December 8, 2010.--------------------------------------------------------------------------- Some argue that establishing limits expeditiously in order to meet what they consider to be negotiable or arbitrary deadlines under the Dodd-Frank Act will drive market activity off-shore to trading environments that are free from such limits (as we saw earlier with the Amaranth case). This argument is a red herring, as the Dodd-Frank Act anticipates this response and establishes new registration requirements for foreign boards of trade (FBOTs) that seek to allow access from within the U.S., provided they meet a list of comparable regulatory criteria, including the imposition of speculative position limits.\11\ The stated intent of the Congress was to prevent limits imposed by the CFTC to ``cause price discovery in the commodity to shift to trading on the foreign board of trade.''--------------------------------------------------------------------------- \11\ Pub. L. 111-203, 738 and 737(a)(4).--------------------------------------------------------------------------- In addition, regulators in Europe and elsewhere are currently in the process of drawing up their own plans to impose speculative position limits in addition to the many other transparency requirements and other regulatory initiatives prescribed by the Dodd-Frank Act. If the CFTC were to fail to apply aggregate position limits to implement the Dodd-Frank Act, the impetus for regulatory reform in other jurisdictions could be jeopardized. As we learn of the extraordinary measures that he Federal Reserve Bank took to provide European banks with hundreds of billions of dollars of loans on extremely favorable terms,\12\ we are reminded of the high cost of relying completely on financial industry self-regulation. Weak position limits or a return to position accountability would provide industry with de facto self-regulation.--------------------------------------------------------------------------- \12\ Harding, Robin with Tom Braithwaite and Francesco Guerrera, ``Europe's banks tapped Fed,'' Financial Times, December 2, 2010.--------------------------------------------------------------------------- On November 1, 2010, our coalition submitted preliminary comments regarding the implementation of various regulatory initiatives under the Dodd-Frank Act. We announced then our opposition to any delay in the formulation and imposition of speculative position limits. We also suggested that additional stability and restraint on speculation could be achieved were the CFTC to develop limits specifically for index funds and to distinguish them as separate and distinct from more traditional speculators.\13\ These so-called ``passive investors'' and their rolling contracts in energy and food commodities places commodities in a perpetual state of contango, where out-month futures prices are perpetually higher than spot prices. Such an investment strategy ignores market fundamentals and distorts the price discovery nature of the markets. These large funds have transformed commodities markets from a means to hedge fluctuating prices into a new asset class for pure financial accumulation.--------------------------------------------------------------------------- \13\ General Comments to the CFTC on the Implementation of Title VII of the Dodd-Frank Act, Commodity Markets Oversight Coalition, November 1, 2010, p. 6.--------------------------------------------------------------------------- We also agree with a recent suggestion by CFTC Commissioner Bart Chilton that separate limits might also be considered for high-frequency trading (HFT) or so-called ``computer algorithm-based trading'' or ``algo-trading'' in commodity markets. Today, HFT accounts for \1/3\ of all trading activity in U.S. futures markets and it is growing fast. Futures regulators and the Congress need to address this trend, especially in light of the ``flash crashes'' that have been witnessed in the securities markets, for which HFT has been considered at least partly responsible (including the 1000 point plunge in the Dow on May 6, 2010). Such ``flash crashes'' in the commodity trading markets could have devastating consequences for U.S. businesses and consumers.3. Limits Will Restore Confidence in Commodity Markets Establishing and imposing timely and meaningful speculative position limits as required by the Dodd-Frank Act will send a signal of confidence and stability to all market participants that end-users will again be able to rely on transparent, orderly and functional commodity markets. Continued inaction is not an option. Our coalition and the businesses and consumers we represent rely upon the CFTC to do their best to protect against fraud, manipulation and excessive speculation and to ensure a fair, transparent and accountable marketplace. Decisive action will be a strong and long overdue step in the protection of market integrity and the stability of the broader economy. As the 111th Congress comes to a close, we commend it--and especially the Chairs and Members of the Agriculture, Banking and Financial Services Committees--for the hard work, political courage and leadership that made derivatives reform possible. Generations of Americans will be forever grateful for what you've done. But now this legislative legacy is in the hands of regulators. We trust that they will implement and enforce new authority, and that the new Congress will continue to provide them with the political support and financial resources necessary to do so. Thank you again for the opportunity to testify. We would be pleased to answer any questions that you might have. AttachmentGroups Supporting Testimony ActionAid USA Air Transport Association California Black Farmers and Agriculturalists Association Colorado/Wyoming Petroleum Marketers Association Columban Center for Advocacy & Outreach Consumer Federation of America Consumer Watchdog Florida Petroleum Marketers Association Food & Water Watch Fuel Merchants Association of New Jersey Gasoline & Automotive Service Dealers of America Inc. Illinois Petroleum Marketers & Convenience Store Association Independent Connecticut Petroleum Association Louisiana Oil Marketers & Convenience Store Association Massachusetts Oilheat Council Maine Energy Marketers Association Maryknoll Office for Global Concerns Michigan Petroleum Association/Michigan Association of Convenience Stores Montana Petroleum Marketers & Convenience Store Association National Association of Oilheating Service Managers National Association of Truckstop Operators National Farmers Union Nebraska Petroleum Marketers & Convenience Store Association New England Fuel Institute New Mexico Petroleum Marketers Association New Rules for Global Finance New York Oil Heating Association North Dakota Petroleum Marketers Association Oil Heat Institute of Long Island Oil Heat Council of New Hampshire Oil Heat Institute of Rhode Island The Organization for Competitive Markets Petroleum Marketers Association of America Petroleum Marketers & Convenience Store Association Kansas Petroleum Marketers & Convenience Stores of Iowa Propane Gas Association of New England Public Citizen R-CALF--USA South Dakota Petroleum & Propane Marketers Association United Egg Producers Utah Petroleum Marketers & Retailers Association Vermont Fuel Dealers Association West Virginia Oil Marketers and Grocers Association Western Peanut Growers Western Petroleum Marketers Association " CHRG-111shrg55117--32 Mr. Bernanke," Yes, sir. You are absolutely right. Inventory liquidation is not complete yet, but it is substantially advanced, and that will be a support to production both here and perhaps even more so abroad, which will create a stronger global economy, which will be helpful indirectly. We expect a recovery, and there is still a great deal of uncertainty, but we expect a recovery to start off relatively slow, and in part it is because of the consumer who is facing a damaged balance sheet, still has high debt on the balance sheet. Wealth has been reduced by housing and equity price declines. So we do not expect the consumer to come roaring back by any means, particularly with the labor market in the condition that it is in. So the American consumer is not going to be the source of a global boom by any means. On that very topic we are continuing to encourage our trading partners in Asia and elsewhere to understand--and I believe that they do--that they need to substitute their own domestic spending, their own domestic demand, for American consumers as the engine of growth in their economies. And we are seeing, for example, in China, with their large fiscal package there and their attempts to strengthen their infrastructure spending, we are seeing some motion in that direction. So our anticipation is for a recovery that will start slowly, begin to pick up speed over time, but it depends very much on to the extent consumers can get comfortable with their financial situations going forward, and also to the evolution of the labor market. Senator Bennett. Thank you. " CHRG-111hhrg51698--405 Mr. Pickel," Well, we look at the existing structure under the CFMA in terms of the exempt commodities, the excluded commodities, and that structure is how we look at the treatment of different types of financial instruments. Ms. Herseth Sandlin. Okay. But I would like to just understand a little bit better. Since the draft legislation includes the authority to grant exemptions, do you question the CFTC's ability in particular to grant these exemptions? Is that where your concern lies? " CHRG-110hhrg44901--135 Mr. Bernanke," I believe so. Yes. Ms. Moore of Wisconsin. All right. I know that the CFTC and the SEC have been having talks. Do you think--this committee, by the way, doesn't have jurisdiction over the CFTC, and I think most of the questions have been related to commodities. Do you think that we need to modernize our regulatory system by having these commodities come under the same jurisdiction as the SEC? I know the CFTC and SEC have been talking about such a collaboration or merger, and I am wondering, do you think there would be any benefit in that? " CHRG-111hhrg63105--192 Mr. Collura," Right, versus the index funds which have a different investment strategy when it comes to commodity investments. " FOMC20070628meeting--117 115,MR. HOENIG.," Thank you. I will spend just a couple of minutes extra on the District this time because, generally speaking, our District economy continues to perform very well despite the weakness in the housing sector. Energy and agriculture remain very strong, and manufacturing remains generally strong although we have seen some leveling-off of that in the past month. The strength in these three sectors has helped spur broad-based job growth throughout the District and a significant tightening of our labor markets and their conditions. Many of our contacts report labor shortages and higher wage pressures. Demand for skilled labor remains very strong, and some firms have limited hiring plans because of the unavailability of qualified workers. To bolster recruiting, a few companies have partnered with vocational schools to offer industry- specific training programs to try to fill the gap. Since our last meeting, hiring announcements, which we try to track, have outpaced layoff announcements by a margin of 6 to 1. One anecdotal piece of information—we have some fairly large engineering firms in Kansas City that build power plants globally, including in China, and also ethanol plants. Last year, one CEO told me that they hired 2,100 engineers and were unable to fill 900 positions on a global basis. So there is a lot of activity going on out there. Construction activity remains mixed, with weakness in residential construction balanced by strength in commercial construction. On the residential side, we have seen some pickup in sales, but high inventories have limited new construction. For us, problems with subprime loans are concentrated in Colorado and in a few other areas. But because of the strength in energy and agriculture, some parts of the region are actually experiencing a housing boom, with strong home-price appreciation. Relative to the total market, that is small, but it is a rather sharp contrast. Conditions in agriculture are the best in recent years. Spring rains have alleviated drought conditions in much of our region. Strong demand and limited supplies continue to boost farm commodity prices and farm incomes. However, we are also beginning to see the effects of higher livestock and crop prices on retail food prices themselves. An additional concern is the sharp rise in land prices throughout much of our District. First-quarter cropland values in the District rose roughly 12 percent above year-ago levels, and ranchland values have strengthened as well, that much or perhaps a little more. Our contacts in the real estate industry indicate that some of the recent surge in land prices is speculative in nature, and some District bankers have expressed concern about the bubble in farmland values driven in part by the ethanol boom that we have heard about. In recent examination reports, our supervision staff have begun to see some increases in nonperforming real estate loans, and that includes some pickup in other real estate owned as well. These developments are very preliminary, but they are reminiscent of an earlier time, and we are trying to pay a little more attention to that. On the national outlook, data released since the last meeting support the view that growth will pick up over the year. I have been encouraged by the recent pickup in retail sales and by positive news on employment and personal income. At the same time, the recent increase in longer-term interest rates, if sustained, is likely to damp growth somewhat in the period ahead. In particular, the rise in the thirty-year fixed mortgage rate may deepen and prolong the ongoing housing slump. The combined effects of weaker growth in the first quarter and the rise of long-term rates have led me to lower my estimate of growth in 2007 to about 2.3 percent. I expect growth of 2.7 in ’08 and 2.8 in ’09. I now think the risks, perhaps, are roughly balanced. While the downside risk from housing remains, the outlook for other sectors, as others have reported, has appeared to improve. Markets seem to have adopted this view as well, as removal of the expected policy easing has contributed to the flattening of the yield curve at this point. In terms of the inflation outlook, recent data have been favorable, with core CPI on a twelve-month basis down to 2¼ percent. I expect continued moderation over the year. In particular, if owners’ equivalent rent continues at the slower pace of the past three months, it will help bring down the twelve-month core inflation number over time. Despite these recent improvements, I continue to believe that upside risks to inflation remain. The possible pass-through of recent energy and food price inflation to core inflation may slow progress toward lower inflation. In addition, pressures from resource utilization and slow productivity growth, if that happens to be the case, could affect that outlook as well. Finally, I am somewhat concerned with the recent uptick in longer-term inflation expectations. We have talked about the TIPS five-year, five-year-ahead breakeven inflation rate; as mentioned in the earlier briefing, it has increased about 20 basis points over the past month. So in light of these factors, I believe it is important that we continue to signal to the markets that current inflation rates are not acceptable over the longer term. Thank you." FOMC20060328meeting--130 128,MR. HOENIG.," Thank you, Mr. Chairman. A couple of things, first, on the region. Like the nation, our region continues to grow at a fairly robust pace. But one of the questions we kept asking in our discussions was whether it was strong but leveling out, or accelerating. I think, for the most part, the consensus is that it’s strong but leveling out. Turning to just a couple of examples, manufacturing activity did expand in February and, we think, in March on a preliminary basis, but at a somewhat slower pace than in January and even in December for us. Production and new orders rose only modestly in the February and early March period. Housing activity, as others have discussed, has shown some signs of leveling off, although it is still high by historical standards. Residential construction has edged down in most areas of our District, and builders to whom we’ve talked expect further easing in the months ahead. I think it is important, too, that home sales are showing little or no growth, with high-end sales softer than most of the other segments in our markets. Just to mention commercial real estate, it has actually improved somewhat in our region. Vacancy rates have continued to edge down in the Denver and Kansas City areas, so we have seen some pickup in activity. Energy activity continues to expand very rapidly, despite shortages of labor and equipment throughout the western part of our region. In some of our Rocky Mountain communities, concern has increased that the energy boom will drive away some of the other core business because of the costs of labor, land, and houses—it is really a boom environment there. I will talk quickly about inflation in our area. Wage pressures, in fact, remain mostly subdued. We have seen some backdown in wholesale prices, although retail prices have edged up. Manufacturers reported to us somewhat slower growth in raw material prices so far this year compared with last year. However, I would say they are also concerned that they cannot pass price increases on as they work through the process. Let me just say one thing on the auto industry in our region. I talked with one of the largest retailers-dealers in the region, in Denver—actually, he goes into Texas and some other areas. He told me that in just the first two weeks of March they’ve seen a general slowdown in some demand for their products, both domestic and foreign. But he said that, obviously, the domestic market is really suffering greatly. In fact, he has seen other dealers refuse to take inventory from the domestic auto dealers, which gives him real concern about that industry going forward. Turning quickly to the national outlook, I agree that, for the most part, it is very positive. I think that in the first quarter, maybe the first half, we will see a strong GDP number, perhaps as high as the Greenbook has indicated or even higher, which will then move back down toward the trend rate of growth over the course of the year. Like President Stern, I think part of this in the first quarter and first half is reflective of a couple of things. One is the bounceback from the year-end. Another is the last effects of accommodative policy that we had in the previous year, because a lot of money is still searching to be deployed right now but is beginning to be used up. And for the first time in a while, I’ve heard more and more businesses talk about the prime rate. I haven’t heard that in four years. They are much more sensitive to it. They’ve seen it go up, and now they’re negotiating around that, which I think tells you that some of the catch-up in terms of the policy effects of our past moves has begun, and I think you’ll see more of it in the coming months and quarters." CHRG-110hhrg34673--133 Mr. Garrett," Thank you, Mr. Chairman, and thank you, Mr. Chairman, for your testimony today. I appreciate your spending the time with us. I would like to go back and begin my questioning with a topic that is of great importance to me, and we have already touched on it, at least with one series of questioning, and that is dealing with GSE reform. On the one hand, I am pleased to see that the Administration is taking what I would say is a slightly tougher tone, if you will, on pushing for a brighter line test between what is appropriate and what is inappropriate between the primary and the secondary markets and what the GSE's are involved in. That is on the positive side. On the negative side, from my position, I have seen something of a softening with the Treasury stance with regard to portfolio limitations, which I believe should be a true concern to us. I know that there are ongoing negotiations, if you will, between the Treasury and our esteemed and gracious chairman behind us to try to reach a compromise on this issue, and as part of the negotiations there is consideration of what has been dubbed the MTI, the mortgage tax increase, better known as the ``Housing Fund,'' and I would be curious to have your take on an aspect of that. I raised a similar question to you when you were here before the committee a year ago and new on board, but I know since that time you have had an opportunity to get into the weeds a little bit more on this topic. You have already testified here and before other committees with regard to the importance of the housing market in general to our boom in the economy that we have had and the slight slowness of the housing market and what impact that could have on the overall economy. My first question to you is: What additional impact could we see if we did have a tax, if you will, on that marketplace by having a fee or an assessment on the GSE's for this new Housing Fund, or the MTI? " CHRG-111hhrg51698--175 Mr. Greenberger," President Roosevelt would have agreed with you, Congressman. Because, in 1934, he proposed the Commodity Exchange Act, which included speculation limits in it. That wasn't to bar speculation. It was to bar excessive speculation. The Act does bar excessive speculation. What we did in 2000 with the Commodity Futures Modernization Act was take oil futures, agriculture futures, and swaps outside of the speculation limits to ban not speculation, which we need, but excessive speculation. " CHRG-111hhrg63105--13 The Chairman," We would like to request that the other Members submit their opening statements for the record so the witnesses may begin their testimony and ensure there is ample time for questions. I would like to welcome our first panel which, of course, is the Honorable Gary Gensler, Chairman of the Commodity Futures Trading Commission and the Honorable Bart Chilton, Commissioner of the Commodity Futures Trading Commission. Chairman Gensler, welcome. Please begin when you are ready. FOMC20080805meeting--32 30,MR. KAMIN.," For the next couple of weeks, millions of people around the world will be watching the Olympic games in Beijing. For those of us charged with forecasting the global economy, of course, China-watching is a year-round task. But notably, the most salient developments since your last meeting have arisen outside of China. Chief among them, of course, have been the precipitous fluctuations in the price of oil. When the last FOMC meeting concluded on June 25, the spot price of WTI crude oil was running at $134 per barrel. It soared to over $145 by mid-July before plunging to about $119 as of this morning. The $26 per barrel drop over a three-week period was the largest on record in nominal dollar terms, although in percent terms, the 18 percent decline we've seen has been exceeded on a couple of occasions in recent years. Notably, many other commodity prices, especially those for natural gas and many food crops, also declined sharply. It has been heartening, and a welcome change, to see oil prices undershoot rather than overshoot our previous forecast. But it would be premature to pop open the champagne. We've seen several other steep declines in oil prices in recent years that gave way to renewed upward surges, and it remains to be seen whether an important shift in the supply�demand balance has occurred. Saudi Arabia added a total of 400,000 barrels a day to its production of oil in May and June, and there are indications that its production rose in July, too. However, these increases bring total OPEC production up only to their level in early 2006, and the world economy has grown considerably larger since then. Analysts have cited gloomier forecasts of global economic growth, and thus global oil demand, as contributing to the weaker oil prices; but those forecasts have been coming down for the past year with little apparent effect. Although oil consumption in the industrial economies clearly has slowed over the past year, we have yet to see either a concerted buildup in U.S. oil inventories or any indications that oil demand among developing countries is slowing. Therefore, a further lurch upward in oil prices is a distinct possibility. Moreover, with spot and futures prices having first soared and then plunged since your last meeting, the relatively flat path of oil prices that we are projecting is only about $12 per barrel lower, on balance, than in the previous forecast. In the meantime, indicators of foreign growth have come in a bit weaker than we expected, and inflation readings have been on the high side. These gloomier aspects of the international outlook counterbalance, to some extent, the improved tone of oil and other commodity markets. Clearly, prospects appear weakest in the advanced economies. Consistent with our earlier forecasts of a sharp deceleration in activity, we estimate that growth in all four of our largest industrial country trading partners--Canada, the euro area, the United Kingdom, and Japan--came in below 1 percent in the second quarter. In the United Kingdom, a sharp contraction in the housing sector appears set to drag the economy into a mild recession in the second half of this year. The remaining major economies should skirt recession but remain quite weak in the near term amid slackening export performance, continued stresses in financial markets, tightening credit standards, and very sharp erosions in business and consumer confidence. Why are the foreign industrial economies slowing about as much as in the United States, when the subprime crisis originated in this country and the major drag on the U.S. economy is the slump in a nontradables sector, housing? Clearly, part of the story involves the international financial linkages that have led foreign markets and institutions to share in the stresses and losses induced by the U.S. subprime crisis. Another part of the story involves a common shock--the global boom in oil and food prices--that has cut into real household income and spending around the globe. Third, even as the persistent decline in the dollar since 2002 has buoyed U.S. exports and growth, this has come at the cost of trade performance and economic activity in our trading partners. Finally, the foreign industrial countries have enjoyed little or none of the substantial monetary and fiscal stimulus we've seen in the United States over the past year. We estimate that growth in the emerging market economies also slowed further in the second quarter, to a pace of roughly 4 percent, where we have it staying for the remainder of the year. Obviously, this is well above the growth rate of roughly 1 percent that we've penciled in for the industrial economies, but it is still below their likely potential rate as many developing countries struggle with softening export demand and rising food and energy prices. Notably, however, even after slowing in the second quarter, estimated Chinese growth powered on at about 10 percent. By 2009, we see both foreign advanced and emerging market economies accelerating as financial stresses ease, the U.S. economy picks up, and commodity prices stop restraining the growth of real household incomes. This recovery scenario depends crucially on our projection that headline inflation starts moving down within the next quarter or two, so that substantial monetary tightening is not needed. The recent decline in oil and other commodities prices provides some comfort that this scenario will materialize. However, we saw some surprisingly sharp increases in consumer prices in June, bringing 12-month headline inflation to around 4 percent in the euro area and the United Kingdom, 5� percent in Mexico, and 6 percent in Brazil. In most of our major trading partners, inflation excluding energy and food prices has remained better contained; and in China, headline inflation has actually moved down from its February peak of 8.7 percent, registering 7.1 percent in June. Even so, until we see several quarters in a row of declines in aggregate measures of inflation, we will not be out of the woods. So far, the imprint of slowing foreign growth and rising foreign inflation on the U.S. external sector has been limited but not negligible. Turning first to prices, core import price inflation has moved up sharply, from about 3 percent last year to 11 percent in the second quarter; this was the fastest quarterly increase since 1987. Most of this acceleration was concentrated in material-intensive goods, such as food and industrial supplies, and was likely due to rising commodity prices rather than to more-generalized pricing pressures abroad. However, inflation in imported finished goods also increased this year. As we noted in a special box in the Greenbook, prices of imports from China have been moving up briskly as a result of increases in domestic costs and in the value of the renminbi. This step-up in the so-called China price explains less than one-fifth of the overall acceleration of core import prices but about one-third of the run-up in inflation for finished goods imports. Even so, assuming commodity prices stabilize going forward, we expect changes in overall core import prices to slow quite substantially in coming quarters. So far, U.S. external sector performance has held up well in spite of the slowing global economy. Net exports added 2� percentage points to real GDP growth in the second quarter, the largest quarterly positive contribution since 1980. Admittedly, much of this reflected a 6 percent decline in imports, which were dragged down both by weak U.S. demand and the quirky seasonal pattern in the data on oil imports. Even so, exports expanded at a very healthy 9� percent, supported both by the depreciation of the dollar and by continued robust demand for commodities. Going forward, we anticipate export growth holding up at a still healthy 7 percent or so, as foreign economic growth picks up right around the time that the boost from previous dollar depreciation starts wearing off. The contribution of net exports to U.S. GDP growth should move down, but this will chiefly reflect a recovery in imports as the U.S. economy picks up. Thank you. David and I will now be happy to address your questions. " CHRG-111hhrg74855--282 Mr. English," That was 1994, and we did have jurisdiction out of my subcommittee at the Commodity Futures Trading Commission back in those days. " CHRG-111shrg54589--13 Chairman Reed," Thank you very much, Chairman Schapiro. " Chairman Gensler,"STATEMENT OF GARY GENSLER, CHAIRMAN, COMMODITY FUTURES TRADING CHRG-111hhrg53234--158 Mr. Berner," Thank you, Mr. Chairman, Ranking Member Paul, and other members of the committee. Thanks for inviting me to this hearing to address this important question, the role of the Federal Reserve in systemic risk regulation. I think the broader question here is how should we address the significant weaknesses in our financial system and our financial regulatory structure that the current financial crisis has exposed? Among market participants, and I talk to many of them, I think there are two policy changes that are needed that are well recognized: first, strengthen our regulatory infrastructure; and second, adopt appropriate regulation oversight to mitigate systemwide risks across financial market instruments, markets, and institutions. In addition, I believe that macroeconomic policy should lean against asset and credit booms, which create financial instability. In my view, the Federal Reserve is best equipped to take the lead on systemic risk regulation and oversight. Like others, I think this function is an essential and natural extension of the Fed's traditional monetary policy role and of its responsibilities as lender of last resort. Three factors support that claim: First, the Fed is the ultimate guardian of our financial markets, and so it should be the agency that ensures the safety and soundness of the most important financial institutions operating in those markets. Second, the process of intermediation through traditional lenders in the capital markets has become increasingly complex. Supervision of the institutions involved will enhance the Fed's ability to make the right monetary policy decisions. And, finally, the Fed's expertise in financial markets and institutions makes it the natural choice for this role. The Fed's leadership in the Supervisory Capital Assessment Program demonstrated that expertise. In short, good monetary policy and financial stability, in my view, are complementary. Asset booms and busts destabilized the economy and financial system at great cost. A financial stability mandate for the Fed requires that focus on asset and credit booms as well as systemic regulation and oversight. And the policy tools required for each overlap substantially. That may explain why the other countries that separate such responsibilities from the traditional role of the central bank have fared no better than we did in this crisis. The U.K. is a good example. While the Bank of England and the Financial Services Authority clearly have collaborated in the recent crisis, their separation of powers did not help manage the current crisis more successfully than U.S. regulators. However, naming the Fed to this role won't solve all of our problems that I just enumerated. To see why, in the rest of my time, I outline some related remedies. I will conclude by answering the four questions you posed. In my view, our regulatory system has three major shortcomings: First, we supervise institutions rather than financial activities, which allows some firms to take on risky activities with inadequate oversight. A focus on systemic risk is one remedy for that problem. Designating the Fed to take the lead will limit risky activities and important market information slipping through the cracks, and it will promote supervisory accountability. Second, our regulatory safety net is excessively prone to moral hazard, encouraging inappropriate risk-taking. Concentration, as you have all alluded to in this hearing, in our financial services industry has created institutions that are too big to fail. Remedies needed should include: more extensive oversight and supervision of large, complex financial institutions; an explicit regulatory charge on such institutions to help us offset the moral hazard created by an implicit guarantee; and a strong resolution framework that is understood by all before crisis hits. An ad hoc approach creates uncertainty and reduces the credibility of policy. The third problem is procyclicality. Our regulatory infrastructure encourages excessive leverage, which magnifies financial market volatility. Three remedies needed here are: First, we need a stronger system of capital regulation that should improve financial stability and help monetary policy lean against the wind of asset booms. We must resolve the tension between accountants who want to limit reserves and regulators who want to build them--in favor of the regulators. Second, securities must be more transparent and homogeneous and less reliant on credit ratings. And third, to reduce settlement and payment system risk, we need greater use of central counterparties for over-the-counter derivatives. I want to conclude by answering your four questions. Are there conflicts with the Fed's traditional role here? Yes, there can be. In a crisis, decisions about particular firms likely would involve the Fed in inherently political considerations and the use of taxpayer funds that could compromise its independence. We should insulate the Fed's independence with two firewalls. First, the resolution of troubled financial institutions should fall to the FDIC; and, second, and globally, we must change institutions now too big to fail into being too strong to fail. Remedies will include many of the options I just discussed. Both firewalls should strengthen the Fed's role as lender of last resort by reducing moral hazard, especially by reducing the chance that we will keep nonviable institutions alive, a concern you have expressed. What are the policy pros and cons here? In my view, the pros outweigh the cons. Interconnectedness means that supervision must look horizontally across instruments, markets, institutions, and regions rather than in vertical silos. In my view, the Fed has the most expertise and reach to provide that. The Fed is also best positioned to prescribe and enforce remedies to procyclicality and to build financial shock absorbers. Now, I hasten to state the obvious: The Fed is imperfect. As the guardian of our financial system, the Fed in the past has come up short in a number of ways. I would only say that while we consider making the Fed the lead systemic regulator, the Fed and we must examine how it can improve its functioning to take on these new duties. What about the arguments against? Well, ensuring financial stability may be too big a job for just one regulator. Even if the Fed takes the lead, coordination with other regulators will be essential for success. Coordination with regulators and central banks abroad may be even more critical than being in sync with regulators at home. Our markets and institutions are global, but our regulation is largely local. So I like the President's recommendations for the Financial Services Oversight Council and international cooperation and coordination especially. Last, what about reassigning some Federal responsibilities to other agencies? Regulators should do what they do best. And, for example, as others have said, consumer protection and promotion of financial literacy could go to another agency, but I think that the Fed may still play a useful role in supporting these areas. Mr. Chairman, let me add that these views are mine and not necessarily those of my employer, Morgan Stanley, or its staff. I want to thank you for your attention. I am happy to answer any questions. [The prepared statement of Dr. Berner can be found on page 46 of the appendix.] " FOMC20050503meeting--69 67,MS. JOHNSON.," We collect import prices at the border, so to speak. So I can’t speak to the question of this showing through to retail prices. David might want to comment on that; I don’t know. Import price inflation has been surprising us a bit on the upside, and we have attributed part of that to higher global commodities prices. It shows up in our case in the industrial supplies types of categories, but we’ve seen some in the manufacturing area as well. When we break out the actual data for how import prices have moved, we’re getting contributions from both those pieces into import price inflation. So, relative to the last Greenbook, we have extended the period of elevated import price increases into the second quarter and a little into the third quarter because the global indexes of commodity prices—based on futures at this point for those periods—show the prices not rising further but remaining high, and we think it will take some time for that to be fully reflected in May 3, 2005 25 of 116 last year was that commodity prices tended to be showing up more rapidly in U.S. import prices than our models would suggest is the historical average. We have that as a second term, in addition to foreign prices and the exchange rate and so forth. So embedded in our story is that import prices were high in the first quarter and will decelerate somewhat in the second and third quarters, but not hugely and not as much as we had thought before. It involves a somewhat more extensive pass-through of high global commodity prices into import prices, and a little bit is probably still the effect of dollar depreciation at the end of 2004. Those things, in essence, go away thereafter, and we have import price inflation dropping down very much—to less than 1 percent in 2006. That is conditioned on two assumptions: the assumption we have been making routinely for the dollar of late—because we don’t know a better one to make—which is that it will change only little going forward; and the futures path for commodity prices. So the projection that import prices will decelerate in stepwise fashion through the second half of this year and into 2006 is very much a reflection of these two conditioning assumptions. And we don’t have a whole lot of information other than that." CHRG-110shrg50369--26 Mr. Bernanke," Well, Senator, to answer that question, the PPI, the Producer Price Index, that you referred to mostly reflects the effects of large increases in prices of energy and other commodities. We live in a world where energy and metals and other commodities are globally traded, food as well, and demand of emerging market economies and a growing global economy has put pressure on the available supplies of those resources and has driven up those prices. And as I mentioned, the price of oil has quintupled or more. Senator Shelby. Do you see that abating? " FOMC20050322meeting--31 29,CHAIRMAN GREENSPAN., And the weight of steel is much larger than copper and aluminum combined. So it’s an odd sort of commodity index. CHRG-111hhrg53246--23 The Chairman," Chairman Gensler. STATEMENT OF THE HONORABLE GARY GENSLER, CHAIRMAN, COMMODITY FUTURES TRADING COMMISSION (CFTC) " FOMC20050503meeting--58 56,VICE CHAIRMAN GEITHNER.," David, you referred in your remarks to the exercise shown in the package of materials for Monday’s Board briefing. I’m looking at the pass-through into core inflation of the rise in energy prices, import prices, and commodity prices. If back in December ’03, which is your baseline for this exercise, you had had a forecast for energy prices, commodity prices, import prices, and the dollar that is consistent with what happened, would you have expected your model to show this much pass-through to core inflation prices? Or would this result have been surprising?" FOMC20080430meeting--74 72,MR. PLOSSER.," Thank you, Mr. Chairman. I have two questions. One, in comparing the staff's forecast with a lot of the private-sector forecasts--what it looks like and its shape--one thing that is striking about the forecast is the very large adjustment swing that occurs in inventories. My interpretation is that one thing that is occurring in the way you've made adjustments to your forecast--or maybe this is more of a question--is that the spending of the tax rebates appears to be occurring out of inventories. Therefore, there is no production response, or less production response, to the presumably increasing demand that may materialize. Can you give me some feeling about why you chose that way of treating this? The second question goes back to inflation. I thought your discussion of the uncertainties around inflation was excellent. Part of what you talked about in the Greenbook was the uncertainty about pass-throughs of commodity price increases and oil price increases into various measures of consumer price inflation, which you indicated were imprecise and which we don't really know much about. I was struck that, if there is more pass-through than the baseline says, we're going to get more inflation in the near term, and then disinflation will be more rapid when you assume that commodity prices are going to come down. But if commodity prices only stabilize and don't come down, then it's going to be a more complicated picture. You do have an alternative scenario that says that commodity prices keep rising, but you allow expectations to move up only fairly modestly in the model. It seems to me that, particularly if expectations become more unanchored than that, the time paths of the funds rate that are implicit in the simulations become much more aggressive on the other side. I just want to make sure that my intuition is correct here. " CHRG-111hhrg56767--114 Mr. Royce," Again, I raise this issue not because this $6.3 million is going to make Fannie and Freddie solvent again, but because as we look at the housing boom and bust, which caused the financial collapse, one of the roads leads to Fannie Mae and Freddie Mac. Some of us were raising alarms about these institutions long before their failure and well before their accounting scandals, and we understood the fundamentally flawed structure of socialized losses and privatized profits. We saw the overleveraging and the build-up in junk loans there. Frankly, the Federal Reserve came and warned us about it. We had an obligation to the taxpayers to prevent their failure, but we failed, largely because of Chuck Hagel's bill the Fed had requested which passed out of committee on the Senate side and was blocked by the lobbying of Fannie and Freddie. Fannie and Freddie executives leaned in and said no, in terms of those portfolios, in terms of the issue of the overleveraging and the arbitrage which the Fed was trying to get a handle on, we want to block that, and that legislation was blocked. Now, because of that failure, the taxpayers own 80 percent of those companies. We now have an obligation, I think, to see that those most responsible for this failure are held accountable. If the FHFA fails to take action to: first, get the money back from the legal defense fees; and second, curb these executive payouts, then I hope Congress would intervene. These are wards of the state. In my view, at the end of the day, they should be treated as wards of the state. I will yield back, Mr. Chairman. " CHRG-111hhrg53021Oth--107 Secretary Geithner," It is absolutely recognized, and it is a significant issue of concern. But, what is causing those pressures on both borrowers and banks is the fact that large parts of the financial system in this country just took on too much risk during the boom. And the costs of that--it is fundamentally unfair, but that is what happens in financial crises--fall not just on those who took too much risk, but they fall on a bunch of businesses and banks across the country which were very responsible and prudent. And that is why these things can be so damaging. And that is why it is very important that we do everything we can to put a better foundation for recovery in demand and growth, and try to make sure that the financial system has capital where it is necessary, and that these markets for credit start to get moving again. And that is the basic philosophy that has underpinned everything we have done. You are also right that there is a risk in financial crises that people overcorrect; that, after a period of taking on too much risk, that they take too little. People that got way overextended pull back too much. And that can cause, also, a lot of collateral damage. And, again, that is the basic rationale in a financial crisis for trying to make sure you do as much as you can to provide enough support for the economy to get back on track. But, I am very much aware of the concerns you expressed. I believe that the principal bank supervisors are, too. They are carefully managing those risks. And you are also right that any time you think about reform to legislation in the financial area, that is going to come with a period of uncertainty. We need to minimize that uncertainty. And, that is one reason why we want to bring clarity, relatively quickly, to the rules of the game that govern our financial system, going forward. If we were to wait years to do this, the markets would be left with a greater period of uncertainty, and that might deter more lending and risk taking. " CHRG-111hhrg53021--107 Secretary Geithner," It is absolutely recognized, and it is a significant issue of concern. But, what is causing those pressures on both borrowers and banks is the fact that large parts of the financial system in this country just took on too much risk during the boom. And the costs of that--it is fundamentally unfair, but that is what happens in financial crises--fall not just on those who took too much risk, but they fall on a bunch of businesses and banks across the country which were very responsible and prudent. And that is why these things can be so damaging. And that is why it is very important that we do everything we can to put a better foundation for recovery in demand and growth, and try to make sure that the financial system has capital where it is necessary, and that these markets for credit start to get moving again. And that is the basic philosophy that has underpinned everything we have done. You are also right that there is a risk in financial crises that people overcorrect; that, after a period of taking on too much risk, that they take too little. People that got way overextended pull back too much. And that can cause, also, a lot of collateral damage. And, again, that is the basic rationale in a financial crisis for trying to make sure you do as much as you can to provide enough support for the economy to get back on track. But, I am very much aware of the concerns you expressed. I believe that the principal bank supervisors are, too. They are carefully managing those risks. And you are also right that any time you think about reform to legislation in the financial area, that is going to come with a period of uncertainty. We need to minimize that uncertainty. And, that is one reason why we want to bring clarity, relatively quickly, to the rules of the game that govern our financial system, going forward. If we were to wait years to do this, the markets would be left with a greater period of uncertainty, and that might deter more lending and risk taking. " FOMC20080318meeting--41 39,MR. SHEETS.," Over the intermeeting period we have lived through an experience that manifests the upside risk to our inflation forecast; and I would indicate that, with the � percentage point markup to headline foreign inflation in 2008 in our forecast, the vast majority of that is a reflection of these red-hot commodity markets, which then presses the question to us, Well, what is going on there? Certainly, in the case of the demand in these markets, by now I would have expected to have seen some attenuation or a bit of softening. Really, it seems to be quite the opposite. The demand since the first of the year has accelerated. Some other factors are at work as well--idiosyncratic supply stories, electrical outages that made it harder to smelt aluminum and copper, and so on. So there are some supply factors as well. The demand side seems to be important, and to the extent that demand remains strong, I am not sure where these commodity prices are going to top out. The futures path is a reasonable guess at sort of the balance of supply and demand. There is also some upward pressure on these prices from the depreciation of the dollar. But to the extent that commodity prices move up, I would say that we will probably be marking up our forecast of foreign inflation next time. Just a broader comment on the linkages between the U.S. and the foreign economies-- again, I was surprised at the strength of demand in these commodity markets. I would have expected by this point to have seen more marked evidence of slowing in the foreign economies. So we have marked down our forecast for 2008 in line with these prospective developments, the further slowing in the United States, and the financial stresses. But we didn't mark down our forecast very much, just a tenth or two, and mainly in Canada in Q1; and the data that we have in hand are not pointing to a dramatic slowing. We are expecting more of that to come through in the second and the third quarters. " fcic_final_report_full--199 In June  Freddie Mac staff made a presentation to the Business and Risk Committee of the Board of Directors on the costs of meeting its goals. From  to , the cost of the targeted goal loans was effectively zero, as the goals were reached through “profitable expansion” of the company’s multifamily business. Dur- ing the refinance boom, the goals became more challenging and cost Freddie money in the multifamily business; thus, only after  did meeting the multifamily and single-family goals cost the GSE money. Still, only about  of all loans purchased by Freddie between  and  were bought “specifically because they contribute to the goals”—loans it labeled as “targeted affordable.” These loans did have higher than average expected default rates, although Freddie also charged a higher fee to guaran- tee them. From  through , Freddie’s costs of complying with the housing goals averaged  million annually. The costs of complying with these goals took into account three components: expected revenues, expected defaults, and foregone revenues (based on an assumption of what they might have earned elsewhere). These costs were only computed on the narrow set of loans specifically purchased to achieve the goals, as opposed to goal-qualifying loans purchased in the normal course of business.  For comparison, the company’s net earnings averaged just un- der  billion per year from  to .  In , Fannie Mae retained McKinsey and Citigroup to determine whether it would be worthwhile to give up the company’s charter as a GSE, which—while af- fording the company enormous benefits—imposed regulations and put constraints on business practices, including its mission goals. The final report to Fannie Mae’s top management, called Project Phineas, found that the explicit cost of compliance with the goals from  to  was close to zero: “it is hard to discern a fundamen- tal marginal cost to meeting the housing goals on the single family business side.”  The report came to this conclusion despite the slightly greater difficulty of meeting the goals in the  refinancing boom: the large numbers of homeowners refinanc- ing, in particular those who were middle and upper income, necessarily reduced the percentage of the pool that would qualify for the goals. In calculating these costs, the consultants computed the difference between fees charged on goal-qualifying loans and the higher fees suggested by Fannie’s own mod- els. But this cost was not unique to goal qualifying loans. Across its portfolio, Fannie charged lower fees than its models computed for goals loans as well as for non-goals loans. As a result, goals loans, even targeted goals loans, were not solely responsible for this cost. In fact, Fannie’s discount was actually smaller for many goal-qualifying loans than for the others from  to . Facing more aggressive goals in  and , Fannie Mae expanded initiatives to purchase targeted goals loans. These included mortgages acquired under the My Community Mortgage program, mortgages underwritten with looser standards, and manufactured housing loans. For these loans, Fannie explicitly calculated the oppor- tunity cost (foregone revenues based on an assumption of what they might have earned elsewhere) along with the so-called cash flow cost, or the difference between their expected losses and expected revenue on these loans. For , as the market was peaking, Fannie Mae estimated the cash flow cost of the loans to be  million and the opportunity cost of the targeted goals loans  million, compared to net income that year to Fannie of . billion—a figure that includes returns on the goal- qualifying loans made during the normal course of business.  The targeted goals loans amounted to  billion, or ., of Fannie Mae’s  billion of single-family mortgage purchases in .  As the markets tightened in the middle of , the opportunity cost for that year was forecast to be roughly  billion.  FOMC20050322meeting--36 34,MR. STOCKTON.," It is the case, however, Mr. Chairman, that there has been a broad- based upward movement in commodity prices in the last four weeks. So—" CHRG-111hhrg52397--179 Mr. Johnson," Well, I think the pricing is more stable, although we had some wild gyrations that went on after the Lehman failure. I think the more stable and the more commodities and-- " FOMC20050322meeting--10 8,CHAIRMAN GREENSPAN., Agricultural commodities. But grain prices have come down in the most recent data. I assume iron ore is in there? CHRG-111hhrg74855--168 Mr. Walden," I think one of the issues that has been raised is that this should be clear it doesn't cover the physical delivery of commodities such as electric power and gas, and is that clear? " FOMC20050630meeting--325 323,MS. JOHNSON.," Yes. And remember, what we’ve done is just decelerate foreign activity; and we’ve hugely decelerated commodity prices." FOMC20060920meeting--142 140,MR. KOHN.," Thank you, Mr. Chairman. Whatever you want to call me is fine. [Laughter] I’m just glad to be here. [Laughter] I don’t think I can follow that up. Given the initial conditions—the doubling and more of energy prices over the past two years, the overexuberant housing market coming to grips with a renormalization of interest rates, a very low personal saving rate, and an uncomfortable increase in inflation this spring—a period of modestly below-trend growth and gradually ebbing inflation, as in the Greenbook forecast, is about as good an outcome as we can expect, as Dave Stockton noted. In that regard, several developments over the intermeeting period have made me a bit more comfortable with the plausibility of such an outlook. The weakness in housing has deepened and is more definitively leading to growth of output below potential. In fact, in my view the behavior of the housing market constitutes the main downside risk to sustained moderate economic growth. We’re in the middle of a housing adjustment, which has been hard to forecast, especially because it involves the unwinding of an unknown amount of speculative demand. With inventories rising and reports of price cuts getting greater prominence, the market isn’t yet showing signs of clearing and stabilizing. In the Greenbook forecast, residential investment, though weak, is supported by continued growth of income and relatively low mortgage rates, while house prices basically level out in nominal terms. As the Greenbook notes, however, this forecast leaves some aspects of the existing disequilibrium intact, most notably the high level of prices relative to rents. Also, the cutback in construction doesn’t completely offset the apparent excess building of the boom period. As a consequence, I see the housing forecast in the Greenbook as very far from the worst-case scenario that President Minehan characterized it as. And, we are just beginning to see the effect of the downshift in house-price inflation on consumption starting to play out. Outside of housing, however, recent developments should help to sustain continued economic expansion. Financial conditions remain quite supportive of both business and household spending. Long-term interest rates have fallen appreciably since midyear, and they are low in both real and nominal terms. Risk spreads are narrow, banks have not pulled back on business credit, and equity prices have risen on balance in recent months. Lenders and investors appear to remain confident that the economy will continue to expand at a decent pace. Higher levels of labor income in the first half of the year, along with a favorable effect on disposable income of a decline in energy prices, will help support consumer spending going forward. Economies elsewhere seem to be expanding at a solid clip. Moreover, they are probably less vulnerable to spillovers from a housing-led slowdown of growth in the United States than they were to weakness in 2001. That weakness was centered in a global market for investment goods and was reflected in global declines in equity prices. The less robust economy should present businesses with a more competitive environment in which it will be harder to pass through cost increases. In addition, the decline in energy prices, along with the leveling out of other commodity prices, will reduce cost pressures on businesses and should feed through in some measure to lower core inflation, especially as slower growth damps pricing power. The drop in energy prices has already restrained inflation expectations a bit. For all these reasons, I’m also a little more comfortable with the forecast of gradually ebbing core inflation. Nonetheless, I still see significant upside risk to such a path for inflation. In part, this reflects my uncertainty as to the reasons for the rise in inflation this spring and summer. Feed- through of energy and other commodity prices must have contributed to some extent, and we can see evidence of this in the greater price increases for some of the more energy-intensive sectors, such as for airfares. A portion of the pickup is in the rent-of-shelter category, likely from a shift to rental housing as expectations of house-price appreciation have been scaled back. But price increases have picked up in a number of other categories, and although energy costs probably accounted for some of this acceleration, we can’t dismiss the possibility that other forces were at work—for example, more general pressure of demand on potential output. A reduction of those types of pressures is still only a forecast. On the cost side, as many have commented, the compensation and unit labor cost data, while flawed in many respects, could be pointing to a risk that higher labor costs will persist, putting pressure on prices that might only be partially and reluctantly absorbed by profit margins. In sum, Mr. Chairman, I’m a bit more comfortable with something like the path for the economy and inflation in the Greenbook forecast, but uncertainties are quite high. They might even justify the “higher than usual” description. The downward path for inflation remains at risk, and as others have noted, the costs of exceeding that path could be disproportionate. Thank you." CHRG-111hhrg51698--587 Mr. Marshall," I just want you to assume that we have concluded that they are destabilizing. It is because they have a different interest. It is a longer-term view of things. They have been instructed to take a position that is just part, say an endowments fund, and it is part of our portfolio management strategy. We are going to take a position in commodities, and the way we choose to do that is we go through Goldman Sachs' Commodity Index Fund, stay longer, we do it some other way, but basically we effectively get on the futures market as a way to hedge our long-term position. We have done that, and we are not really acting like the traditional speculator, each day trying to figure out where things are going. " CHRG-110hhrg44901--132 The Chairman," The gentlewoman from Wisconsin. Ms. Moore of Wisconsin. Thank you, Mr. Chairman. And thank you, Mr. Chairman, for all the work that you did over the weekend for sort of cooling out the housing crisis. I read through your testimony, and I was very interested in your comments regarding the commodities market. You say that you doubt that financial speculation is the cause, a causal factor, in the upward pressures on oil prices, but you find that you are baffled by what it could be. You say that ``this is not to say that useful steps could not be taken to improve the transparency and functioning of futures markets, only that such steps are unlikely to substantially affect the prices of oil and other commodities in the longer term.'' I was curious. I would like for you to expand on that and explain that to me. " CHRG-110hhrg44901--72 Mr. Bernanke," Well, as we look back on it, we see that there were just some serious failures in the management of risks. There were many firms that had exposure to the housing market in a variety of ways across the firm, including holding mortgages and other ways. And they didn't fully appreciate that in the contingency that the housing boom would turn around, that house prices would begin to drop; they didn't fully appreciate their exposure to that situation. The regulators bear some responsibility on that. It is our job to make sure that they measure and manage their risks appropriately. We have been working on that for a number of years related to bank supervision initiatives like the Basel Initiative, for example, and so on. But it is clear that we need to redouble our efforts to make sure that the risk management is sound, that the underwriting is sound, and that we don't get ourselves into this kind of situation again. Ms. Pryce. Well, you mentioned Basel. Are there further risks ahead to our system and therefore the overall economy that might arise, and the new capital adequacy standards in Basel? You know, if we are trying to have this happen simultaneously, could that create new risk to the system? Effects of a crisis in any overseas market, could that affect our system in a negative way? Further decline in the dollar. There is a list of many things that could potentially happen. One of the things I would like your comment on is the commercial real estate market. You know, many banks astutely avoided the subprime lending, and they instead expanded their commercial real estate lending. So everywhere we turn we see increased vacancy signs and downward pressure on rents. And do we expect another wave of pressure from that market? And are we planning ahead as a country to address these things as opposed to, you know, being reactionary as it seems that we have had to be of late? " CHRG-111shrg52619--106 Chairman Dodd," I am sorry, Senator. Senator Menendez. No. Thank you, Senator Dodd. I appreciate it. Just one more line of questioning. You know, we had a witness before the Committee, Professor McCoy of the University of Connecticut School of Law, and she made some statements that were, you know, pretty alarming to me. She said, ``The OCC has asserted that national banks made only 10 percent of subprime loans in 2006. But this assertion fails to mention that national banks moved aggressively into Alternate-A low-documentation and no-documentation loans during the housing boom.'' ``Unlike OTS, the OCC did promulgate one rule in 2004 prohibiting mortgages to borrowers who could not afford to pay. However, the rule was vague in design and execution, allowing lax lending to proliferate at national banks and their mortgage lending subsidiaries through 2007.'' ``Despite the 2004 rules, through 2007, large national banks continued to make large quantities of poorly underwritten subprime loans and low- and no-documentation loans.'' ``The five largest U.S. banks in 2005 were all national banks and too big to fail. They too made heavy inroads into low- and no-documentation loans.'' And so it just seems to me that some of the biggest bank failures have been under your agency's watch, and they, too, involved thrifts heavily into nil documents, low documents, Alternate A, and nontraditionals, and it is hard to make the case that we had an adequate job of oversight given those results. We have heard a lot here about one of our problems is regulatory arbitrage. Don't you think that they chose your agency because they thought they would get a better break? " CHRG-110shrg50409--85 Mr. Bernanke," Well, there are a number of pieces of evidence against the view that speculation is a primary force. I mentioned in my testimony the absence of hoarding or inventories that you would expect to see if speculation was driving prices above the supply demand equilibrium. There are a number of studies which show that there is little or no connection between the open interest taken by non-commercial traders in futures markets and the subsequent movements in prices. It is also interesting to note that there are many commodities--or at least some commodities--that are not even traded on futures markets, like iron ore, for example, which have had very large increases in prices. So I think the evidence is fairly weak. That said, I think that transparency in futures markets, information available to the overseer, the CFTC, is a positive thing. And I expect that the CFTC will come forward with some suggestions in that regard. But I just do not think it is going to be a magic bullet to address this very difficult problem of high oil and commodity prices. Senator Martinez. In other words, well, it might be helpful and useful to have more transparency ultimately. The supply and demand equilibrium is only going to be impacted by more supply or less demand. " FOMC20050322meeting--123 121,MR. BERNANKE.," Thank you, Mr. Chairman. We are experiencing a mini-inflation scare in financial markets—a development that we need to take very seriously. The primary reason for the scare was the recent rapid increase in the prices of oil and other basic commodities. Other determinants of inflation, it should be noted, seem to be largely under control. Still-strong productivity growth and subdued wage increases have been sufficient to induce some recent deceleration in unit labor costs. At the sectoral level, recent increases in auto prices seem unlikely to continue, given the industry’s inventory overhang. And I note that this morning’s report showed a 0.9 percent decline in February in auto prices. Prices of imported consumer goods have also been remarkably tame, rising about 1 percent in the year to January despite the fall in the dollar. And the influx of low-cost apparel imports associated with the end of the Multifiber Agreement should provide more help on that front. Inflation in services is stable, and far future inflation compensation, which effectively strips out oil effects, has not risen. How serious is the inflation risk posed by rising commodity prices? One view, which, if correct, would be quite worrisome, is that commodity prices are the canary in the coal mine— indicators of easy monetary policy and building inflationary pressure. I don’t find this view persuasive, and I note that the academic literature has found essentially no support for it. Instead, recent commodity price increases seem to be largely the result of economic developments unrelated to U.S. monetary policy, which I would call supply shocks, although without disagreeing with President Poole. What we’re saying here is that China is exogenous. [Laughter] In the case of oil, for example, international agencies have recently revised downward their projections of non-OPEC March 22, 2005 57 of 116 likelihood that growth in demand this year will be disproportionately concentrated in energy- inefficient countries, such as China. The weak dollar, which I suspect is responding more to the current account situation than to monetary policy per se, is also affecting the oil price. Since 2000, oil prices have risen 98 percent in dollar terms, but they have also risen by 45 percent even in euro terms and by 76 percent in yen terms. If the supply shock interpretation is correct, then the effects on core inflation of the recent run-up should be moderate. As is well known, commodities and raw materials make up a small share of producers’ costs. For example, the staff estimates that even in a full employment situation, in which firms have some pricing power, a 1 percent increase in the core PPI for intermediate goods should result in less than a 5 basis point increase in the core CPI. By the way, I think that fact helps to reconcile to some extent the benign inflation numbers with the anecdotal reports of price increases, since many of them take place at the intermediate level. An interesting datum from last week’s survey of 22 primary dealers is that, on average, they expect core PCE inflation of 1.91 percent at an annual rate during the third quarter of this year, up only 6 basis points from what they expected for the same period as of the week before the last FOMC meeting. If we are, indeed, facing a supply shock, then to some extent the situation is analogous to where we were last spring when inflation pressures proved transitory and policy patience paid off. However, all economists have two hands. And on my other hand, I agree that there are also important differences from the situation last spring. The expansion has considerably more March 22, 2005 58 of 116 would not like to see it go much higher. Finally, futures markets suggest that this time the shocks to commodity prices are expected to be relatively more permanent than they were last time. For these reasons, the risks to both the output and inflation objectives of a slightly more aggressive policy posture seem fairly modest. My bottom line is that I support raising the funds rate by only 25 basis points today. However, I believe that it would behoove the Committee to modify the statement in a way that signals the possibility of stronger actions in the near future. Thank you." CHRG-111hhrg63105--94 Mr. Luetkemeyer," What is the impact with the lack of a rule? If we keep putting this off or we delay, what is the impact on the markets? What is the impact that we can expect for our farmers and our commodity folks? " CHRG-111hhrg51698--331 Mr. Lucas," Thank you, Mr. Chairman. Mr. Pickel, would you care to comment on Mr. Taylor's testimony that this bill will not discourage speculators from participating in commodity markets? " CHRG-111hhrg56847--26 Mr. Bernanke," The signal that gold is sending is in some ways very different from what other asset prices are sending. For example, the spread between nominal and inflation index bonds, the breakeven remains quite low, suggests that markets expect about 2 percent inflation over the next 10 years. Other commodity prices have fallen quite severely, including oil prices and food prices. So gold is out there doing something different from the rest of the commodity group. I don't fully understand the movements in the gold price, but I do think that there is a great deal of uncertainty and anxiety in financial markets right now and some people believe that holding gold will be a hedge against the fact that they view many other investments as being risky and hard to predict at this point. " CHRG-111hhrg55811--16 The Chairman," We will now begin with our witnesses. We have the Chair of the Commodities Futures Trading Commission. And let me acknowledge, particularly in the presence of the ranking member of that committee, that the primary jurisdiction over this agency is in the Agriculture Committee. And I want to say I am very pleased because I think jurisdictional disputes are Congress at its worst. Egos and pettiness come out. We have worked very closely with the Agriculture Committee, that was in complete agreement, and I thank the gentleman for acknowledging that. We even had an unusual joint hearing on the subject. And we will continue to work with the Agriculture Committee because cooperation between our two committees, as between these two agencies, is essential if we are going to get this job done. " Chairman Gensler," STATEMENT OF THE HONORABLE GARY GENSLER, CHAIRMAN, COMMODITY CHRG-111hhrg74855--378 Mr. Duane," The only point I will add is to remind everyone here that electricity is an extraordinary volatile commodity and the ability to hedge that price volatility is essential. " CHRG-111hhrg51698--226 Mr. Conaway," Yes. Your interest in restricting the physical assets that go along with certain commodities, how do you--the guy that grows corn, you would restrict him from being able to work in these markets as well? " CHRG-109shrg24852--52 Chairman Greenspan," We have had such experiences in the past, and quite correctly, there have been regional problems associated with unwinding of frothy local housing markets. One thing that obviously is an issue with respect to the overall economy of these metropolitan areas, is that unlike earlier history, we have developed a mortgage instrument to a point, and the ability to extract equity from homes to such an extent, that now a surprisingly large proportion of consumer expenditures and home modernization outlays are financed by home equity extraction. That is clearly a consequence of one, house turnover, largely because, of course, the seller of the home extinguishes a mortgage which is less than the mortgage of the buyer of the home, which is essentially a reduction or extraction of equity from that home of that exact difference. Then of course there are cash-outs, which have increased over the years, associated with refinancing, and then finally, a significant amount of extraction of unrealized capital gains essentially from home equity loans. These are large enough to be an issue in the overall consumption expenditures of a local community, and in the event that you begin to get a retrenchment in house turnover, which would presumably be associated with unwinding of a frothy market, you would probably also have impacts on consumer expenditures in that particular area. There are obviously national implications of this as well. We would expect as the housing boom eventually simmers down, as we have long expected it would but find no evidence that it is about to, that it would begin to have some impact on consumption expenditures, and if not for the fact that we perceive capital investment picking up the slack, it would give us some pause as to economic consequences of the adjustment process. Senator Allard. Mr. Chairman, you kind of moved into my second question where people were extracting this equity out of their home. If the value of these homes should begin drop or something, that could create some problems for our national economy, or would it not? " FOMC20080318meeting--42 40,MR. STOCKTON.," President Fisher, I will just basically reiterate what I said earlier and amplify many of the same things that Nathan just said in terms of the influences on our headline forecast. We revised up � percentage point as well, and that really is coming from higher energy prices, higher food prices, and higher commodity prices, all of which we think are already showing through to some extent and we expect to continue to show through to headline inflation. Despite the fact that we run with a much larger output gap in this forecast, we haven't revised down our forecast for 2009 because of the lingering effects of the run-up in commodity prices that we are expecting. As I indicated, we think there has probably been some small deterioration in inflation expectations as well. " CHRG-111hhrg74855--334 Mr. Markey," Great, thank you. Mr. Duane, what changes would be made if PJM had to adhere to the principals in place under the Commodities Exchange Act as a derivative clearing organization? What effect would those requirements have on the marketplace? " CHRG-110shrg50409--46 Mr. Bernanke," I think it will be probably positive if it contributes to a slowing in commodity prices. Senator Tester. You talked about the long-term oil supplies are down. I believe that is what you said. " CHRG-111hhrg74855--169 Mr. Gensler," That is right just as in the Commodities and Exchange Act for 70-some years it has not only excluded the physical delivery but also the forward markets that is excluded. Similarly 3795 and the administration would exclude the forward, these day-ahead markets and so forth. " CHRG-111shrg49488--85 Chairman Lieberman," Mr. Nason, I take it that historically the reason we had both the SEC and the CFTC is that the CFTC grew up from the trading in agricultural commodities and they did not want to be mixed with the Wall Street regulators. " CHRG-110shrg38109--103 Chairman Bernanke," Well, there have been a number of papers, and we would be happy to send you a few surveys or summaries of some of the research that has been done. A number of papers have looked at this demographic issue and viewed it as being important, although not necessarily the whole story. The other important part of the story is that personal savings rates are out of current income, and they do not include capital gains of any kind. So the general strength of the stock market and then more recently of the housing market has meant that people could increase their wealth without saving, and that has been, I think, an important factor in leading to a lower savings rate more recently. The other technical point to make is that private saving actually consists of the sum of the household or personal savings together with the savings done by corporations. Savings by corporations has become a larger share of the private saving than overall, and in a sense, the corporations ultimately belong to the households, whether you are a small business owner who is keeping profits in your business or an investor who is enjoying capital gains in stocks. Some of that saving is not appearing in households because it is taking place in corporations. It is a measurement issue. But I think it is an issue because the national savings rate has come down, and it contributes to issues like the current account deficit we have talked about. Our anticipation, as I mentioned in the testimony, is that the household saving rate should rise a bit in the next couple of years partly because housing prices are not rising as fast and people will turn back to saving from their current income. But we do not anticipate anything like the 12 percent in 1985 anytime soon. It is going to be a slow process. Senator Sununu. Thank you very much. Thank you, Mr. Chairman, and I would note, since I am not a member of the baby-boom generation and you are, I look at every possible opportunity to blame something bad on your generation. Thank you. " CHRG-111hhrg51698--562 The Chairman," Mr. Kaswell, you are highly critical of setting the position limits, speculative position limits for all contracts. If we have limits and they have worked in the agricultural markets, why wouldn't it be appropriate to have them for all other markets of physical commodities? " CHRG-109hhrg31539--190 Mr. Bernanke," It is a trick question. As I said in my testimony, our expectation is that core inflation will be moderating over the next 2 years for a variety of reasons. However, we do see some risks, and one of the risks would be that because product markets are tight, that there would be ability of firms to pass through energy and commodity prices into other goods. " FOMC20081029meeting--263 261,CHAIRMAN BERNANKE.," Okay. Thank you. Let me try to summarize all that I heard today and yesterday, and then I'll try to add some new comments to that. The outlook for economic growth appears to have deteriorated quite significantly since the last meeting. Data on consumer spending, production, and employment had weakened more than expected even before the recent intensification of the financial crisis. Over the past six weeks or so, however, financial conditions have greatly worsened, and risk aversion has increased, despite actions here and abroad to stabilize the banking system. Equity values have declined sharply amid conditions of low liquidity and extraordinary volatility. Credit market conditions have improved modestly since the global actions to recapitalize banks and guarantee their deposits, assisted also by additional central bank liquidity actions. However, in almost all credit markets, spreads remain much wider, maturities shorter, and availability more constrained than was the case before the intensification of the crisis. Firms face continued funding risk and rollover risk. Banks have probably not reserved sufficiently for the credit losses to come, and hedge funds will be hitting their net asset value triggers in greater numbers, forcing them to liquidate assets. The duration of future financial turmoil is hard to judge, but it could be lengthy. The worst thing is that financial conditions appear already to have had a significant and remarkably quick effect on activity and consumer and business expectations and plans. Most Committee participants see us in or entering a recession and have marked down significantly their expectations for near-term growth or for the pace of the recovery. The difficulty of predicting the course of the crisis or its effects on the economy has also increased forecast uncertainty. In particular, the ultimate effects of some major policy actions, such as the creation of the TARP and the bank guarantee, are not yet known. Uncertainty about future policy actions, as well as uncertainty about the economy, has affected behavior in markets and the broader economy. Consumer spending has weakened considerably and probably fell sharply in the third quarter, reflecting in part a recessionary psychology. Consumer durables, such as automobiles and discretionary expenditures, have been particularly hard hit. This weakness reflects the same set of negative influences on consumption that we have been seeing for a while, now compounded by losses of equity wealth and confidence effects on prices, although lower oil prices may provide some relief. The labor market continues to decline, with many firms reporting that they are cutting back workers. The housing sector has not been noticeably worse than expected, and reports are somewhat mixed. But on a national basis, the contraction is continuing, and recent developments in the economy and credit markets are likely to have adverse effects. Inventories of unsold new homes remain high, putting pressure on prices. Nonresidential construction continues at a moderate pace; but backlogs are falling, and the sector is looking increasingly vulnerable to weakening fundamentals and tighter credit conditions. Whether a new fiscal stimulus package will be passed and to what extent such a package would be helpful remain open questions. Manufacturing production has weakened significantly as have expectations of demand, including export demand. Credit is becoming more of a problem for many firms and their customers. Spending on equipment and software appears to have slowed, reflecting greater pessimism and uncertainty. Falling commodity prices may reduce mining activity and cool the boom in agriculture. On the plus side, firms are reporting fewer cost pressures, and inventories do not appear excessive. Deterioration in global growth expectations has been marked. Industrial economies had already shown signs of slowing, and they have been hit hard by recent financial developments. Emerging market economies, until recently evidently not much affected by the U.S. slowdown, have in recent weeks also been hit hard by the spreading financial crisis. Together with the stronger dollar, these developments are likely to restrain future growth of U.S. exports. Inflation risks have declined materially, reflecting the fall in the prices of energy and other commodities, the stronger dollar, and the prospect of considerable economic slack. Firms report much reduced pricing power and lower markups. Inflation expectations have come down, both in the surveys and in the TIPS market, though it wasn't noted--but I will note--that the TIPS market is distorted by illiquidity and other problems there. Most participants see both overall and core inflation moderating in the coming quarters toward levels consistent with price stability, with some seeing a risk of undesirably low rates of inflation. Some note, however, that financial dislocations affect aggregate supply as well as aggregate demand and may reduce the extent to which slower growth damps inflation. So that's just my sense. Any comments? Additions? Let me make just a few additional comments, none of which will be radically different from what we have already discussed. I do think it is overwhelmingly clear that we are now in a recession and that it is going to be a severe one. To give some sense of perspective, the postwar record for duration is 16 months. If the NBER sets this experience as having begun early this year, I think we have a reasonable chance to break that record. The largest increase from peak to trough in unemployment rate was in 1981. It was 3.6 percentage points. Starting from 4.4 percent, I think we have a chance to come close to that number. Yesterday's drop in consumer confidence in one month from 61 to 38 shattered the previous low of 43 in December 1975. So I think we are talking about an episode here that could easily be among the largest postwar recessions. We don't know how things would have evolved without the developments in September, but obviously we have to deal with that reality. It was just a few weeks ago that we were dealing with what might have been a true systemic crisis, in the week leading up to the G-7 and IMF meeting. I think it has been very fortunate that Europe, the United States, and other countries have adopted vigorous responses to that, including bank capitalization, bank guarantees, and other measures. That has been very important in calming the situation somewhat and reducing the systemic aspects of investor concerns. That being said, concern about counterparties remains very strong. Risk aversion is intense, spreads remain high, and I think that this has now become really pervasive. It isn't just a question of junk bonds and weak borrowers or weak credit histories. The spreads on GSE debt, on high-grade corporate debt, and other areas have also widened, leading to a very broad based tightening in credit conditions. So I think that, overall, any reasonable reading of financial conditions suggests that the tightening of credit or financial conditions in the last six weeks or so has been quite substantial and overwhelms the effects of our coordinated rate cut. Now, normally you would expect to see a tightening of credit conditions affect the economy with some lag. It takes time for people to borrow money and to use the money they borrow to make expenditures. But compared with that prediction, we have instead seen a sudden stop--a remarkable and very rapid effect on economic activity. It is possible this is due less to the direct effects of credit availability and more to the psychological impact of these events. One possible analogy is the 1980 Carter credit controls, when the government announced what seemed to be a tightening of credit. There was a very sharp response in economic activity, probably based more on expectations than on actual credit availability. Unfortunately, the credit controls could be removed by government fiat; we are not able to do that today. One interesting development is that the labor market has not yet shown as much weakness as one would expect. Unemployment insurance claims and other indicators do not yet show a marked deterioration. I expect that we will see more deterioration of the labor market. Besides the intensification of the financial crisis that has markedly increased the restrictiveness of financial conditions, I think the other very important development since our last meeting has been the internationalization of the crisis. We had already seen weakening in Europe before the most recent intensification, but it has become much more severe. There is little doubt that the United Kingdom and Europe are in or about to enter recession. My sense is that their monetary policy responses will be stronger than what the Greenbook anticipates. I believe they will be very aggressive in responding to that. A new and particularly worrying development is the fact that the crisis has now spread beyond the industrial countries to the emerging markets. The G-7 weekend was quite an interesting one. It was a striking experience. I heard over and over again from the Indians, from the Brazilians, and from all over the world that, until the middle of September we were fine, we were not being much affected, we didn't see much effect on our trade flows, and suddenly everything changed; and now we are under severe stress. We are seeing tremendous outflows. Our currencies are plummeting. Commodity price declines are hurting many countries. I think that is going to be a very significant development as we go forward. Just to give some data, in just a few weeks the EMBI spread, the emerging market sovereign debt spread, went from 280 basis points to 850 basis points; and the emerging market equity index has fallen about 40 percent since the last meeting. It is not obvious that these changes were justified by economic fundamentals. Many of these countries are very well run and had shown a lot of progress in their domestic policies and their domestic economies. Instead, I think they are suffering contagion from us mostly. Unfortunately, the implications of this will be not only the usual trade and commodity price type of implications but also, and even more important, financial implications. We are now seeing that the adverse feedback loop, which we've been talking about for a long time in the United States, is becoming a global phenomenon. In particular, European banks are very heavily exposed to emerging market debt. So we are going to see yet more of this interaction between the financial markets and the broader economy, except at a global rather than a national level. These developments, obviously, are very disturbing and don't bode well for U.S. growth or now for global growth. Somewhat ironically, all of this deterioration in the global outlook has led the dollar to appreciate very sharply, which is interesting to say the least. For us that obviously also has important implications for inflation, and as Governor Kohn mentioned, it means that we will be less a recipient of foreign strength and more a supporter of foreign weakness than we have been until now. On inflation, I know there is some discomfort in talking about a 1 percent policy rate and promising to keep it low for a protracted period--and all those things. We have seen this movie before, and I think we all have to recognize the importance of watching the implications of that for our economy and for asset prices and to take quite seriously the responsibility for removing accommodation in a timely fashion once the crisis has begun to moderate. That being said, I don't think that there is really any case in the near term to be worrying very much about inflation--or, perhaps even less so, the dollar--as we look at our policy. Pricing power is evaporating. And given what is happening in the global economy, I don't see a commodity price boom any time soon, although I think as the economies do begin to recover in the next year or so that we might see some recovery in commodity prices. So I think that, as everyone has indicated, this is a very worrisome situation. I don't think we have control of it. I don't think we know what the bottom is, so we have to remain very flexible and very open to new initiatives as they become necessary. There has been some comparison of this to the Japanese situation. I'm beginning to wonder if that might not be a good outcome. The advantage of the Japanese was, first of all, that they were isolated. The rest of the world was doing okay, and they were able to draw strength from their exports and the rest of the global economy. Although they had very slow growth, they never really had a deep recession or big increases in unemployment. I think we are looking at perhaps a much sharper episode, and our challenge will be to make sure that it doesn't persist longer. I do think that one lesson of both Japan and the 1930s as well as other experiences is that passivity is not a good answer. We do have to continue to be aggressive. We have to continue to look for solutions. Some of them are not going to work. Some of them are going to add to uncertainty. I recognize that critique. I realize it's a valid critique. But I don't think that this is going to be a self-correcting thing anytime soon. I think we are going to have to continue to provide support of all kinds to the economy. Let me stop there and, unless there is any question or comment, ask Brian to introduce the policy round. " FinancialCrisisInquiry--221 How do you predict the long-term recovery? And how long do you think that recovery— how much longer will it take in circumstances like that? ZANDI: Well, first, let me say that one of the hallmarks of the Great Recession was how broad- based it was across industries and regions of the country. I mean, in past recessions, you always had a large region or two that avoided the recession, and that was a safety valve. People could move from Michigan and go to Florida or move from California to Nevada, and that wasn’t the case in this downturn. Now, having said that, obviously, there are some areas that are harder hit than others and those that suffer— well, were in the housing boom and bubble and now suffered the housing bust are the most severely hit, and that would include Nevada, Las Vegas, Arizona, California, particularly the Central Valley of California, Florida, Rhode Island, interestingly enough, for various reasons, and, obviously, parts of the industrial Midwest. And it will take much, much longer for an economy like Nevada and Florida to turn because its economic base is much less diversified. Obviously, it’s related to leisure and hospitality, which is a discretionary purchase and will not turn, and migration flows. And as I mentioned earlier, migration is going to be significantly impaired because one-third of homeowners with first mortgages, by my calculation, are underwater and can’t move or won’t move as easily. So Nevada’s problems are very severe and will be very long lasting. VICE CHAIRMAN THOMAS: Isn’t it also home construction? I mean, that was one of the fundamental industries in all those areas. And when that’s the problem and you can’t do it, you implode. ZANDI: Well, I—I would say housing in its totality, so that would include housing transactions, home sales. That’s demand, house prices ... and, obviously, housing construction. FOMC20050322meeting--14 12,CHAIRMAN GREENSPAN., It’s a very unusual index. The reason I raise the issue is because it doesn’t look like any commodity index I’m used to watching—unless oil is a very big component. Do we know that? We can factor out the oil part of this. CHRG-110shrg50369--18 Mr. Bernanke," The increase in commodity prices around the world as the global economy expands and increases demand for those commodities is creating an inflationary stress which is complicating the Federal Reserve's attempts to respond. In some other ways, things are different. You pointed out the dollar was very strong in 2001. That was in part reflective of a large trade deficit at that time. It has since depreciated. But, on the other hand, part of the effect of that depreciation has been that we are at least seeing some improvement in that trade deficit, which is a positive factor. On the fiscal situation, I agree we are in a less advantageous situation than we were. The deficit is certainly higher, and perhaps even more seriously, we are now 7 years further on toward the retirement of the baby boomers and the entitlements, and those costs that are certainly bearing down on us as we speak. So it is a difficult situation, and there are multiple factors. I think there are some similarities, but as a Russian novelist once said, ``Unhappy families are all unhappy in their own way,'' and every period of financial and economic stress has unique characteristics. " CHRG-111hhrg52397--86 Mr. Bachus," Thank you. Thinking about how AIG never imagined that these things could go down, I guess a lot of homeowners, a lot of people who bought commercial property and houses sort of assumed the same thing, obviously to their detriment. But I appreciate those responses, and I think they are very insightful. Dr. Johnson, you mentioned the turf battle here in Congress some time between CFTC and the SEC. Now, the Commodities Exchange Act actually excludes credit default swaps from jurisdiction of--well, they are excluded from the coverage of the Commodities Exchange Act, so the CFTC draws its jurisdiction from that Act. So if we were to give some function on credit default swaps, which are really meant to insure against default by a publicly-traded company I guess or a group of publicly-traded companies defaulting on their debt, if the CFTC was given that authority, would we have to amend the Act or would they have jurisdiction? " FOMC20050630meeting--359 357,MR. HOENIG.," Thank you, Mr. Chairman. First of all, our view regarding the national economy is basically similar to others I have heard here. We agree with the consensus of GDP growth running about 3½ percent, slightly over our potential rate. And we see that going forward through the rest of this year and into next year. I also would say that the anecdotal evidence coming from our region is very consistent with this above-trend growth rate. Consumer spending continues to grow solidly, with retailers reporting June 29-30, 2005 120 of 234 quarters. Tourism continues to expand briskly, boosting occupancy rates at hotels and resorts in our region. And energy activity remains high. One of the interesting anecdotes arose during a recent visit I made to the Cessna plant in Wichita, which is booming right now. They have back orders for their jets—general aviation aircraft—running well into 2007, with prices running from a mere $2½ million to a little better than $20 million for their Citation 10, which flies at 0.8 mach. And the demand is incredible. So the general economic environment reflected in these parts of our region really is consistent with a strong growth rate going forward. On the national inflation outlook, I understand the arguments given today for why inflation should continue to ease off. For that to occur, it is critical in my view that we continue to move policy out of its current accommodative stance. If we don’t, I think we are stimulating demand—I think it’s reflected in some of the other comments here and in some of the anecdotes that I’ve pointed out—and I think we will have future upward adjustments in inflation as we move forward. So I think it is critical that we get ourselves closer to that neutral zone that we talk about, which no one can pinpoint with certainty but which is probably somewhere between 3½ and 4½ percent. I’ll leave it at that." fcic_final_report_full--21 When the Federal Reserve cut interest rates early in the new century and mort- gage rates fell, home refinancing surged, climbing from  billion in  to . trillion in ,  allowing people to withdraw equity built up over previous decades and to consume more, despite stagnant wages. Home sales volume started to in- crease, and average home prices nationwide climbed, rising  in eight years by one measure and hitting a national high of , in early .  Home prices in many areas skyrocketed: prices increased nearly two and one-half times in Sacra- mento, for example, in just five years,  and shot up by about the same percentage in Bakersfield, Miami, and Key West. Prices about doubled in more than  metropol- itan areas, including Phoenix, Atlantic City, Baltimore, Ft. Lauderdale, Los Angeles, Poughkeepsie, San Diego, and West Palm Beach.  Housing starts nationwide climbed , from . million in  to more than  million in . Encouraged by government policies, homeownership reached a record . in the spring of , although it wouldn’t rise an inch further even as the mortgage machine kept churning for another three years. By refinancing their homes, Americans extracted . trillion in home equity between  and , including  billion in  alone, more than seven times the amount they took out in .  Real estate specula- tors and potential homeowners stood in line outside new subdivisions for a chance to buy houses before the ground had even been broken. By the first half of , more than one out of every ten home sales was to an investor, speculator, or someone buy- ing a second home.  Bigger was better, and even the structures themselves ballooned in size; the floor area of an average new home grew by , to , square feet, in the decade from  to . Money washed through the economy like water rushing through a broken dam. Low interest rates and then foreign capital helped fuel the boom. Construction work- ers, landscape architects, real estate agents, loan brokers, and appraisers profited on Main Street, while investment bankers and traders on Wall Street moved even higher on the American earnings pyramid and the share prices of the most aggressive finan- cial service firms reached all-time highs.  Homeowners pulled cash out of their homes to send their kids to college, pay medical bills, install designer kitchens with granite counters, take vacations, or launch new businesses. They also paid off credit cards, even as personal debt rose nationally. Survey evidence shows that about  of homeowners pulled out cash to buy a vehicle and over  spent the cash on a catch- all category including tax payments, clothing, gifts, and living expenses.  Renters used new forms of loans to buy homes and to move to suburban subdivisions, erect- ing swing sets in their backyards and enrolling their children in local schools. In an interview with the Commission, Angelo Mozilo, the longtime CEO of Countrywide Financial—a lender brought down by its risky mortgages—said that a “gold rush” mentality overtook the country during these years, and that he was swept up in it as well: “Housing prices were rising so rapidly—at a rate that I’d never seen in my  years in the business—that people, regular people, average people got caught up in the mania of buying a house, and flipping it, making money. It was happening. They buy a house, make , . . . and talk at a cocktail party about it. . . . Housing suddenly went from being part of the American dream to house my family to settle down—it became a commodity. That was a change in the culture. . . . It was sudden, unexpected.”  CHRG-111shrg49488--86 Mr. Nason," Historically, that is the genesis of the CFTC's creation in the 1970s. But, interestingly enough, when the CFTC was being created, Members of Congress and their staffs asked the SEC if they wanted the jurisdiction for agricultural commodities, and they declined because it was a specialized market. " CHRG-111hhrg74855--182 Mr. Stupak," Thank you, Mr. Chairman. Mr. Wellinghoff, Mr. Dingell indicated that your State of the Markets report and that report strongly indicated a lack of physical market fundamentals was used in determining the price of natural gas and electricity, and the conclusion was that large pools of capital flowed into these various financial instruments that turned the commodities like natural gas into investment vehicles as opposed to providing a product there. Does that accurately reflect FERC's current position that financial speculation in the natural gas market has increased prices? " CHRG-109hhrg23738--15 Mr. Greenspan," No, but I think it is worthwhile reviewing where we are relative to this issue. We know, with as high a level of certainty as you ever can gather, that we are going to get a very substantial acceleration in the number of retirees in this country starting in 2008; but we also know that the next generation coming in behind the baby boomers is much smaller, which means that the working labor force is going to grow at a relatively small, a very small, rate. This means that we are going to have a very substantial amount of people not productive, in the way they had been when they were in the workforce, essentially being supplied with goods and services by a labor force which is growing rather slowly. It is very difficult to convey how important it is when you take as productive a group of people coming out of the baby-boom generation--and they are now in their most productive years--and you move that group into retirement. Its impact is very substantial. But the major point I want to make is that Social Security has over the years, largely because of the demographics that we have observed in recent generations, been able to replace roughly 40 percent of the incomes that workers had prior to retirement. It strikes me that it is going to be very difficult to deliver that in real terms because of the extraordinary demographic shift which we are about to experience. But it is certainly also going to be the case that retirees are going to need something like 80 percent of their immediately pre-retirement income to maintain a reasonable standard of living, and that means a very substantial part of retirement resources is going to come from other than Social Security, of necessity; and that inevitably means private pension funds, defined benefit, 401(k)s, personal savings, other forms of income, and I suspect that we will require fairly significant expanding forms of private savings initiatives. And one of the reasons why I have been supportive of moving a significant part of Social Security toward private accounts is to develop that particular process. I have nothing, basically, new to say on the issue than what I discussed with you in February. " CHRG-111hhrg51698--211 The Chairman," Thank you, Mr. Slocum. Thank both of you for being with us today. I hadn't really thought about, Mr. Slocum, what you had brought up there. I don't really agree with the terminology ``speculation'' for what Goldman Sachs is doing. Because they have created an investment that they are selling to people. That is going into the market, and they are using the regulated market to hedge their risks and so forth. So, the fact that they are selling an index that has 10 percent corn, 40 percent oil, and eight percent copper or whatever, that is going into the market based on those percentages, and there is not a whole lot of thought going into it. It is just an investment vehicle they are selling to people. I am not sure there is anybody sitting around there scheming what is going to happen. They are just getting their commissions by selling these investments to pension funds and some of these other people. They are putting out this information, they are still running seminars trying to convince people that they ought to take their money out of other areas and put them into commodities because they can make more money because oil prices are going up or whatever. So I don't know if I can connect the dots there. But I do have, personally, a concern about this money that has been coming into this market from these areas that don't have anything to do with the underlying commodity situation. In fact, the first draft I put out last year banned pension funds from being involved in this commodity market at all, which I still personally believe we should do. I am just waiting for the day for the pension funds to come to the United States Congress and tell us that we have to bail them out because of this failed strategy that cost them all this money in their pension funds, and now they can't pay the benefits. That is probably going to come at some point here, too. But we will take that under consideration, and I guess I would like to learn more about what you think the connection is there. Mr. Roth, you have some proposed ideas on how to get a handle on this retail stuff that is going on? " FOMC20080430meeting--120 118,MR. MISHKIN.," But I do have a concern about the risk to inflation expectations because of the high commodity prices that we see. This is coming from the very adverse supply shock and the fact that we have had headline inflation so high for so long. The good news, by the way, is that it is actually quite remarkable, given how high headline inflation has been, how anchored inflation expectations have been. I think that has to do with confidence in this institution's doing the right thing. It is very important that we retain that confidence. We have to think about that when we decide what we are going to do regarding policy. About where I think inflation is going to be--I have been a 2 percent guy for a long time. I am not changing that. I think that inflation expectations are around 2 percent and that there is no expectation that we will have excess demand in the economy. If anything, it is the opposite of that. I see the risks as balanced--there are some risks on the upside, particularly because of what is happening with commodity prices. On the other hand, there are risks on the downside because of the expected slack and because there is some downside risk in the economy. So on that ground, I basically have the same story that I had before. Thank you. " CHRG-111hhrg63105--157 Mr. Jones," Good morning, Mr. Chairman, Members of the Subcommittee. I am Robert Jones, Senior Vice President of ABN AMRO Clearing in Chicago, a futures commission merchant. I serve on the Risk Management Committee of the National Grain and Feed Association, and I am here today to represent the views of the National Grain and Feed Association. We appreciate the opportunity to discuss position limits for enumerated agricultural commodities. Federal position limits are already in place for those commodities, and we believe they are at appropriate levels. Generally, we have found that the Commission understands the impacts of its actions on commercial businesses and is responsive to our concerns. However, the deadlines that have been set in the law are very challenging. For our industry, the price discovery occurs primarily in the futures market, so it's extremely important that we get these rules right. Given the choice, we would prefer to go a little slower and make sure we get it right, rather than rush rules through to meet a deadline and find out later about unforeseen consequences. To provide some context for this, I would like you to think back to 2008. Agricultural futures prices escalated rapidly, resulting in a disconnect of cash and futures values, otherwise known as convergence. Basis levels for producers, essentially the difference between the cash and the futures, widened dramatically. The situation increased risk for grain purchasers and hedgers and caused extreme financial stress due to massive margining requirements. At the same time, marketing opportunities for producers were limited. We believe that the expanded participation by nontraditional participants like index funds and pension funds played a role in the 2008 spike--not the only factor but a factor. Today, conditions exist that could lead to a repeat of that situation. If another investment-fueled futures spike occurs, grain buyers may be forced to limit their purchases from U.S. agricultural producers as occurred in 2008. Certainly buyers would be forced to consider tighter limits on forward contract purchases, and at the very time many producers would like to take advantage of those favorable prices. The NGFA believes that it would be imprudent for the CFTC to change current speculative position limits for the enumerated agricultural commodities. In particular, we have a strong reservation about an approach that would create a combined position limit for over-the-counter instruments and futures based on open interest levels. The majority of the risk management activity for the enumerated ag commodities involves futures traded on exchanges. The practical impact of a combined OTC and futures position limit likely would mean limits ratcheting steeply upward for futures. We fear the result would be a sort of perpetual motion machine leading to investment in enumerated ag commodities in ever-greater amounts and even wider basis swings occurring. In addition, the commodity exchanges, notably the Chicago Board of Trade and the Kansas City Board of Trade, have worked diligently to reestablish convergence in their wheat contracts. Getting it wrong on position limits could undo progress that the exchanges are making toward enhancing the performance of their contracts. Proper functioning of futures markets for traditional commercial users and producers should be the CFTC's overriding consideration in establishing position limits. A reliable relationship between cash and futures must be maintained. Convergence matters, not just sometimes, but consistently and predictably. The National Grain and Feed Association does not favor excluding investment capital from agricultural futures markets, as we believe it does provide liquidity to our markets. However, we believe that the CFTC must establish reasonable limits on an investment in the enumerated ag commodities so these relatively small markets are not overwhelmed by investment demand. Ignoring the unique characteristics of these markets could have highly undesirable consequences for agricultural producers and their traditional hedgers who use these markets for price discovery and risk management. Thank you, Mr. Chairman, for the opportunity to present NGFA's views today. And we will be happy to respond to any questions. [The prepared statement of Mr. Jones follows:] Prepared Statement of Robert Jones, Senior Vice President, ABN AMRO Clearing Chicago LLC; Member, Risk Management Committee, National Grain and Feed Association, Chicago, IL Good morning, Mr. Chairman and Members of the Subcommittee. I am Robert Jones, Senior Vice President of ABN AMRO Clearing Chicago LLC, a futures commission brokerage in Chicago. I serve on the Risk Management Committee of the National Grain and Feed Association (NGFA) and I am here today to represent the views of the NGFA. The National Grain and Feed Association is the national nonprofit trade association that represents more than 1,000 companies that operate an estimated 7,000 facilities nationwide in the grain, feed and processing industry. Member firms range from quite small to very large, both privately owned and cooperative, and handle or process in excess of 70% of all U.S. grains and oilseeds annually. Companies include grain elevators, feed mills, flour mills, oilseed processors, biofuels producers/co-product merchandisers, futures commission merchants and brokers, and related commercial businesses. A common thread for NGFA-member firms is that they rely heavily on efficient futures markets to provide price discovery and risk management for their commercial businesses. In particular, consistent and predictable convergence of cash and futures values is of primary importance to the NGFA. Establishing appropriate speculative position limits for the futures contracts utilized by these traditional commercial hedgers is critically important to maintaining the viability of futures contracts for risk management purposes. It also is essential in enabling our member companies to make forward contracting and other risk management tools available to farmer-customers. We are especially glad for the opportunity this morning to discuss position limits for the enumerated agricultural commodities--that is, wheat, corn, soybeans, livestock and cotton. As you know, Federal position limits already are in place for those commodities. We believe those limits are at appropriate levels and that the process for establishing those limits has worked well. However, the Dodd-Frank Act requires that the CFTC now establish speculative position limits for all commodities, including agricultural commodities. In the past, the NGFA generally had been supportive of occasional requests by futures exchanges to increase speculative position limits. However, futures price volatility in recent years and vastly increased participation by nontraditional participants has altered the situation and, at times, threatened the viability of exchange-traded futures for commercial grain hedgers. The rapid escalation of agricultural futures prices during 2008, and a resulting disconnect of cash and futures values, dramatically increased risks for grain purchasers/hedgers and caused extreme financial stress due to massive margining requirements. We believe that dramatically expanded participation in agricultural futures by nontraditional participants like index funds and pension funds played a role in the 2008 spike--not the only factor, but a significant one. Today, conditions exist that could lead to a repeat of those conditions. With investment capital now seeking enhanced returns and many advisers recommending commodities as an investment vehicle, it appears the stage could be set for another investment-fueled spike in futures prices--an increase we fear will be largely unrelated to market fundamentals and could again result in extreme financial stress. If this happens, grain buyers may be forced to limit their purchases from U.S. agricultural producers, as occurred in 2008. Certainly, buyers would be forced to consider tighter limits on forward contract purchases, at the very time that many producers would like to take advantage of favorable prices. Many Members of Congress have heard from producers about wider basis levels in recent years--that is, the difference between cash bids and futures values on-exchange. We believe strongly that artificially inflated futures values, due in part to participation of nontraditional investors, have led to a disconnect between cash and futures. The commodity exchanges, notably the Chicago Board of Trade and the Kansas City Board of Trade, have worked diligently to address the disconnect and to re-establish convergence in their wheat contracts. Getting it wrong on position limits could undo progress the exchanges are making toward enhancing performance of their contracts. For these reasons, the NGFA believes it would be imprudent for the CFTC to change current speculative position limits for the enumerated agricultural commodities. In particular, we have strong reservations about an approach that would create a combined position limit for over-the-counter instruments and futures based on open interest levels. The logic for not linking speculative position limits to open interest levels is as follows. The majority of risk management activity involving the enumerated ag commodities utilizes futures traded on-exchange. The practical impact of a combined OTC and futures position limit likely would mean limits effectively ratcheting steeply upward for futures--attracting greater investment and boosting open interest levels--which would trigger increased position limits--leading to yet greater participation levels and increased open interest--and triggering even higher position limits--and so on. We fear the result would be a sort of perpetual motion machine leading speculative investment capital to invest in enumerated ag commodities in ever-greater amounts, exacerbating artificially inflated futures values and leading us back to even wider basis swings. Instead, the NGFA strongly urges the CFTC to use proper functioning of futures markets for traditional commercial users and producers as the overriding consideration in establishing position limits. That means that a reliable relationship between cash and futures must be maintained. Convergence Matters! Not just sometimes, but consistently and predictably. We also urge the CFTC to be vigilant in reviewing corporate linkage issues through which investment firms or other nontraditional participants may technically comply with position limits through separate entities, while coordinating positions that would circumvent the intent of the rule. This would seem to us consistent with the Commission's intentions to monitor account ownership and control to help ensure compliance. Mr. Chairman, all these points lead back to one very important message: enumerated agricultural futures contracts must function effectively for traditional commercial hedgers and their farmer-customers. The NGFA does not favor excluding investment capital from agricultural futures markets. In fact, we believe that a desire to invest in our industry is a good thing. It forecasts growth and economic opportunity for U.S. agriculture and agribusiness. However, we believe Congress and the CFTC must act prudently to establish reasonable limits on investment in the enumerated ag commodities and help ensure that those relatively small markets are not overwhelmed by investment demand. Ignoring the unique characteristics of the enumerated agricultural commodities when setting position limits could have highly undesirable consequences for U.S. agricultural producers and the traditional hedgers who use these markets for price discovery and risk management. Thank you, Mr. Chairman, for the opportunity to present the NGFA's views. I would be happy to respond to any questions. " CHRG-111hhrg51698--613 Mr. Moran," Mr. Chairman, thank you very much. Let me take this opportunity to congratulate you on becoming the Subcommittee Chairman on General Farm Commodities and Risk Management, a Subcommittee that I chaired at one point in time. And now I am your humble Ranking Member, and I look forward to working with you. " CHRG-111shrg57322--1072 Mr. Blankfein," I can't say what Mr. Paulson is thinking, but there is nothing wrong--speculating--if he was, which I don't know what he was thinking, if he was just a speculator, there are people who speculate in corn and speculate in all sorts of commodities---- Senator McCaskill. I understand. Mr. Blankfein [continuing]. That allow the professional users of those markets to complete their hedges. That is a socially acceptable---- Senator McCaskill. Mr. Blankfein, there is a big difference between finding the opposite side of a certainty in a commodity hedge for a farmer that needs certainty or an airline company that needs to figure out what jet fuel is going to cost and two sides of a deal that are both just betting. There is nothing in a synthetic CDO that is essential to certainty to anybody's business other than somebody just deciding they want to take one side of a deal and the other side of a deal. That is what a synthetic CDO is. " CHRG-111hhrg63105--196 Mr. Collura," My comment was in respect to the earlier comments that Congressman Marshall had raised about index speculation. These folks take passive rolling positions in commodities and can create almost a perpetual situation of entangling a market, where outside of spot months---- " FOMC20080430meeting--129 127,MR. FISHER.," You emphasized the phrase ""reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization."" Can you just refresh my memory? For how long have we been using that phrase--just in the March statement, or have we used it before? " FOMC20080625meeting--29 27,MR. SHEETS.," 2 Thank you, Mr. Chairman. Given that developments in global commodities markets have continued to have influential effects on our forecast for domestic activity and prices, we felt that it would be useful for me to lead off with the international portion of the chart show, which will include a discussion of these markets. Following my remarks, Larry and Bill will present our outlook for the U.S. economy. As shown in the top panel of your first exhibit, total foreign real GDP growth (line 1) stepped down from an average pace of 4� percent in the first three quarters of 2007 to around 3 percent in the fourth quarter of last year and the first quarter of this year. We see growth abroad as likely to decline to 2.2 percent in the current quarter and to pick up only slightly in the second half of the year. Next year, with the expected firming of U.S. activity and diminishing headwinds from the financial turmoil, foreign growth should rise back to a 3� percent pace. Growth abroad was just a bit stronger in the first quarter than we had anticipated, but the composition of that growth came as more of a surprise. Canadian GDP (line 3) posted a slight contraction, reflecting a continuing downturn in exports and stagnant investment. In contrast, the pace of activity in Japan (line 4) and the euro area (line 5) was much more vigorous than we had expected, including a 6� percent surge in Germany. Nevertheless, recent data for these economies point to much weaker growth in the second quarter. As shown in the middle left panel, Japanese manufacturing output 2 The materials used by Messrs. Sheets, Slifman, and Wascher are appended to this transcript (appendix 2). has declined recently, and labor market conditions have softened. For the euro area (the middle right), various indicators are showing weakness, including retail sales and the purchasing managers' index. As highlighted in the bottom panel, growth in the emerging market economies is expected to step down over the next few quarters but should remain relatively resilient, especially compared with the weak performance of these economies during the U.S. recession earlier this decade. Many of the EMEs were particularly vulnerable to the high-tech- and manufacturing-led downturn that occurred at that time, and fundamentals in the EMEs are now stronger than was then the case. In addition, Chinese domestic demand has remained quite robust of late, and this has likely helped to support growth in emerging Asia. As shown in the top left panel of exhibit 2, oil prices have continued to soar with the spot price of WTI closing yesterday at $136 per barrel. The far-dated futures price has climbed to about the same level. Our forecast for the path of oil prices is now roughly $50 a barrel higher than at the time of the January chart show. Divining the causes of this staggering rise in oil prices is no doubt ground on which angels fear to tread, but we continue to assert bravely that the primary driver of higher oil prices is constrained (and price inelastic) oil supply coupled with relatively strong (and price inelastic) oil demand. These deep features of the oil market--along with stressed geopolitical conditions in many oil-producing countries, rising production costs, and concern about the reliability of medium- to long-run supply--have sent oil prices spiraling upward. As shown in the last column of the middle table, the increase in oil prices appears to have contributed to modest declines in oil consumption in the advanced economies, including the United States (line 3). But oil consumption has continued to move up in the emerging market economies, especially in China (line 5) and the Middle East (line 6). Consumers in many EMEs have been shielded from rising prices by government fuel subsidies. The economic and fiscal costs of such subsidies are becoming increasingly burdensome, however, prompting some countries (including China late last week) to allow domestic fuel prices to move toward world levels. As seen on the top right, oil inventories in OECD countries have declined over the past year and a half. Unfortunately, little information is available about the behavior of inventories outside of OECD countries. The bottom left panel shows that the rise in global oil production since 2004 has significantly lagged the expansion of world GDP (weighted by oil consumption); indeed, production has remained relatively flat during most of that period. Notably, however, the lack of oil production is not due to geological constraints. Data on years of proved reserves (shown on the bottom right) are at roughly the same level as a decade ago. But those reserves are now concentrated in areas where production is constrained by acute geopolitical risks, uncertainty about property rights, inadequate investment, and high production costs. Turning to your next exhibit, nonfuel commodity prices have also risen significantly on average since your last chart show, with most of the increase coming in the first few months of the year. Here, too, we believe that the elevated level of prices is a result mainly of strong and sustained global demand, lagging supply responses, and rising production costs. Consistent with this observation, inventories of key commodities, shown in the middle left panel, have trended down in recent years. It bears emphasizing, however, that nonfuel commodity prices certainly have not moved in lockstep with each other. As seen in the bottom left panel, the price of corn has surged to new highs, supported by ethanol demand and, more recently, as adverse weather in the Midwest has endangered a substantial fraction of this year's crop. In contrast, the price of wheat has fallen back from its recent peak, as improved growing conditions in Australia seem likely to boost supply. For metals, the price of zinc has moved down significantly since its peak in late 2006, as new smelters have come on line. The price of copper has moved sideways--but at a high level--over the past two years, as prospective increases in supply have not yet materialized. A number of other explanations for the recent run-up in oil and other commodity prices have also been advanced, including the possibility that increased purchases by ""speculators"" in commodity futures markets may be playing an important role. Given the magnitude of the financial flows into these markets, we are hesitant to slam the door completely on this explanation, but our work finds little supporting evidence. As noted on the top right, prices of a number of commodities that are not traded in futures markets have also risen substantially. Second, a sustained increase in demand by investors would suggest that inventories should be rising; instead, as I have noted, inventories are now relatively tight. Finally, we see no evidence that the positions taken by noncommercial traders in futures markets actually predict commodity prices; for example, such positions for light sweet crude oil on the New York Mercantile Exchange have been roughly flat since mid-2007. Two other frequently cited explanations for the rise in commodity prices are the depreciation of the dollar and declines in interest rates. The middle-right panel shows the correlation of the broad nominal dollar with oil prices and with an index of nonfuel commodity prices. Both correlations are negative over most of the sample, implying that depreciations of the dollar have tended to happen at the same time as rises in commodity prices. While these correlations have become more negative since mid-2007, they remain within the ranges seen in recent years, and interpreting the direction of causality for this relationship is difficult. Also, as Bill noted, the dollar has been relatively stable over the past several months, but oil prices have continued their upward climb. Similar plots of correlations of interest rates with commodity prices (shown on the bottom right) are quite noisy and fail to point to any clear conclusions. As shown in exhibit 4, the run-up in commodity prices has continued to lift headline consumer price inflation in both the advanced foreign economies and the emerging markets. We expect that inflation abroad will remain elevated in the near term but eventually move back down as slower global growth reduces pressures on resources and as commodity prices flatten out (consistent with quotes from futures markets). Of course, one clear risk to these projections is that commodity prices may, yet again, confound our expectations and continue rising. Another risk is that the high rates of inflation now being recorded may become embedded in inflation expectations. As shown in the top right panels, measures of long-term inflation compensation have recently edged up in the euro area and increased more markedly in Canada. In recent weeks, major foreign central banks have intensified their inflation-fighting rhetoric. Notably, the ECB has warned that it may raise rates at its next meeting; and in the United Kingdom, Mervyn King--in his letter to the Chancellor--underscored his determination to ensure that inflation remains contained. As shown on the bottom left, we now assume that both the ECB and the Bank of England will raise rates in the second half of this year, compared with the near-term cuts we had anticipated in the April Greenbook. In addition, we now see the Bank of Canada keeping policy on hold. In the emerging market economies, including Mexico and China (the bottom right panel), increases in inflation have largely been driven by rising food prices, which account for a substantial share of consumer expenditures. Policymakers in the EMEs have taken steps to slow the rise in food prices, with some countries introducing price controls and export bans on agricultural goods. But officials have also relied on more-orthodox policies to combat inflation, including raising policy rates and hiking reserve requirements. Indeed, over the intermeeting period, monetary policy was tightened in a range of emerging market economies, including Mexico, Brazil, China, India, Russia, and Hungary. As shown in the top left panel of exhibit 5, the path of the broad real dollar is now just a little weaker than we anticipated at the time of the January chart show. We continue to expect the dollar to depreciate at an annual rate of 3 percent through the forecast period, reflecting persisting downward pressures associated with the current account deficit. This depreciation is projected to come largely against emerging market currencies (including the Chinese renminbi), which have moved less since the dollar's peak in early 2002. It's safe to say that core import price inflation (on the right) has come in substantially higher than we projected in January. Incorporating the BLS monthly data for April and May, we now see core import prices in the second quarter surging at an annual rate of 10� percent, the fastest rise in two decades. This increase, which comes on the heels of an 8 percent jump in the first quarter, was heavily concentrated in material-intensive goods and suggests a much more rapid and, perhaps, stronger effect from the run-up in commodity prices than we saw in the past. Conditional on nonfuel commodity prices flattening out, core import price inflation should decline to less than 2 percent next year. Finally, summing up what these developments mean for U.S. activity, we now see the contribution from net exports to U.S. real GDP growth (line 3 in the table) as likely to exceed 2 percentage points in the second quarter, as exports expand at a smart pace (supported by the lower dollar) and imports contract sharply. This marked weakness in imports reflects both a steep drop in real oil imports and a continued decline in imports of core goods (reflecting sluggish U.S. GDP growth and rising prices of imported commodities). The positive contribution from net exports moderates to � percentage point in the second half of this year and to � percentage point in 2009. While the pace of export growth is projected to remain strong, at above 7 percent, imports should gradually accelerate as the U.S. economy recovers. Larry will now continue our presentation. " CHRG-109hhrg31539--111 Mr. Bernanke," Congressman, I think there are a number of factors affecting inflation, but probably one of the most important is the fact that energy and commodity prices have gone up so much. And that affects, to some extent, the strength of the global economy, which has been very strong for the 3 or 4 years, and the increased demand for energy coming from China and other places has driven up those prices, and that has been a contributing factor to our inflation issue. " FOMC20070131meeting--55 53,MR. GAGNON.," Your first international exhibit (exhibit 9) covers recent market developments. As shown by the green line in the top left panel, oil prices dropped further this month, bringing the West Texas intermediate spot price back to pre- Katrina levels. The IMF index of nonfuel commodity prices (the red line) was little changed this month after a year of remarkable increases. Readings from futures markets imply a flattening out of nonfuel commodity prices and only a moderate increase in oil prices going forward. The top right panel shows that our real trade- weighted dollar indexes declined on balance last year. In recent weeks the dollar rebounded modestly against the major industrial-country currencies (the red line), but we estimate that it continued to decline in real terms against the currencies of our other important trading partners (the green line). As usual, our forecast calls for a small downward trend from current levels, reflecting our belief that the risk of significant depreciation is slightly greater than the risk of significant appreciation, owing to the unsustainably large U.S. trade deficit. The bottom panels report equity market indexes, with industrial countries shown on the left. The lines are set to equal 100 in March 2000, the previous peak month for the Wilshire 5000. Equity prices have risen broadly across the industrial countries over the past two years and are now just above their March 2000 levels in the United States, the United Kingdom, and Japan, but not in the euro area (the red line). For major emerging markets, on the right, equity indexes are well above March 2000 levels. In Mexico (the blue line), equity prices have more than tripled over this period. In Thailand (the green line), the government’s recent attempts to slow capital inflows and relieve upward pressure on the currency have taken their toll on equity prices, but contagion to other emerging equity markets has been minimal. Overall, commodity and financial market developments are consistent with expectations of strong global growth. Exhibit 10 focuses on financial flows between emerging markets and industrial countries. As shown in the top left panel, the major developing regions have continued the downward trend in their reliance on external borrowing. Fiscal deficits have declined in most countries, and many governments have turned increasingly to local, rather than external, borrowing. The panel to the right shows that yield spreads on dollar-denominated sovereign debt of emerging market countries have dropped to historically low levels. But emerging markets, in the aggregate, have gone much further than just reducing their borrowing. In recent years, emerging markets have experienced record outflows of official capital (the gold bars in the middle panel). These official outflows are composed of the accumulation of foreign exchange reserves, the servicing and paying down of sovereign debt, and the purchase of foreign assets by government-run investment funds such as the Kuwait Investment Authority. In all the emerging market regions, official capital outflows have recently exceeded current account surpluses (the blue bars), which are themselves at record levels. For example, the IMF estimates that in 2006, governments in emerging Asia invested on balance $270 billion outside their borders, a sum that greatly exceeds their combined current account surplus of $185 billion. Most of these official flows have taken the form of additions to foreign exchange reserves, as governments have built up war chests against future financial crises and sought to counter upward pressures on their currencies. The bottom panel looks at these flows from the point of view of the industrial countries, plotting aggregate emerging market net official flows (the gold bars) relative to industrial-country GDP, with negative values denoting net flows into the industrial countries. The statistical accounts do not report the destinations of all these flows, but the available evidence suggests that the overwhelming majority is destined for the industrial countries. Before 2003, net official inflows or outflows from the emerging markets had never exceeded 1 percent of industrial-country GDP. But since 2003, things have changed. Net official outflows from emerging markets are now estimated to equal 2½ percent of the combined GDP of the industrial countries. As shown in the panel, the timing of this unprecedented increase in net official flows corresponds well with the puzzling decline in real short-term interest rates in the industrial countries (the green line) that persisted long after industrial-country GDP growth (the purple line) rebounded from the slowdown early in this decade. The evidence suggests that aggregate policy-driven capital flows from the emerging markets may be an important factor behind low real interest rates in the industrial countries. Moreover, low real rates are not limited to short-maturity instruments. The top panels of exhibit 11 show that ten-year indexed bond yields are also low and have been for several years in the major industrial countries. These rates have ticked up over the past month or two, but only by a small amount. Long-term inflation compensation (shown in the middle row of panels) remains contained. Indeed, in Japan and Canada (the two panels on the right) inflation compensation has moved down in recent months. In the euro area and the United Kingdom (the two panels on the left), where inflation compensation lingers above policymakers’ targets, we project modest additional policy tightening early this year, shown in the bottom row of panels. Despite recent and expected future inflation rates close to zero, the Bank of Japan seems poised to tighten gradually over the next two years. In Canada, policy is expected to remain on hold. If these projections prove to be the peak policy rates for this cycle, they will be the lowest cyclical peaks for short-term interest rates in these countries for at least forty years. Nevertheless, we judge that these policy stances are likely to be consistent with low and stable inflation this year and next. The large capital inflows and low real interest rates in the industrial countries have contributed to rising housing prices in many of these countries. Higher home prices in turn have stimulated housing construction. The top panel of exhibit 12 shows that the extent and timing of the house-price boom differs markedly across countries. The Netherlands (the blue line) was one of the leaders of the global housing boom, with prices rising continuously since the early 1990s, though at much slower rates in recent years. Japan (the green line), on the other hand, is a notable exception to the trend of rising house prices in recent years, reflecting the lingering effects of the bursting of the 1980s asset bubble and Japan’s extended economic slump. The middle panels focus on two countries that experienced strong house-price increases (the purple lines) early in this decade but where house-price increases subsequently halted, at least temporarily. In both Australia and the United Kingdom, as in the United States, residential investment (the green lines) responded positively to higher house prices. In Australia, on the left, real house prices have been flat for the past three years, and residential investment has declined gradually about 1 percentage point of GDP, though it remains above its historical average. In the United Kingdom, on the right, house prices stabilized in 2005 and picked up again modestly last year. Despite lower house-price inflation, residential investment has continued to rise toward historically high levels. The relevance of these foreign experiences for the United States is difficult to gauge, but they provide some support for Larry’s forecast that the downturn in U.S. housing is nearly over. In light of the signals from financial and commodity markets, as well as other real-side indicators, we project continued solid growth in the foreign economies at rates that are not likely to strain resources or to put upward pressure on inflation. As shown in the bottom panel, total foreign growth (line 1) is estimated to have stepped down last year from 4½ percent in the first half to about 3½ percent in the second half, and it is projected to remain around 3½ percent over the forecast period. This projection is about 1 percentage point stronger than the staff’s projection for U.S. growth, shown at the bottom of the panel. The foreign industrial economies (line 2) overall are projected to grow at about the same rate as the United States, Japan a bit slower (line 4), and Canada a bit faster (line 5). The emerging market economies (line 6) are projected to grow at nearly twice the pace of the industrial economies over the forecast period. We expect that emerging Asia (line 7) will continue to grow very rapidly and that Latin America (line 8) will grow at a solid, though not exceptional, rate. Our forecast assumes that the Chinese government will take additional measures if necessary to reduce the growth rate of investment, and we project that Chinese GDP growth will be slower this year than last. But the risks to our growth forecast for China are probably greater on the upside. Exhibit 13 provides an assessment of what all these foreign influences mean for the U.S. economy. Overall import prices, the black line in the top left panel, fell sharply last quarter and are projected to continue to fall in the current quarter, primarily owing to the drop in the price of imported oil. As oil prices stop falling and begin to move gradually back up, overall import price inflation should turn positive. Prices of imported core goods (the red line), which exclude oil, gas, computers, and semiconductors, rose at a rate of nearly 4 percent in the middle of last year, primarily owing to sharply higher prices of nonfuel commodities. With commodity prices projected to stabilize and with only a small depreciation of the dollar in our forecast, prices of imported core goods should increase at a subdued pace over the next two years. The contributions of exports and imports to U.S. GDP growth are shown in the lower panel. We now estimate that the external sector made a positive arithmetic contribution to growth last year, the first positive annual contribution since 1995. Import growth stepped down from previous years as U.S. GDP grew more slowly. Export growth benefited from robust foreign economic activity, but exports turned out even stronger than our models project. Line 1 in the top right panel shows that, for the first eleven months of last year at an annual rate, exports of goods grew 10½ percent from the previous year in real terms. Lines 2 through 4 show that three categories of capital goods—aircraft, machinery, and semiconductors—contributed nearly half of total export growth. Although it is possible that blistering growth rates in exports of these goods may continue, we base our forecast on a return of export growth to a rate more consistent with historical relationships. With the vast majority of aircraft production being exported in recent months and with aircraft factories running at high utilization rates, further large increases in exports from this sector, at least, do not seem likely. Returning to the bottom panel, we project that the negative arithmetic contribution of imports (the red bars) to GDP growth will outweigh the export contribution (the blue bars) in 2007 and 2008 by about ¼ percentage point (the black line). This projection is driven by the historical tendency of U.S. imports to grow at a much faster rate than U.S. GDP. In addition, the larger value of imports relative to exports means that, even if imports and exports were to grow at the same rate, the negative contribution of imports would be greater than the positive contribution of exports. The projected strong growth rates of foreign GDP, discussed in your previous exhibit, are not large enough to outweigh these factors over the next two years. On balance, relative prices have little effect on net exports over the forecast period, as the real trade-weighted dollar has moved in a relatively narrow range over the past couple years and is not projected to move substantially over the forecast period. And now Larry will complete our presentation." CHRG-111hhrg63105--76 Mr. Chilton," It is actually--we know that a lot of money went out. And it went--I mean, look, as the Chairman said, we are not price setters. We are supposed to be commodity blind, although I have a little bit of penchant for the ags, and price neutral. We are not price setters. And I also get concerned when oil is $150 but---- " FOMC20080130meeting--335 333,VICE CHAIRMAN GEITHNER.," Thank you. I agree with President Poole and President Yellen about the need to focus on compensation structures and incentives, but just two observations. One is that, if you look at compensation practices among the guys who actually look as though they did pretty well against those who didn't do so well--I'm not talking about in a mortgage-origination sense but in the major global financial institutions--the structure of compensation doesn't vary that much. What varies a lot is how well people control for the inherent problems in the basic compensation structures. Remember Raghu's presentation was mostly about hedge fund compensation, and I think he is mostly wrong when you think about that and the incentive structure. The difference really is how you design your limits to make sure that your traders' incentives are more aligned with the incentives of the firm as a whole. The biggest errors and differences are in the design of the process of the checks and balances to compensate for the inherent problems in the compensation structure. That's important to know because a lot of these things, if you look at the formal attributes of the risk-management governance structure across these firms, don't look that different. What distinguishes how well the guys did is much more subtle around culture, independence, and the quality of judgment exercised at the senior level, and this is important because, when you think about what you can do through supervision and regulation, to affect that stuff is hard. I have a question for Pat. Pat, not to overdo this, but where do you put in your diagnosis of contributing factors the constellation of financial conditions that prevailed during the boom and what those did to housing prices? You know, there's a tendency for everybody to look at regulation and supervision and the incentives that they have created or failed to mitigate, but there is a reasonable view of the world that you wouldn't have had the pattern of underwriting standards of mortgages without the trajectory of house prices that occurred. Sure, maybe what happened in the late stage of the mortgage-origination process contributed to the upside, but if you look at a chart, the rate of house-price appreciation started to decelerate about the time you had the worst erosion in underwriting practices. Anyway, my basic question is, Where do you put the constellation of financial conditions, not so much just what the Fed was doing but what was happening globally that affected long rates, expectations of future rates, et cetera? " CHRG-111hhrg72887--103 Mr. Rush," The Chair thanks the gentleman and all of the witnesses. The Chair recognizes himself for 5 minutes for the purposes of asking questions of these witnesses. In the subcommittee's last hearing on consumer credit issues, I asked the FTC Chairman, John Leibovitz, about the Commission's record in protecting consumers from unfair and deceptive practices in the past several years. I noted that the FTC arguably didn't do enough to stop the mortgage lending practices during the housing era or housing boom, I might add. The Chairman argued that the FTC argued that the FTC is ``hamstrung'' by the burdensome rulemaking process under Magnuson-Moss, and he assured me that if Congress gave the FTC the authority to issue rules under the Standard Administrative Procedures Act, the FTC would indeed be more effective in this particular area. Today we are considering legislation that would give to FTC this authority that Chairman Leibovitz requested at one of our hearings. My question to Ms. Keest--and I would also like to get a response from Ms. Harrington--Ms. Keest, Congress has duly given the FTC streamlined rulemaking authority on a case-by-case basis. We have taken another approach in this bill. The Chairman has requested we give the FTC broad APA authority to issue rulings on anything involving consumer credit or debt. My question is should we trust the FTC's discretion to essentially use this authority, or will we be better off sticking with direct rulemaking? Ms. Keest. I think it is extremely important to give them discretion for the simple reason that the velocity at which the market changes is far too fast to have to come back and make a record every single time. For example, the last time before Congress passed the H.R.--the predecessor of H.R. 72, 1728, last week, it had been 15 years before Congress acted on consumer mortgage issues. And there is a lot that goes on, and there is a lot that the FTC has on its plate. There is a lot that Congress has on its plate. And in the meantime, the markets develop and move, and I don't really think it is feasible to wait for specific direction as every problem comes up one by one. " CHRG-111hhrg53021Oth--188 Mr. Costa," In the same ballpark, in follow-up to Congressman Scott's question, you talked about capital requirements being uniform between financial and nonfinancial traders. How would you visualize that taking place between commodities, a company continuing to participate in the market, if they are required to have an extensive cash capital? " CHRG-111hhrg53021--188 Mr. Costa," In the same ballpark, in follow-up to Congressman Scott's question, you talked about capital requirements being uniform between financial and nonfinancial traders. How would you visualize that taking place between commodities, a company continuing to participate in the market, if they are required to have an extensive cash capital? " FOMC20050322meeting--16 14,CHAIRMAN GREENSPAN.," But if you take it as a meaningful index, that’s a very impressive move. And the point is that it’s the first time I’ve seen anything like that in the commodities area. I’ve always looked at the CRB futures, which does look something like this, but I assumed it was a third-order matter. Anyway, enough of that." CHRG-110shrg50369--126 Mr. Bernanke," Well, I do not think that foreign investors have lost confidence in the United States by any means. The data you are referring to shows some desire by foreign investors to shift out of corporate credits and other credit products and into treasuries. That is the same shift that American investors are making. They are getting away from what they view as risky credits toward the safety of U.S. Government debt. And, indeed, U.S. Government debt is still the safest, most liquid, desired asset in the world. There is some effect of the dollar on commodities. Oil and other commodities are traded globally. You can think of the price as being set by global supply and demand. If the dollar depreciates a bit, then you would expect to see commodity prices rise to offset that depreciation. But it is important to understand that, for example, oil has risen in euros as well as in dollars. I mean, it is not simply an issue of currencies. It also has to do with global supply and demand for the commodity. So the European Central Bank is concerned about food and energy inflation as well. With respect to the sovereign wealth funds, that is just another indication that foreigners have not lost confidence in the U.S. economy and that there has been a good bit of inflow. In particular, about something close to half of the capital that financial institutions have raised in the last few months has come from sovereign wealth funds, from other countries. I think that, in general, that is quite constructive. If we are confident, as I think we are in this case, that the investments are made for economic reasons and not for political reasons or other noneconomic reasons, and there is no issue of national defense, which the CFIUS process takes care of, then that inflow of investment is good for our economy and certainly is helping, in this case, the financial system. At the same time, allowing inflows of foreign capital through reciprocity gives us more opportunities to invest abroad. I know that Congress is very interested in sovereign wealth funds, and you should certainly take a close look at it. International agencies, like the International Monetary Fund and the OECD, are developing codes of conduct. The basic idea there is that sovereign wealth funds should be as transparent as possible. We should understand their governance and their motivations, and, in particular, we should be confident that they are investing, again, for economic rather than political or other purposes. If we are confident in that, then it is in our interest to keep our borders open and to allow that capital to flow in. And I think it will continue to flow in. " CHRG-110hhrg44901--137 The Chairman," I will say in the 10 seconds I will borrow from the gentlelady, my jurisdiction proposal is we leave with the Agriculture Committee jurisdiction over all those futures and things you can eat, and we get the rest. The gentleman from California. Mr. Miller of California. Thank you, Mr. Chairman. I kind of enjoyed the comments that the Federal Reserve is getting blamed for not dealing with the predatory issue as it applies to subprime. But I recall 5 years ago, I repeatedly tried to introduce language to effectively define what predatory was versus subprime and included the issues you have dealt with finally. So I feel guilty blaming you for something 5 years ago we should have done and didn't. The purpose and intent of the GSEs was to inject liquidity into the marketplace, which we have done. If you look at the amount of loans that are out there, I think it has proven to be very beneficial to the housing market. Having been a developer for over 35 years, I have been through the 1970's recession, 1980's, 1990's. Any time you see a housing boom, you know eventually there is a going to be a housing recession occurs. It has happened repeatedly. This one is a little different, but every one I have been through has been somewhat different. In the stimulus package we passed recently, I think the most important part on the economy was increasing conforming loan limits for FHA and GSEs. Sending people a check, yes, there is a benefit to that. But the main reason I think for the situation the economy is in today is because of the housing recession we have gone through. I think raising conforming loan limits in high-cost areas has gone a long way to mitigating an impact that could have been worse than it was. Especially in California and other areas there are many lenders that will not make a loan today if it is not conforming because they don't have the assets basically to tie their capital up if they can't make the loan and sell the loan off. Now, there has been discussion about after December 31st, we are going to be dropping those limits down to much lower levels. I believe that is going to have a major detrimental impact on the housing market because it sends--even the discussion and debate about doing that sends a message that we are not going to be committed in the future to trying to create liquidity in these high-cost areas. I would like to have your opinion on that issue. " fcic_final_report_full--74 DOTCOM CRASH: “LAY ON MORE RISK ” The late s was a good time for investment banking. Annual public underwrit- ings and private placements of corporate securities in U.S. markets almost quadru- pled, from  billion in  to . trillion in . Annual initial public offerings of stocks (IPOs) soared from  billion in  to  billion in  as banks and securities firms sponsored IPOs for new Internet and telecommunications compa- nies—the dot-coms and telecoms.  A stock market boom ensued comparable to the great bull market of the s. The value of publicly traded stocks rose from . tril- lion in December  to . trillion in March .  The boom was particularly striking in recent dot-com and telecom issues on the NASDAQ exchange. Over this period, the NASDAQ skyrocketed from  to ,. In the spring of , the tech bubble burst. The “new economy” dot-coms and telecoms had failed to match the lofty expectations of investors, who had relied on bullish—and, as it turned out, sometimes deceptive—research reports issued by the same banks and securities firms that had underwritten the tech companies’ initial public offerings. Between March  and March , the NASDAQ fell by almost two-thirds. This slump accelerated after the terrorist attacks on September  as the nation slipped into recession. Investors were further shaken by revelations of ac- counting frauds and other scandals at prominent firms such as Enron and World- com. Some leading commercial and investment banks settled with regulators over improper practices in the allocation of IPO shares during the bubble—for spinning (doling out shares in “hot” IPOs in return for reciprocal business) and laddering (doling out shares to investors who agreed to buy more later at higher prices).  The regulators also found that public research reports prepared by investment banks’ ana- lysts were tainted by conflicts of interest. The SEC, New York’s attorney general, the National Association of Securities Dealers (now FINRA), and state regulators settled enforcement actions against  firms for  million, forbade certain practices, and instituted reforms.  The sudden collapses of Enron and WorldCom were shocking; with assets of  billion and  billion, respectively, they were the largest corporate bankruptcies before the default of Lehman Brothers in . Following legal proceedings and investigations, Citigroup, JP Morgan, Merrill Lynch, and other Wall Street banks paid billions of dollars—although admitted no wrongdoing—for helping Enron hide its debt until just before its collapse. Enron and its bankers had created entities to do complex transactions generating fictitious earnings, disguised debt as sales and derivative transactions, and understated the firm’s leverage. Executives at the banks had pressured their analysts to write glowing evaluations of Enron. The scandal cost Citigroup, JP Morgan, CIBC, Merrill Lynch, and other financial institutions more than  million in settlements with the SEC; Citigroup, JP Morgan, CIBC, Lehman Brothers, and Bank of America paid another . billion to investors to settle class action lawsuits.  In response, the Sarbanes- Oxley Act of  required the personal certification of financial reports by CEOs and CFOs; independent audit committees; longer jail sentences and larger fines for executives who misstate financial results; and protections for whistleblowers. Some firms that lent to companies that failed during the stock market bust were successfully hedged, having earlier purchased credit default swaps on these firms. Regulators seemed to draw comfort from the fact that major banks had succeeded in transferring losses from those relationships to investors through these and other hedging transactions. In November , Fed Chairman Greenspan said credit de- rivatives “appear to have effectively spread losses” from defaults by Enron and other large corporations. Although he conceded the market was “still too new to have been tested” thoroughly, he observed that “to date, it appears to have functioned well.”  The following year, Fed Vice Chairman Roger Ferguson noted that “the most re- markable fact regarding the banking industry during this period is its resilience and retention of fundamental strength.”  CHRG-111shrg57322--1073 Mr. Blankfein," Every futures contract on oil or anything consists of you could characterize it as a bet, but not the underlying commodity. Some of these things just don't even settle in physical form, but they provide the liquidity and the opportunity for people who want to hedge themselves to get in and take that position. Senator McCaskill. And we can't take this too far. " CHRG-110shrg50410--107 Chairman Dodd," Senator Schumer. Senator Schumer. Well, thank you. And I apologize to the witnesses. As I am sure people have mentioned, we have our Democratic and Republican Caucus lunches, and so I had to be there. First I just, not my main point of questions, but I wanted to underscore what Senator Casey said. We are going to need broad bipartisan support to get this done. There is already word that one Republican senator said he would do everything he could to block it, which then means we need 60 votes. So we have to do this in a bipartisan way. And we just need your commitment and the President's, that they are going to do everything they can to get this done and done quickly. I, for one, think that you have put together a good plan. And you are sort of in a funny situation here. I mean, markets always get overconfident. That is the history of them. That is why we have booms and busts. But in this world of universal knowledge, everyone gets overconfident at once. And it is not one corner of a State or then one corner of a country or even one country in the world, but everybody. And so when the problem occurs and everyone thinks OK, we can all do no doc mortgages because housing values will always get up, everybody gets in trouble. And that means you need broad solutions. And so I, for one, think that the irony here is the more limits we put on this, the more worried the markets be. And if the real issue here is not the fundamental strength of Fannie and Freddie, low as their stock price is, but rather the psychology, in a certain sense the more open-ended the power, the ability--not the use but the ability, as I think you said, it is a bazooka in your pocket that you hope you do not have to use--the better. So I hope we can move this quickly and I think we ought to be careful before imposing various limitations in terms of giving the markets confidence that if, God forbid, something bad happens--and I do not think it will--the Government will be there. So I salute you on that. The two kinds of limitations that I think are appropriate are one, in time. You have had 18 months. Maybe it should just be a year and we will renew it if, God forbid, it is still bad. The second, and you have done some of this, is to make sure the Government comes first over the shareholders, that the Government is fully repaid before the stockholders and other financial interests get repaid. Can you assure us that the plan we put together will keep that limitation, which I think is a reasonable limitation that will not spook the markets in any way, is there? " fcic_final_report_full--65 A key OTC derivative in the financial crisis was the credit default swap (CDS), which offered the seller a little potential upside at the relatively small risk of a poten- tially large downside. The purchaser of a CDS transferred to the seller the default risk of an underlying debt. The debt security could be any bond or loan obligation. The CDS buyer made periodic payments to the seller during the life of the swap. In re- turn, the seller offered protection against default or specified “credit events” such as a partial default. If a credit event such as a default occurred, the CDS seller would typi- cally pay the buyer the face value of the debt. Credit default swaps were often compared to insurance: the seller was described as insuring against a default in the underlying asset. However, while similar to insurance, CDS escaped regulation by state insurance supervisors because they were treated as deregulated OTC derivatives. This made CDS very different from insurance in at least two important respects. First, only a person with an insurable interest can obtain an insurance policy. A car owner can insure only the car she owns—not her neighbor’s. But a CDS purchaser can use it to speculate on the default of a loan the purchaser does not own. These are often called “naked credit default swaps” and can inflate potential losses and corresponding gains on the default of a loan or institution. Before the CFMA was passed, there was uncertainty about whether or not state insurance regulators had authority over credit default swaps. In June , in re- sponse to a letter from the law firm of Skadden, Arps, Slate, Meagher & Flom, LLP, the New York State Insurance Department determined that “naked” credit default swaps did not count as insurance and were therefore not subject to regulation.  In addition, when an insurance company sells a policy, insurance regulators re- quire that it put aside reserves in case of a loss. In the housing boom, CDS were sold by firms that failed to put up any reserves or initial collateral or to hedge their expo- sure. In the run-up to the crisis, AIG, the largest U.S. insurance company, would ac- cumulate a one-half trillion dollar position in credit risk through the OTC market without being required to post one dollar’s worth of initial collateral or making any other provision for loss.  AIG was not alone. The value of the underlying assets for CDS outstanding worldwide grew from . trillion at the end of  to a peak of . trillion at the end of .  A significant portion was apparently speculative or naked credit default swaps.  Much of the risk of CDS and other derivatives was concentrated in a few of the very largest banks, investment banks, and others—such as AIG Financial Products, a unit of AIG  —that dominated dealing in OTC derivatives. Among U.S. bank holding companies,  of the notional amount of OTC derivatives, millions of contracts, were traded by just five large institutions (in , JPMorgan Chase, Citigroup, Bank of America, Wachovia, and HSBC)—many of the same firms that would find them- selves in trouble during the financial crisis.  The country’s five largest investment banks were also among the world’s largest OTC derivatives dealers. While financial institutions surveyed by the FCIC said they do not track rev- enues and profits generated by their derivatives operations, some firms did provide estimates. For example, Goldman Sachs estimated that between  and  of its revenues from  through  were generated by derivatives, including  to  of the firm’s commodities business, and half or more of its interest rate and cur- rencies business. From May  through November ,  billion, or , of the  billion of trades made by Goldman’s mortgage department were derivative transactions.  CHRG-111hhrg53246--71 Mr. Gensler," It is a very good point. It is why we have asked Congress and this committee to consider in over-the-counter derivatives regulation that we also make sure that the position limit authority for commodities of finite supply, that we also be able to do that in the over-the-counter market if it serves a price discovery function back into the other regulated markets. Because you are right that you could move from the futures to the over-the-counter derivatives. And we saw that in a number of cases in the last several years. " CHRG-111hhrg51698--303 Mr. Short," Thank you. Chairman Peterson, Ranking Member Lucas, I am Johnathan Short, Senior Vice President and General Counsel with IntercontinentalExchange or ICE. We are grateful for the opportunity to provide comments on the discussion draft of the Derivatives Markets Transparency and Accountability Act, and I fully support the goals of the Act to bring transparency and accountability to commodity markets. As the owner of regulated exchanges and clearinghouses in the United States, the United Kingdom and Canada, ICE has committed to facilitating global regulatory cooperation to ensure that regulatory best practices are adopted around the world. As the global nature of this financial crisis aptly illustrates, systemic market problems cannot be solved unilaterally, and solutions will require close cooperation between governments of major developed nations and a willingness on the part of those governments to implement the best financial market practices, regardless of their source of origin. Combined with commitment to open markets, such an approach will be the best way to achieve the goals of the DMTAA. Against this backdrop, we would offer brief thoughts on three sections of the Act: section 3, foreign boards of trade; section 6, trading limits to prevent excessive speculation; and section 16, limitation on the ability to purchase credit default swaps. Please note that our views on specific provisions of the Act should not be misconstrued as opposition to the Act as a whole, or opposition to the important steps that this Committee has taken to restore confidence in our financial markets. Beginning with section 3 on foreign boards of trade, ICE is generally supportive of this provision as it codifies existing obligations that ICE Futures Europe has been complying with since late last year, including implementation of position limits and accountability for DCM link contracts. And, for the first time in a European exchange regulation, the generation of large trader reporting to assist the CFTC in its markets surveillance efforts. However, section 3 of the Act contains one provision that would inappropriately discriminate against foreign exchanges and the competition that they bring to bear. Unlike the requirements applicable to domestic exchanges, section 3 requires that foreign exchanges adopt position limits taking into consideration the relative sizes of respective markets. This provision would hamper competition between exchanges and would effectively prevent foreign exchanges from attaining sufficient market liquidity to offer the type of trading markets necessary to compete with domestic exchanges as all competitors would, by definition, start with little or no market share. Domestic exchanges could ultimately be impacted as well by this provision if foreign governments adopt similar provisions in their laws. Considering the significant benefits that competition has brought to the marketplace and the need for international regulatory cooperation, we would respectfully request that this provision of the Act be modified, and would note that if the goal of the provision is to prevent multiplication of positions across numerous exchanges, the same goal could be achieved through requiring market participants to liquidate positions should they exceed an aggregate limit observed by the CFTC. Turning to section 6 of the Act, ICE's subsidiary, ICE Futures U.S., formerly the New York Board of Trade, is a designated contract market regulated by the CFTC. Among the products it lists for trading are three international soft commodity contracts: coffee, wool, sugar and cocoa; and it is the preeminent market for price discovery in these commodities. None of these commodities are grown in the United States or are subject to any domestic price support programs, unlike domestic commodities'; and all of these commodities are also traded on established exchanges in London, Brazil and the Far East. Section 6 fails to distinguish between the international agricultural commodities and domestically grown agricultural commodities that have traditionally been the focus of the Committee's oversight. Section 6 would require the CFTC, rather than ICE Futures U.S., to set position limits with respect to these international markets, and would replace ICE Futures' strong market expertise in these areas to the detriment of both the exchange and the broader markets, potentially shifting trading in these commodities to foreign markets that are not subject to CFTC jurisdiction. Finally, turning to section 16 of the Act that prohibits trading and credit default swaps without ownership and the underlying obligation. As with all trading markets, hedgers must be able to transact with another party willing to buy their risk for a price. Section 16 would likely end the CDS market in the United States due to the inability of hedgers to find counterparties legally able to buy their risk, and could prove problematic for the trading of CDS indices in which parties would apparently have to own all of the underlying bonds to trade an index. This would be counterproductive, as transparent and stable CDS markets are important for the recovery of broader financial markets. Many of the problems that have been identified in the CDS market relate to the lack of transparency in markets and outsize risks undertaken by financial entities, and we believe that these issues can be addressed through central counterparty clearing. ICE is proud to be working towards establishing ICE U.S. Trust to clear these products. In conclusion, ICE strongly supports the goals of the Act and will continue to work cooperatively with this Committee to find solutions that promote the best marketplace possible. [The prepared statement of Mr. Short follows:] Prepared Statement of Johnathan H. Short, Senior Vice President and General Counsel, IntercontinentalExchange, Inc., Atlanta, GAIntroduction Chairman Peterson, Ranking Member Lucas, I am Johnathan Short, Senior Vice President and General Counsel of IntercontinentalExchange, Inc., or ``ICE.'' We are grateful for the opportunity to provide comments on the ``discussion draft'' of the Derivatives Markets Transparency and Accountability Act (DMTAA). ICE fully supports the goal of the DMTAA to ``bring transparency and accountability to commodity markets.'' Over the past decade, we have worked with regulators both in the United States and abroad to achieve this end and appreciate the opportunity to work on additional improvements. As background, ICE operates three regulated futures exchanges: ICE Futures Europe, formerly known as the ``International Petroleum Exchange,'' is regulated by the U.K. Financial Services Authority (FSA). ICE Futures U.S., previously known as ``The Board of Trade of the City of New York (NYBOT)'' and the New York Clearing Corporation are both regulated by the CFTC. ICE Futures Canada, which was previously called the Winnipeg Commodity Exchange, is regulated the Manitoba Securities Commission. In addition, ICE operates an over-the-counter (OTC) energy platform as exempt commercial market, as defined by the Commodity Exchange Act. On these exchanges, ICE offers futures and options contracts on energy products (including the benchmark Brent and WTI contracts), agricultural commodities, currencies and equity indexes. ICE has worked to provide transparency to a varied array of markets. For example, ICE brought transparency to OTC energy markets nearly a decade ago, with a digital platform that transformed the marketplace from an opaque, telephone-based network of brokerages to a global market with real-time prices on electronic trading screens. In its 2007 State of the Markets Report, Federal Energy Regulatory Commission (FERC) observed that ICE ``provides the clearest view we have into bilateral spot markets.'' \1\--------------------------------------------------------------------------- \1\ Federal Energy Regulatory Commission, 2007 State of the Markets Report, pg. 9 (Issued, March 20, 2008).--------------------------------------------------------------------------- In 2002, in response to the credit and counterparty risk crisis that were then gripping the energy markets, we introduced clearing into the OTC energy markets. Cleared contracts now account for more than 90 percent of ICE's OTC business. Believing that centralized clearing is an essential next step in stabilizing the credit derivatives market, since last summer ICE has been working with the Federal Reserve System, the New York Banking Department and a number of industry participants to develop a clearing solution for credit default swaps (CDS). Last May, as part of the farm bill reauthorization, Congress provided the CFTC with greater oversight of electronic OTC markets, or Exempt Commercial Markets. The new law provides legal and regulatory parity between fully regulated futures exchanges and OTC contracts that serve a significant price discovery function,\2\ while also recognizing and preserving the role of OTC markets in providing innovation and customization. ICE supported this legislation, and we remain grateful for this Committee's leadership during that debate.--------------------------------------------------------------------------- \2\ This provision of the farm bill is commonly referred to as the ``Closing the Enron Loophole Act.''--------------------------------------------------------------------------- Because ICE operates markets in both domestic and foreign jurisdictions, ICE is keenly aware of the global nature of most commodity and financial derivative markets. Furthermore, ICE is committed to facilitating global regulatory cooperation and the implementation of best practices in financial markets around the world. As the global nature of this financial crisis illustrates, systemic market problems cannot be solved independently, and solutions will require both close coordination and cooperation between governments of major developed nations and a willingness to implement best practices regardless of their source of origin. Combined with a commitment to open markets, such an approach will be the best way forward toward solving the problems that have impacted economies around the world. We offer our comments on several provisions in the bill in the spirit of finding solutions that will achieve the stated purpose of improving transparency and accountability in commodity markets.Section 3--Foreign Boards of Trade Earlier last month, the G30's Working Group on Financial Reform, led by Chairman Paul Volcker, published its Framework for Financial Stability. Core recommendation two states, ``The quality and effectiveness of prudential regulation and supervision must be improved. This will require better-resourced prudential regulators and central banks operating within structures that afford much higher levels of national and international policy coordination.'' Recommendation 6b, on regulatory structure, states, ``In all cases, countries should explicitly reaffirm the insulation of national regulatory authorities from political and market pressures and reassess the need for improving the quality and adequacy of resources available to such authorities.'' By supporting coordination and information sharing among international regulators, the foreign board of trade provision in the DMTAA, advances the G30's recommendations. We are concerned; however, that one aspect of that provision could limit competition between domestic and foreign exchanges and ultimately threaten cooperation between domestic and foreign regulators, and indeed domestic and foreign governments, in implementing uniform standards to improve markets. Since 2006, ICE has worked with the United Kingdom's Financial Services Authority to provide the CFTC with visibility into markets traded on its foreign board of trade to allow the CFTC to properly surveil domestic regulated markets. On June 17, 2008, the CFTC revised the conditions under which ICE Futures Europe operates in the United States by amending the ``no-action relief letter'' that permits that exchange to have direct access to U.S. customers for its WTI Crude Oil Futures Contract. The amended letter conditioned ICE Futures Europe's direct screen based access on the adoption of U.S. equivalent position limits and accountability levels, together with reporting obligations, related to contracts that are linked to the price of a U.S. designated contract market price. Since October, ICE Futures Europe has been complying with the revised No Action letter. Section 3 of the DMTAA essentially codifies the conditions set forth in the CFTC's revised No Action letter for ICE Futures Europe, with one important exception. Unlike the requirements applicable to domestic exchanges, section 3 requires foreign exchanges to adopt position limits for the affected contract taking ``into consideration the relative sizes of the respective markets''. This provision discriminates against foreign exchanges, and would effectively prevent them from attaining sufficient market liquidity to compete with domestic exchanges as all competitors would by definition start out with little or no market share. In addition, domestic exchanges could be impacted through the adoption of similar provisions of law in foreign countries which have a larger relative share of the underlying commodity market. In recent years, the only effective competition in the futures industry has come from foreign exchanges and exempt commercial markets. That competition has led U.S. exchanges to transition markets to transparent electronic trading, with full audit trails and improved risk management through straight through processing. It has also resulted in more efficient markets bringing about many benefits for market participants such as lower trading costs and tighter bid/ask spreads. With one exchange in control of more than 97 percent of U.S. futures market, competition is more important than ever. Requiring foreign markets to set position limits according to respective market size would effectively bar foreign exchanges from competing in the U.S., would likely be viewed was extraterritorial regulation by foreign market regulators, and would be inconsistent with the higher level of international policy coordination contemplated by the G30 policy recommendations. ICE respectfully requests that this particular provision of section 3 be reconsidered for the broader policy goals that are sought to be achieved by the G30 policy recommendations and in recognition of the fact that no single piece of legislation adopted here or elsewhere will achieve its ends unless appropriate standards are adopted on an international basis.Section 6--Trading Limits To Prevent Excessive Speculation ICE's U.S. subsidiary, ICE Futures U.S. (formerly the New York Board of Trade) is a designated contract market regulated by the CFTC. Among the products it lists for trading are three international soft commodities--coffee, world sugar and cocoa--and it is the pre-eminent market for price discovery of these commodities. None of these commodities is grown in the United States or is subject to domestic price support programs. Moreover, none of them was the subject of hearings last year conducted by Congressional Committees or reviews by the CFTC into the rise and fall of certain commodity prices. Because they are liquid contracts traded on a designated contract market, our futures and options contracts in these commodities have been subject to position accountability levels and spot month position limits that have been established and administered by the Exchange for more than a decade without incident. Under the terms of the standardized futures contracts, ICE Futures U.S. also regulates physical delivery of those three international commodities from ports or warehouses located in more than two dozen foreign countries around the world. Section 6 of the proposed legislation fails to distinguish between ICE's international agricultural contracts and the domestically-grown agricultural commodities that we believe were the bill's intended subjects. Specifically, the legislation would require the CFTC to set position limits on the number of futures and option contracts that a person could hold in any one futures month of a commodity, in all combined futures months of a commodity, and in the spot month. In contrast, ICE Futures U.S. sets limits for its coffee, sugar and cocoa contracts based on its extensive experience with these markets. In addition, the proposed legislation would amend the Commodity Exchange Act core principles applicable to designated contract markets like ICE Futures U.S. by eliminating the availability of ``position accountability'' levels for speculators in international agricultural commodities. As noted previously, ICE Futures U.S. has set and administered position accountability levels in its internationally-based products for over a decade. For example, through its market oversight, ICE Futures U.S. has been able to respond to market conditions and the needs of its users in a flexible manner, while maintaining transparent and liquid markets relied upon throughout the world. This provision, if implemented, would replace ICE Futures U.S.'s strong market surveillance role with an inflexible regime that would be established, and possibly administered, by the CFTC. This could very well drive business to London, Brazil and the Far East where these products already trade on established futures markets. We do not believe this was the drafters' intent.Section 6--Limitations on index traders Section 6 defines bona fide hedging in a way that would prohibit index traders from taking a position in excess of position limits. This would be a significant change in market structure and will have an immediate and deleterious impact. A recent market study performed by Informa examined the impact of index funds on market volatility. The study employed both Granger causality and vector auto-regression tests and determined that there was no link between index funds and market volatility. Greatly reducing the participation of index funds in the market would be disadvantageous to the market at-large and would most likely only benefit the very largest participants in a given market. In a soft commodities market (e.g., coffee, sugar or cocoa), the removal of this additional liquidity could potentially enable a single large entity or a small group of entities to wield considerable influence on the market dynamics. Section 9 requires the CFTC to study the impact of commodity ``fungibility'' and whether there should be ``aggregate'' position limits for similar agriculture or energy contracts traded on DCMs, DTEFs, 2(g) and 2(h) markets. Sec. 10 requires a GAO study of international regulation of energy commodity markets. Both reports are due in a year. ICE supports these studies without reservation, and we believe this legislation would be improved if it were informed by equally thorough reports on the issues we have discussed today.Section 16--Limitation on Ability To Purchase Credit Default Swaps Section 16 of the bill would prohibit trading in credit default swaps without ownership of the underlying reference obligation. This provision is problematic on several levels. First, CDS perform an important market function in allowing parties to hedge credit risk. Section 16 is titled ``Limitation on Eligibility to Purchase a Credit Default Swap.'' However, the language in subsection (a) prohibits parties from ``entering into a credit default swap'' unless they own the underlying bonds. As with all trading markets, another party must be willing to assume the hedger's risk; therefore, section 16 would likely end the CDS market in the United States due to the inability of hedgers to find counterparties legally able to ``buy their risk''. This would be counterproductive, as a transparent and stable CDS market is important for the recovery of financial markets. Furthermore, not all credit risk has a tailored credit default swap. Section 16 would prohibit parties from hedging default exposure by purchasing credit default indices, unless the party owned every underlying bond in the index. Second, ICE believes that the goals of transparency and mitigation of counterparty credit risk and systemic risk can be achieved through central clearing of CDS and through resulting public and regulatory transparency. Section 16 would run counter to this goal as it would impair the liquidity needed to efficiently manage risk within a clearinghouse in the event of a default or similar event. ICE respectfully requests that the Committee consider eliminating this provision of the draft bill. During the financial crisis, as cash markets evaporated, and markets for commercial paper, corporate bonds and other debt instruments dried up, the CDS market has remained liquid, offering lenders and investors a way to hedge risk and--just as important--a market-based, early-warning price discovery function. Broader availability of credit protection can encourage sovereign and corporate lending. As lenders and investors consider ways to improve credit risk evaluations, CDS spreads have proven to be more reliable indicators of an institution's financial health than credit agency ratings. Finally, on the note of global cooperation, last week in Davos, E.U. Financial Services Commissioner Charlie McCreevy said he would not support a ban on trading credit default swaps unless the party held a position in the underlying bonds. Prohibiting this trade in the United States will almost certainly lead to a wholesale migration of the CDS marketplace overseas, outside the reach of U.S. regulators and this Committee. We do not believe that is the intent of this legislation.Conclusion ICE is a strong proponent of open and competitive derivatives markets, and of appropriate regulatory oversight of those markets. As an operator of global futures and OTC markets, and as a publicly-held company, we understand the essential role of trust and confidence in our markets. To that end, we are pleased to work with Congress to address the challenges presented by derivatives markets, and we will continue to work cooperatively for solutions that promote the best marketplace possible. Mr. Chairman, thank you for the opportunity to share our views with you. I am happy to answer any questions you may have. " fcic_final_report_full--202 Synthetic CDOs boomed. They provided easier opportunities for bullish and bearish investors to bet for and against the housing boom and the securities that de- pended on it. Synthetic CDOs also made it easier for investment banks and CDO managers to create CDOs more quickly. But synthetic CDO issuers and managers had two sets of customers, each with different interests. And managers sometimes had help from customers in selecting the collateral—including those who were bet- ting against the collateral, as a high-profile case launched by the Securities and Ex- change Commission against Goldman Sachs would eventually illustrate.  Regulators reacted weakly. As early as , supervisors recognized that CDOs and credit default swaps (CDS) could actually concentrate rather than diversify risk, but they concluded that Wall Street knew what it was doing. Supervisors issued guid- ance in late  warning banks of the risks of complex structured finance transac- tions—but excluded mortgage-backed securities and CDOs, because they saw the risks of those products as relatively straightforward and well understood.  Disaster was fast approaching. CDO MANAGERS: “WE ARE NOT A RENTAMANAGER” During the “madness,” when everyone wanted a piece of the action, CDO managers faced growing competitive pressures. Managers’ compensation declined, as demand for mortgage-backed securities drove up prices, squeezing the profit they made on CDOs. At the same time, new CDO managers were entering the arena. Wing Chau, a CDO manager who frequently worked with Merrill Lynch, said the fees fell by half for mezzanine CDOs over time.  And overall compensation could be maintained by creating and managing more new product. More than had been the case three or four years earlier, in picking the collateral the managers were influenced by the underwriters—the securities firms that created and marketed the deals. An FCIC survey of  CDO managers confirmed this point.  Sometimes managers were given a portfolio constructed by the securities firm; the managers would then choose the mortgage assets from that portfolio. The equity in- vestors—who often initiated the deal in the first place—also influenced the selection of assets in many instances. Still, some managers said that they acted independently. “We are not a rent-a-manager, we actually select our collateral,” said Lloyd Fass, the general counsel at Vertical Capital.  As we will see, securities firms often had particu- lar CDO managers with whom they preferred to work. Merrill, the market leader, had a constellation of managers; CDOs underwritten by Merrill frequently bought tranches of other Merrill CDOs. According to market participants, CDOs stimulated greater demand for mort- gage-backed securities, particularly those with high yields, and the greater demand in turn affected the standards for originating mortgages underlying those securities.  As standards fell, at least one firm opted out: PIMCO, one of the largest investment funds in the country, whose CDO management unit was one of the nation’s largest in . Early in , it announced that it would not manage any new deals, in part be- cause of the deterioration in the credit quality of mortgage-backed securities. “There is an awful lot of moral hazard in the sector,” Scott Simon, a managing director at PIMCO, told the audience at an industry conference in . “You either take the high road or you don’t—we’re not going to hurt accounts or damage our reputation for fees.” Simon said the rating agencies’ methodologies were not sufficiently strin- gent, particularly because they were being applied to new types of subprime and Alt- A loans with little or no historical performance data.  Not everyone agreed with this viewpoint. “Managers who are sticking in this business are doing it right,” Armand Pastine, the chief operating officer at Maxim Group, responded at that same confer- ence. “To suggest that CDO managers would pull out of an economically viable deal for moral reasons—that’s a cop-out.”  As was typical for the industry during the cri- sis, two of Maxim’s eight mortgage-backed CDOs, Maxim High Grade CDO I and Maxim High Grade CDO II, would default on interest payments to investors—in- cluding investors holding bonds that had originally been rated triple-A—and the other six would be downgraded to junk status, including all of those originally rated triple-A.  CHRG-111hhrg51698--9 Mr. Buis," Thank you, Chairman Peterson, Ranking Member Lucas, and Members of the Committee. It is indeed an honor to be able to testify on this important issue before the Committee. We got involved in this last winter and spring, when we started receiving numerous phone calls from farmers. As wheat prices hit record levels, corn prices were also in the record category. Farmers were calling and saying they couldn't market their grain the way they would normally market it, which is, by and large, being able to price their grain after harvest for delivery. When they were precluded, they were told that the reason was many of the local elevators and co-ops were running up against their credit limits because the prices of the commodities were going up to the limit day after day and having to meet those margin calls; and their only alternative was to quit offering futures contracts after harvest. So, we contacted the CFTC and urged them to take a look at it, not long after they held a hearing. There were a number of people there, but they started out the hearing, and basically they went through all of their data and concluded before the hearing was even over that nothing out of the ordinary was happening. Well, Mr. Chairman, something out of the ordinary was happening. Farmers, who were probably the original derivative, were being precluded from the marketplace at a time when they could have really capitalized on the higher market prices. So we were a little frustrated with the reaction. As the year went on, we began to find out more and more that really what was causing higher food prices, really what was causing higher input costs was the excessive speculation that was going on in the commodity markets. Whether you look at oil, whether you look at grains, you look at any of the inputs, fertilizer, they were all based on either energy and/or future feed use or future use for other processing. As a result, farmers and ranchers didn't get the high prices and had to wait for prices to come down at harvest in order to sell their wheat and other commodities. We also witnessed something that I don't think anyone can explain, and that is the cotton market virtually doubled overnight. Our impression is that we have a lot of cotton in storage. It is difficult to move. As a result, it was definitely a speculative market that lasted a very short time. I have yet to meet a cotton farmer that got those pries up in the 90 cents range for their cotton. So we were impacted tremendously. I think it caused higher food prices, which impacted consumers. It caused a divisive attitude among agriculture producers, because livestock producers were being told that corn prices and feed prices were going to go even higher. So they had to lock in their prices. I just got back from Central Valley of California, Mr. Chairman, and many of those producers that locked in feed prices because they believed all the speculative reports that prices were going to continue to rise, and they did the prudent thing in locking in their future feed uses, and now they are all in as bad a financial shape as I have ever seen in the dairy industry. It is the same for other livestock producers and livestock processors. Ethanol companies did the same thing. They were all sort of wrapped up in this speculative environment. So I really commend you for your efforts, both last year and this year, to move forward. It is badly needed. Your legislation is right on target establishing speculative limits for all commodities, the increased transparency, providing the resources for CFTC, and including even carbon credits to be traded on the marketplace and a regulated marketplace. Actually being able to give the regulators a chance to know how much money is in there, who it is by, whether it is commercial, whether it is speculative, or whether it is under an exemption or over-the-counter or foreign exchanges has to be done. I think it is the most important thing for the rural economy, which, as you know, has certainly flipped in the last few months. Thank you, Mr. Chairman. [The prepared statement of Mr. Buis follows:] Prepared Statement of Tom Buis, President, National Farmers Union, Washington, D.C. Good afternoon, Mr. Chairman and Members of the Committee. I appreciate the opportunity to testify on behalf of the farm, ranch and rural members of National Farmers Union (NFU). NFU was founded in 1902 in Point, Texas, to help the family farmer address profitability issues and monopolistic practices while America was courting the Industrial Revolution. Today, with family farm, ranch and rural family members, NFU continues its original mission to protect and enhance the economic well-being and quality of life for family farmers and ranchers and their rural communities. Last spring, NFU called upon the Commodity Futures Trading Commission (CFTC) to conduct a thorough and comprehensive investigation regarding the activity and volatility in the commodities markets. In particular, the role of speculative commodity futures trading, both on and off-exchange, in increasing that volatility, with much of that trading hidden from view of the CFTC in the derivatives and other off-exchange markets. Farmers and ranchers are generally relieved to end the 2008 agriculture market roller coaster, but they are extremely anxious as they approach the 2009 production year. During 2008 we witnessed periods of record or near record nominal prices for many commodities traded on U.S. exchanges. As the year ended, we have also witnessed a historic collapse in market prices for major grains and dairy products. NFU was frustrated by remarks from some CFTC officials who suggested that the market volatility was simply a response to market fundamentals. This assessment did not adequately explain the price shock in the cotton market or lack of convergence between cash and futures markets during the contract settlement period. This assessment also failed to explain why many farmers were precluded from utilizing traditional market risk management tools, such as forward cash contracts, because of excessive margin risk to those who typically would offer such products to their customers. As speculators created a market bubble and attitude that higher prices were set to stay, crop, livestock and dairy producers locked in higher inputs and feed costs. The false signals were not reserved for agricultural producers, but extended beyond production agriculture to the ethanol and biodiesel industries and input suppliers, all locking in higher feedstocks and supplies. The 2008 economic collapse and bursting of bubble have jeopardized the economic livelihoods of all these players, which will ripple throughout our rural communities. This impact will not be short-lived, as it could take up to a year or longer before the negative impact is resolved. In these times of despair, commodities and industries become pitted against each other creating a divisive environment in which to establish helpful policy. As you can imagine, it was very frustrating for farmers who were paying record amounts for inputs, but could not implement effective marketing plans or strategies to take advantage of the higher prices for their crops. While this activity was occurring in 2008, the media, with help from food processors, held fast to the position that farmers and ranchers were getting rich from record high commodity prices and cited these prices as the sole cause of increasing retail food prices. Nothing could have been further from the truth. The reality of what happened has come to light as commodity prices have plummeted, yet retail food costs remain high. The effort being made by this Committee to ensure that we do not experience a repeat of 2008, is to be commended. It became obvious, in a number of areas, that modernized regulations were warranted to ensure the mistakes of the past are not repeated. The broad, bipartisan support for increased oversight and transparency with the House-passed Commodity Markets Transparency and Accountability Act of 2008 provided a good starting point. The Derivatives Markets Transparency and Accountability Act (DMTAA) of 2009 would be of even greater benefit to agricultural producers and the entire economy. In a letter to the CFTC last year, NFU cited the single biggest concern among producers as a lack of market transparency. This is still the case. Provisions within the DMTAA, seek to inject necessary transparency through the detailed reporting and disaggregation of market data and the over-the-counter (OTC) transparency and record-keeping authorities as outlined in the legislation. Without these provisions, the public will continue to be in the dark regarding who is involved in commodity markets and to what capacity. These new authorities are needed to ensure regulators are able to keep pace with the use of new financial and market instruments that result in market manipulation, fraud or excessive speculative market volatility. NFU has called for an investigation to determine the role and impact that OTC trading and swaps have on markets. Without full access to data and other information concerning these types of trading activities, it is impossible to determine whether manipulation, fraud or excessive speculation is occurring. DMTAA requires all prospective OTC transactions to be settled and cleared through a CFTC regulated clearinghouse or other appropriate venue. The addition of principles for the designated clearing organizations, including (1) daily publication of pricing information; (2) fitness standards; and (3) disclosure of operational information, will protect the integrity of the new OTC requirements by assuring the clearinghouses remain transparent. The legislation also requires the CFTC to study and report on the effects of potential position limits within OTC trading. Again, this information will enhance the public's confidence that markets are not being manipulated, fraudulently exploited or overwhelmed by speculation and if so, corrective action can be launched. When the CFTC proposed increasing speculative position limits in 2007, NFU filed public comments in opposition to such action. Speculators have an important role to play in the commodity markets in terms of providing market liquidity. However, when left unregulated and allowed to become excessive, the positive attributes that speculators bring to the markets undermines the legitimate price discovery and risk management functions these markets were designed to provide to commercial market participants. DMTAA establishes new standards and limits for all commodities. Moreover, we are pleased to see the establishment of a Position Limit Agricultural Advisory Group. By involving producers and traditional users of the market in making recommendations concerning position limits, the new limits will be legitimized and fair. With the rapid growth of market speculation, we are in unchartered waters today and we believe this third-party review function can significantly help in ensuring market integrity in the future. NFU believes the CFTC needs to take a broader look at the concept of manipulation and it implications for price discovery. Unfortunately, the CFTC's test to determine manipulation requires that an individual or group of traders acquire a market position that enables them to consciously distort prices in noncompliance with market fundamentals. What the CFTC is failing to recognize is that the deluge of money from Wall Street, hedge funds and other large traders in and of itself is driving prices in ways that may not reflect the fundamentals of the underlying markets. In 2006, NFU became an approved aggregator for trading carbon credits on the Chicago Climate Exchange (CCX). Currently, we are the largest aggregator of agricultural soil carbon offsets to CCX. The CCX is the world's first greenhouse gas emissions registry, reduction and trading system, trading more than 86 million tons of carbon offsets to date. As carbon trading continues to advance rapidly, NFU appreciates the provision within the legislation that will protect the integrity of carbon credit trading by requiring those contracts to be traded on a designated contract market. Furthermore, the cross pollination between the CFTC and the U.S. Department of Agriculture to develop procedures and protocols for market-based greenhouse gas programs will help ensure these markets will perform a legitimate function for participants and the public in general. This legislation will begin to answer many of the questions from 2008. We are currently enduring the train wreck caused in large part by the dysfunction of the futures market--in 2008. NFU strongly endorses this bill and looks forward to its swift approval; I am hopeful Congress will continue its bipartisan efforts to establish greater oversight of the commodity and energy futures markets. I thank the Committee for the opportunity to be here today and look forward to any questions you may have. " CHRG-111hhrg63105--40 Mr. Moran," Let me broaden my question by asking a similar question but with a different conclusion. Has the CFTC or its staff completed a report that found excessive speculation positions in commodity futures markets were leading to market manipulation? Which I think is the direction you were telling me is more important; that you are there to regulate market manipulation. " FOMC20070509meeting--16 14,MS. JOHNSON.," The basic message from the rest of the global economy is that economic conditions are favorable and appear likely to remain so through the end of next year. Although small variations in the basically optimistic outlook are present, real GDP growth in the foreign economies seems poised to continue at an average annual rate of about 3½ percent throughout the forecast period. Inflation risks are present as slack has been reduced in several foreign economies. However, we anticipate that central banks abroad will respond further as needed such that inflation abroad will edge up only slightly through the end of 2008. In this forecast round, the staff had to contend with a move back up in global crude oil prices and further increases in nonfuel commodities prices—shocks common to the whole global economy. In addition, for the U.S. outlook, we needed to take account of the depreciation of approximately 2 percent in the foreign exchange value of the dollar over the intermeeting period, as Dave discussed. We have recently revisited the question of whether we could improve upon the forecast for crude oil prices embedded in market futures prices and have convinced ourselves based on empirical evidence that we cannot. As a result, our projections for future WTI spot oil prices and the average oil import price are shifted up and down over time by fluctuations in spot and futures oil prices. This has been an “up” forecast round. After reaching a peak around August of last year, global oil prices fell through very early this year and then reversed to trend back up, but not smoothly. The upward move of oil prices over the intermeeting period was apparently a response to the surprising degree of continued production restraint from OPEC and heightened concerns about supply from Iran, Iraq, and Nigeria. The strength in global demand for energy, too, no doubt provided support for continued elevated prices. In this forecast we also had to take into account a deviation in the usual price spread between West Texas intermediate and other grades of oil. Reduced refinery activity has led to an unusually large accumulation of crude oil stocks in the Midwest, the delivery area for WTI, and depressed its price relative to that for other grades. When we were finalizing the baseline forecast, spot and futures prices implied an increase to our projection for WTI crude oil in the current quarter of about $4.50 per barrel relative to the projection in the March Greenbook; however, this change understates a bit the upward shift in overall oil prices because of the change in spreads. These considerations led us to revise upward the average oil import price in the Greenbook for the current quarter about $6.50 per barrel. We expect that over the forecast period the relative prices of WTI and other grades will gradually move back toward normal, so our upward revision narrows somewhat in future quarters, particularly by the second half of 2008. The baseline forecast reflects the consequences of these higher oil prices for the U.S. economy and the rest of the world. Turning points in the ups and downs of oil prices have an uncanny way of happening at the time that we are finishing the Greenbooks, and such a turning point might have happened again. Since the Greenbook path was set, crude oil prices have moved back noticeably. If we were concluding our forecast today based on yesterday’s futures prices, we would show an upward revision in the near term of only about half that in the Greenbook. For 2008, our upward shift would be about two-thirds of that in the Greenbook. The effects of this more benign level for oil prices would be slightly positive for real GDP growth both in the United States and abroad. Such a lower projected path for oil prices would also slightly lessen the pressures on headline inflation rates that are a feature of the baseline forecast. Another element in the forecast worth a brief mention is the upward revision to both core import price inflation and core export price inflation for the second quarter, to annual rates of 4.5 percent and 5.5 percent, respectively. Prices for core imports and core exports accelerated in the first quarter as prices for food and industrial supplies, particularly fuels and metals, surged. Metals prices have continued to rise in recent weeks, and the increase, along with the recent depreciation of the dollar, led us to revise up our current-quarter projections. In constructing our forecast for these trade prices, we base our projection of the commodity-price component on market futures prices. Again, we have done recent work to see if a better alternative is available, but we have concluded that none is. Despite rapid increases in prices of various traded commodities over the past few years, the futures markets are implying a path through the end of 2008 that is about flat for an index of nonfuel commodities. In combination with our projection for only modest real dollar depreciation and no major changes in overall inflation rates here and abroad, such an outlook for commodity prices yields a deceleration in both core import prices and core export prices. Our forecast for the increase in these prices in 2008 remains low, at 1.3 percent. Although oil prices have been revised up this time, their projected path flattens in mid-2007. This outlook and the flat projected paths for commodity prices and the dollar imply a waning of the upward push to consumer prices that has resulted from rising oil and commodity prices. Consequently, in the Greenbook forecast, only limited further tightening by some foreign central banks is required to contain inflation. That events in these markets may surprise futures traders and us for yet another year with additional commodity-price increases is a major risk to our outlook for inflation. David and I will be happy to take any questions." FOMC20080625meeting--37 35,MR. SHEETS.," In the process of preparing our forecast, we do come up with estimates of slack for the emerging market economies, but we are not inclined to put a whole lot of weight on them. The concept of an output gap is not really a well-defined construct for, say, China. Nevertheless, these economies will be growing a little more slowly than they have in the past, and some of the pressures on resources associated with that growth may abate a bit. I think that is at least a piece of the story of what you see here as the decline. But at the end of the day, it has to be a story about commodity prices. Food prices and energy prices have pushed this up. Depending on exactly which emerging market economy you're in, food prices will range anywhere from 25 percent to 33 percent of their basket. As long as those food prices and energy prices are moving up dramatically, you are going to see rapid increases in inflation. So the decline that you are seeing in this chart really is conditioned first and foremost on commodity prices flattening out. I wish I had a better story. " CHRG-111hhrg63105--36 Mr. Moran," Has there yet been a--one of the conversations we have had in this Committee for a long time is about the connection between excessive speculation and price fluctuations. Is there--there is--make sure I understand this to be true--I'll ask it this way: Has the CFTC or its staff completed a report that found excessive speculation caused an unwarranted or unreasonable price fluctuation in commodity markets? " CHRG-111hhrg51698--204 Mr. Roth," Thank you, Mr. Chairman. My name is Dan Roth, and I am the President of National Futures Association. I would like to thank you very much for the opportunity to be here today to discuss our views. Certainly the draft bill that you have been discussing this afternoon couldn't be more timely. I think we all know that the current financial crisis has highlighted the importance of these issues. So I applaud you for your efforts to deal with these very complex issues. We have some suggestions in our written testimony regarding some improvements that we think could be made to the bill, and we would be happy to discuss those. But one thing I want to talk about today, at risk of getting us off on a little bit of a tangent, and I certainly don't mean to do that. But, as important as the issues are that are covered by the bill, I hope we don't lose sight of an important customer protection issue that needs to be addressed and is somewhat overdue. As we sit here today, we have to recognize that we have completely unregulated futures markets aimed expressly at unsophisticated retail customers. That is not a good situation to be in. Through a series of bad cases, starting with the Zelener decision, we have had a series of decisions which essentially gutted the CFTC's ability, gutted the CFTC's jurisdiction with respect to bucket shops. Those contracts, those cases basically hold that certain contracts that may walk like a futures contract, talk like a futures contract, smell like a futures contract will be deemed by the courts not to be a futures contract if the scammer drafts the contract in a certain way, and therefore deprives the CFTC of jurisdiction. Congress addressed this issue last May with respect to forex contracts--and God bless you for doing that--but, as we said at the time, the problem isn't limited to forex contracts and the solution can't be limited to that way, either. We testified previously that if we only dealt with the forex aspect of this problem, then we would simply see a migration of problematic contracts from forex to other commodities; and that is exactly what we have seen. I don't have exact numbers, because, of course, these entities are unregistered, but just in our routine Internet surveillance and through customer complaints we are aware of dozens, dozens of these markets that are aimed exclusively at retail customers that are offering futures look-alike products for gold, silver, and energy. For all these markets, there is no capital requirement. There is no registration requirement. There is no one doing audits and examinations. There is no sales practice rules. There is no arbitration. There is no nothing. These are completely unregulated markets, and they are taking advantage of retail customers. We had a caller a couple weeks ago, a gentleman lost over $600,000 with one of these outfits. It was essentially all of his life savings. I think it is safe, given the volume of the activity that we see, that there are thousands of customers who have lost millions of dollars through these types of unregistered, unregulated markets. It is not right, and the time has come to fix that problem. We have a solution. It is a solution we have discussed before. It is a solution that we have worked on with the exchanges. Basically, what we have proposed in the past, and have proposed now, would be a statutory presumption that any market that offers a leveraged contract offered to retail customers, and that retail customer has no commercial use for this product and no ability or capacity to take delivery, that under those circumstances there would be a presumption that those were in fact futures contracts, and therefore had to be traded on-exchange. This is simply nothing more than the codification of the Co Petro case, which the Zelener case overturned. That presumption would ensure that customers get the regulatory protections they deserve and need if trading in a regulated environment, and it is a change which is long overdue. So, Mr. Chairman, I know there are other very important, very complex issues on the table. We have our opinions about some portions of the draft bill. We have included that. But I hope we don't lose sight of this important customer protection issue while you are dealing with this legislation. Thank you, Mr. Chairman. [The prepared statement of Mr. Roth follows:] Prepared Statement of Daniel J. Roth, President and CEO, National Futures Association, Chicago, IL My name is Daniel Roth, and I am President and Chief Executive Officer of National Futures Association. Thank you, Chairman Peterson and Members of the Committee, for this opportunity to present our views on legislation to bring greater transparency and accountability to commodity markets. NFA is the industry-wide self-regulatory organization for the U.S. futures industry. NFA is a not for profit organization, we do not operate any markets, we are not a trade association. Regulation and customer protection is all that we do. NFA certainly understands the importance of responding to the current financial crisis, dealing with systemic risk and creating greater transparency in OTC markets. NFA would like to point out that as a result of bad case law, more and more retail customers are being victimized in off-exchange futures markets. This is a customer protection issue that needs to be addressed now.Customer Protection For years, unsophisticated, retail customers that invested in futures had all of the regulatory protections of the Commodity Exchange Act. Their trades were executed on transparent exchanges, their brokers had to meet the fitness standards set forth in the Act and their brokers were regulated by the CFTC and NFA. Today, for too many customers, none of those protections apply. A number of bad court decisions have created loopholes a mile wide and retail customers are on their own in unregulated, non-transparent OTC futures-type markets. Congress acted to close those loopholes last May with respect to forex trading but customers trading other commodities, such as gold and silver, are still stuck in an unregulated mine field. It's time to restore regulatory protections to all retail customers. Let me remind you how we got here. In the Zelener case, the CFTC attempted to close down a boiler room selling off-exchange forex trades to retail customers. The District Court found that retail customers had, in fact, been defrauded but that the CFTC had no jurisdiction because the contracts at issue were not futures, and the Seventh Circuit affirmed that decision. The ``rolling spot'' contracts in Zelener were marketed to retail customers for purposes of speculation; they were sold on margin; they were routinely rolled over and over and held for long periods of time; and they were regularly offset so that delivery rarely, if ever, occurred. In Zelener, though, the Seventh Circuit based its decision that these were not futures contracts exclusively on the terms of the written contract itself. Because the written contract in Zelener did not include a guaranteed right of offset, the Seventh Circuit ruled that the contracts at issue were not futures. For a short period of time, Zelener was just a single case addressing this issue. Since 2004, however, various Courts have continued to follow the Seventh Circuit's approach in Zelener, which caused the CFTC to lose enforcement cases relating to forex fraud. Last year Congress plugged this loophole for forex contracts but not for other commodities. Unfortunately, the rationale of the Zelener decision is not limited to foreign currency products. In testimony before this Subcommittee in 2007, I predicted that if Congress only addressed the forex aspect of the Zelener decision, the fraudsters would merely move their activities to other commodities. That's just what has happened. We cannot give you exact numbers, of course, because these firms are not registered. Nobody knows how widespread the fraud is, but we are aware of dozens of firms that offer Zelener contracts in metals or energy. Some of these firms are being run by individuals that we have kicked out of the futures industry for fraud. Several weeks ago, we received a call from a man who had lost over $600,000, substantially all of his savings, investing with one of these firms. We have seen a sharp increase in customer complaints in the last 3 months. It is safe to say that these unregulated bucket shops have plundered millions of dollars from retail customers. NFA and the exchanges have previously proposed a fix to Zelener that goes beyond forex and does not have unintended consequences. Our approach codifies the approach the Ninth Circuit took in CFTC v. Co Petro--which was the accepted and workable state of the law until Zelener--without changing the jurisdictional exemption in section 2(c) of the Act. In particular, our approach would create a statutory presumption that leveraged or margined transactions offered to retail customers are futures contracts if the retail customer does not have a commercial use for the commodity or the ability to make or take delivery. This presumption is flexible and could be overcome by showing that the transactions were not primarily marketed to retail customers or were not marketed to those customers as a way to speculate on price movements in the underlying commodity. This statutory presumption would effectively prohibit off-exchange contracts--other than forex--with retail customers when those contracts are used for price speculation. This is the cleanest solution and the one NFA prefers. If Congress is hesitant to ban these transactions, however, they should at least be regulated in the same manner as retail OTC forex futures contracts. (See section 2(c)(2)(B) of the Act.)Commission Resources NFA strongly supports the bill's effort to provide the Commission with much-needed resources. CFTC staffing levels are at historic lows. As trading volume rose over the years, staffing levels moved in the other direction. Something here is not right. It is always a struggle for a regulator to keep up with an ever changing market place, but that becomes harder and harder to do when you have fewer people on hand to do more work. NFA applauds proposals for emergency appropriations to the CFTC to hire additional people and upgrade its technology.Position Limits NFA is concerned with the proposal to impose position limits on futures contracts for excluded commodities. In 2000, Congress amended the Commodity Exchange Act to define certain commodities as ``excluded commodities.'' These are primarily financial commodities, indices, and contingencies. By their very nature, excluded commodities are not susceptible to manipulation, either because there is such a large supply that it cannot be cornered or because, as with the contingencies, the contracts are based on events that are beyond anyone's control. Therefore, position limits in excluded commodities serve no purpose except to reduce the liquidity that helps banks and other institutions manage their risks. Furthermore, this reduced liquidity would come at a time when risk management is more critical than ever.Credit Default Swaps Section 16 of the draft bill is an even greater threat to liquidity. That section appears to restrict the use of credit default swaps to hedgers. NFA supports efforts to bring greater transparency to these transactions and to reduce their systemic risk. This proposed remedy, however, is likely to kill the patient. You cannot have an effective market if you do not have liquidity and you cannot have liquidity if you do not have speculators. Eliminating speculators from the credit default swap market will make it much more difficult for firms to manage their risks, which cannot be good for those firms or for the economy.Mandatory Clearing of OTC Derivatives Clearing organizations in the U.S. futures markets have performed superbly for over 100 years. The current financial crisis has posed the ultimate test to the clearing system--a test that was passed with the highest possible grades. Even under the greatest market stress we have seen for generations, no futures customers lost money due to an FCM insolvency and positions were transferred from distressed firms to healthy ones smoothly and efficiently. There has been no Federal bailout necessary for the futures industry. Clearing in the futures markets works and the spread of clearing to OTC markets can be a very positive development. All OTC derivatives, however, are not like futures. It is the standardized nature of futures contracts and the ability to mark them to a liquid and transparent market that make clearing work so well. Many OTC instruments are quite standardized and susceptible to clearing. Others, though, are highly individualized and privately negotiated and difficult to mark to a market. The bill attempts to recognize these problems by providing the CFTC with exemptive authority. That authority, however, is circumscribed. I suspect it is impossible to draft legislation that can take into account all of the factors that might make it appropriate to exempt an OTC transaction from mandatory clearing. We would suggest that the bill give the CFTC greater flexibility to exercise its exemptive authority. In conclusion, NFA's overriding concern with the bill is in what it does not contain. Retail customers trading in OTC metals and energies should not be left at the mercy of scammers. We encourage the Committee to revise the draft to prohibit--or at least regulate--Zelener-type contracts in commodities other than currencies. As always, NFA looks forward to working with the Committee, and I would be happy to answer any questions. " CHRG-111hhrg51698--20 Mr. Cota," Thank you, Honorable Chairman Peterson and Ranking Member Lucas, distinguished Members of the Committee. Thank you for the invitation to testify before you today. I appreciate the opportunity to provide some insight on your draft legislation. First, I would like to thank Chairman Peterson and the Committee for their tireless efforts in bringing greater transparency and accountability to commodity markets. Without your dedication, this issue would never have gained the attention it deserves and needs. I serve as an officer of the Petroleum Marketers Association of America. PMA is a national federation of 47 states and regional associations, representing over 8,000 independent fuel marketers. These marketers account for nearly half of the gasoline and nearly all of the distillate fuel consumed in the United States. I am also here representing the New England Fuel Institute, which represents over 1,000 heating oil dealers in the Northeast. Further, I am a third generation co-owner and operator of a home fuel delivery company in Vermont and New Hampshire. My business provides home heating fuel to 9,000 homes and businesses. I also market motor fuels and biofuels. Unlike larger energy companies, most retail fuel dealers are small, family-run businesses that personally deliver products to the doorstep of American homes and businesses. We respectfully urge the Committee to impose aggregate position limits at the control entity level on noncommercial traders across all trading environments, including the over-the-counter markets that do not have any direct physical connection to the underlying commodity. We have been voicing our concerns to Congress regarding dark markets for more than 3 years. Large-scale institutional investors speculating in the energy markets continue to act as the driving force behind energy prices. The rise in crude oil prices, which reached $150 a barrel for December delivery in July of last year, only to fall to a low of $33, was not the result of supply and demand. It was the direct result of large and excessively leveraged speculators, index traders, and hedge funds. According to a CBS News 60 Minutes investigation last month, oil should not have skyrocketed to the levels seen last year. The piece highlighted how investment speculators, or ``invesculators,'' looking to make a fast buck in a paper trade caused oil prices to rise faster and fall harder than ever could be explained by ordinary market forces alone. American consumers, small businesses, and the broader economy were forced into a roller coaster ride of greed and fear. The retail petroleum industry is one of the most competitive industries, dominated by small, independent businesses. As gas prices go up, markets become even more competitive; and, at times, retailers sell gasoline below cost. In addition, because they must pay for their inventory before they sell it, credit lines were stretched to the max, creating a credit crisis with marketers' banks. The resulting liquidity problems caused serious financial hardship for many petroleum marketers and gas station owners. Many were forced to close shop. This problem extends to the heating fuel industry. In the summer of 2008, Goldman Sachs, which trades commodities, predicted that crude oil would hit $200 per barrel, translating to $6 per gallon heating oil by winter. Heating oil dealers, who typically hedge fuel in warmer months, were experiencing the highest prices ever. Some consumers, scared by these statements made by Goldman Sachs and others, demanded fixed-price agreements with their dealers in an attempt to shelter their family from higher prices. Many dealers offered these contracts. They committed to purchase fuel they needed to supply these contracts during the winter months; and when the invesculators exited the market this fall, heating fuel dealers and their customers who had locked in were committed to a fuel at a much higher cost than it is currently worth. Commodity markets were not designed as an investment class. They are set up for physical hedgers and to manage price risk by entering into futures contracts to hedge price for future delivery. Bona fide hedgers, like my company, rely on these markets to provide the consumer with quality product at a price that is reflective of market fundamentals. Traditional speculators are important and healthy in this role; invesculators are not. We support the bill and urge Congress to move it quickly through the legislative process. Do not allow this important bill to be stalled by the financial service regulatory reform debate that is ongoing or by Wall Street's opposition. We strongly support the following provisions in this bill: expanding transparency, record-keeping, and clearing requirements to the OTC trades; closing the foreign markets or the London loophole; closing the swaps trading loophole to distinguish between legitimate hedgers and pure speculation; and providing the CFTC with sufficient staff and resources to do its job. We also urge you to make further adjustments to the bill by immediately mandating aggregate speculation limits in energy futures trades across all markets at the control level or the ownership level for contracts traded within the United States or by U.S. traders. Additionally, we urge you to mandate the aggregate position limits, regardless of any study that takes place required under section 9 of the bill. We are encouraged by your desire to take a strong stand against excessive speculation and abusive trading practices that have artificially inflated energy and severely damaged our economy. Let's return these markets so that they are driven by supply and demand and not purely by the speculative whims and greed of Wall Street. Thank you for this opportunity to testify. [The prepared statement of Mr. Cota follows:] Prepared Statement of Sean Cota, Co-Owner and President, Cota & Cota, Inc.; Treasurer, Petroleum Marketers Association of America, Bellow Falls, VT; on Behalf of New England Fuel Institute Honorable Chairman Peterson, Ranking Member Lucas and distinguished Members of the Committee, thank you for the invitation to testify before you today. I appreciate the opportunity to provide some insight on draft legislation entitled the ``Derivatives Markets Transparency and Accountability Act.'' I am also pleased to speak to the affect that opaque, inadequately regulated commodities markets and abusive trading practices have had on our nation's independent fuel marketers and home heating fuel providers. First, I would like to thank Chairman Peterson and the Committee for their tireless efforts to bring greater transparency and accountability to commodity markets. Without your dedication, this issue would never have gained the attention it deserved. I serve as Treasurer on the Petroleum Marketers Association of America's (PMAA) Executive Committee. PMAA is a national federation of 47 state and several regional trade associations representing over 8,000 independent fuel marketers. These marketers account for approximately half of the gasoline and nearly all of the distillate fuel consumed by motor vehicles and home heating equipment in the United States. I am also here representing the New England Fuel Institute (NEFI), a 60 year old trade association representing well over 1,000 heating fuel dealers and related service companies within the Northeastern United States. In addition, I speak before you today as co-Owner and President of Cota & Cota, Inc. of Bellows Falls, Vermont, a third generation family-owned and operated home heating fuel provider in southeastern Vermont and western New Hampshire. My business provides quality home heating fuel, including propane, heating oil and kerosene, to approximately 9,000 homes and businesses. I also market motor fuel, off-road diesel fuel, jet fuel and biofuels. Unlike larger energy companies, most retail fuel dealers are small, family-run businesses. Also unlike larger energy companies, we personally deliver product directly to the doorstep of American homes and businesses. Before I begin, I would like to highlight the fact that PMAA and NEFI are hereby respectfully urging the Committee to impose aggregate position limits at the control entity level on noncommercial traders and across all trading environments, including over-the-counter markets that do not have any physical connection to the underlying commodity. Our organizations have been voicing concern to Congress regarding the activities in ``dark'' commodity markets for more than 3 years now. It has become abundantly clear that large-scale, institutional investors speculating in the energy markets, were and continue to act as the driving force behind energy prices. The rise in crude oil prices, which reached $147 in July of last year only to fall dramatically to as low as $33 in December was not a result of supply and demand fundamentals--it was the direct result of excessively-leveraged speculators, index investors and hedge funds. After 3 years of advocating for greater transparency and accountability in these markets, we have seen very little progress to this end. I would like to thank the Members of this Committee for passing the ``Close the Enron Loophole Act'' which was enacted as part of last year's farm bill. It was an important first step. However, as addressed by this Committee last year in H.R. 6604, this is a serious problem that needs a more aggressive legislative response, especially in light of the 2008 unprecedented run-up in commodity prices. The solution requires an unwavering commitment to vigorous oversight and enforcement by the new President and the Commodity Futures Trading Commission, which we believe to have been lacking in recent years. According to a January 11, 2009 60 Minutes investigation titled, ``Did Speculation Fuel Oil Price Swings?'' several experts agreed that oil should not have skyrocketed to previously mentioned record levels last year, only to see prices dramatically collapse few months later. The piece highlighted how investors were looking not to actually buy oil futures, but to make a fast buck in a ``paper trade.'' This practice caused oil prices to rise faster and fall harder than could ever be explained by ordinary market forces alone. American consumers, small businesses and the broader economy were forced onto a roller coaster ride of greed, fear and uncertainty. However, the greatest victim of the 2008 energy crisis was consumer confidence in these markets' ability to determine a fair and predictable price for energy. In 2007 and most of 2008, gasoline and heating oil retailers saw profit margins from fuel sales fall to their lowest point in decades as oil prices surged. The retail motor fuels industry is one of the most competitive industries in the marketplace, which is dominated by small, independent businesses. Retail station owners offer the lowest price for motor fuels to remain competitive, so that they generate enough customer traffic inside the store where station owners can make a modest profit by offering drink and snack items. As gas prices go up, the market becomes even more competitive and at times retailers are selling gas at a loss. In addition, because petroleum marketers and station owners must pay for the inventory they sell, their lines of credit were approaching their limit due to the high costs of gasoline, heating oil and diesel. This created a credit crisis with marketers' banks, which created liquidity problems and caused serious financial hardship for many petroleum marketers and station owners--some even were forced to close up shop. In the summer of 2008, Goldman Sachs, a firm that trades in the crude oil market, predicted that crude oil would hit $200 per barrel (translating to $6 per gallon heating oil) by winter. Heating oil dealers, who typically purchase fuel in the summer months when seasonal product costs are typically at their lowest, were experiencing higher prices than ever before. Some customers, scared by statements made by Goldman Sachs and others, began demanding a fixed-price agreement with their dealer in an attempt to shelter their family budgets from higher prices. Many dealers offered such contracts to meet this demand, driving many of them to purchase the fuel needed to supply these contracts up front during the summer months; for fear that prices would only head higher. When institutional investors exited the market in the fall, heating fuel dealers and their customers who had ``locked in'' to a price contract were put in a very bad spot, committed to fuel at a much higher cost than its current worth. Many of these consumers are elderly Americans and struggling families trying to make ends meet in a slumping economy riddled with high unemployment rates and evaporating savings and retirement accounts. Ignoring or unaware of the potential consequences of their actions, investment-only speculators were concerned only about turning a profit. They were completely disconnected from the commercial marketplace and the struggling consumers that fuel retailers like me serve personally every day. Commodity markets were not designed as an investment class--they were set up for physical hedgers to manage price risk by entering into a futures contract in order to lock in a price for future delivery. These ``Investulators,'' funds who believe commodities are an asset class, are really unwitting speculators, and are so large and lack any commodity market fundamental knowledge; they have dramatically distorted the markets we rely on. The abuse of this original intent must end now. We rely on these markets to provide the consumer with a quality product at a price reflective of market fundamentals. Traditional speculators serve an important and healthy role by providing needed liquidity in the commodities market for this to be accomplished. However, institutional investors have wreaked havoc on the price discovery mechanism that commodity futures markets provide to bona fide physical hedgers, including heating fuel dealers. Congress should act quickly to restore the transparency and oversight needed for secure and stable commodities markets and help restore the confidence in these markets that physical hedgers and consumer once had. Therefore, PMAA and NEFI urge Congress to pass the ``Derivatives Markets Transparency and Accountability Act'' and enable the critical changes to the Commodity Exchange Act (CEA) needed for fully regulated futures markets. We further urge Congress to expedite commodity markets reform legislation through the legislative process and not allow the bill to be stalled by the financial services regulatory overhaul debate. PMAA and NEFI strongly support most provisions in the ``Derivatives Markets Transparency and Accountability Act,'' including: Distinguishing between legitimate hedgers in the business of actually delivering the fuel to consumers, and those who are in the market for purely speculative purposes; Closing the ``London Loophole'' by requiring foreign exchanges with energy contracts for delivery in the U.S. and/or that allow U.S. access to their platforms to be subject to comparable U.S. rules and regulations; Closing the ``Swaps Loophole'' which allows so-called ``index speculators'' (that now amount to \1/3\ of the market) an exemption on position limits which enable them to control unlimited amounts of energy commodities; and Increasing staff at the CFTC with an additional 200 employees and other resources. While we applaud the Committee for its diligent work on this legislation, we urge you to make the necessary adjustments to the ``Derivatives Markets Transparency and Accountability Act of 2009'' by mandating aggregate speculative position limits on energy futures across all contract markets at the control or ownership level for contracts traded within the U.S. or by U.S. traders. This important measure will help return the market to the physical market participants it was intended to serve. Aggregate position limits will also prevent a trader from going into one commodity exchange and trading the maximum amount of crude oil allowed and then going into another exchange to trade another large amount of futures positions, thereby circumventing anti-manipulation measures in order to take a massive and controlling position in one commodity. Additionally, PMAA and NEFI urge you to either strike Section 9--Review of Over-the-Counter Markets, which requires the CFTC to study and report on the effects of potential position limits in OTC trading and aggregate limits across the OTC market, designated contract markets, and derivative transaction execution facilities. Or to include section 9 but still mandate aggregate OTC position limits immediately before any study takes place. We and our customers need our public officials in the new Congress, including those on this Committee, in the new Administration and the CFTC, to take a stand against excessive speculation and abusive trading practices that artificially inflate energy prices. We strongly support the free exchange of commodity futures on open, well regulated and transparent exchanges that are subject to the rule of laws and accountability. Reliable futures markets are crucial to the entire petroleum industry and the American economy. Let's make sure that these markets are competitively driven by supply and demand and not the speculative whims and greed of Wall Street. Thank you again for allowing me the opportunity to testify before you today. " CHRG-111hhrg55814--157 The Chairman," The gentleman's time has expired. The gentleman from Texas? Dr. Paul. Mr. Secretary, more and more people today are looking critically at the Federal Reserve and wondering what's going on and of course, the people are asking more questions and they want to know exactly what role the Federal Reserve has played in our financial crisis. In the past, the Federal Reserve was held in very high esteem; that they produced prosperity and full employment and stable prices. Today, they are viewed somewhat differently. And many economists are joining in this. Today the Congress is, by the number of 307, who are asking for more transparency of the Federal Reserve. But also, everybody agrees that we have a financial crisis and we're working very hard on regulations. And I think, sometimes, we get misdirected in this because if indeed the source of our problem is coming from the Federal Reserve, then you're depending too much on regulations without looking at the real cause. We're treating symptoms rather than the cause. Just the idea that the Federal Reserve is the lender of last resort, contributes horrendously to moral hazard, especially when we're dealing with the reserve currency of the world. But everybody knows that, no matter what happens, the lender is going to be there to bail them out. But, you had an interview this year and you were asked what you thought were the really, the causes of this crisis, and I was fascinated with your answer. Because, in a way, it seems like you might have agreed a little bit with what I'm saying. Because you listed as number one, you say, one, the monetary policy was too loose, too long, and that created this just huge boom in asset prices, money chasing risk, people trying to get a higher return. That was just overwhelmingly powerful. And I think that really makes my point and unless you deal with that, and the suggestion is, is that what we do is move in with more regulations and hope and pray that'll work. But again, if this is true, that a monetary policy way too loose lasted too long, how can the solution be speeding it up? How can you say, this is the real problem, so we'll double the money supply. Interest rates were too low at 1 percent, let's make them \1/4\ percent. I can't reconcile this. How can you reconcile this on just common sense? " fcic_final_report_full--226 THE BUST CONTENTS Delinquencies: “The turn of the housing market” .............................................  Rating downgrades: “Never before” ...................................................................  CDOs: “Climbing the wall of subprime worry” .................................................  Legal remedies: “On the basis of the information” .............................................  Losses: “Who owns residential credit risk?” ......................................................  What happens when a bubble bursts? In early , it became obvious that home prices were falling in regions that had once boomed, that mortgage originators were floundering, and that more and more families, especially those with subprime and Alt-A loans, would be unable to make their mortgage payments. What was not immediately clear was how the housing crisis would affect the fi- nancial system that had helped inflate the bubble. Were all those mortgage-backed securities and collateralized debt obligations ticking time bombs on the balance sheets of the world’s largest financial institutions? “The concerns were just that if people . . . couldn’t value the assets, then that created . . . questions about the solvency of the firms,” William C. Dudley, now president of the Federal Reserve Bank of New York, told the FCIC.  In theory, securitization, over-the-counter derivatives and the many byways of the shadow banking system were supposed to distribute risk efficiently among investors. The theory would prove to be wrong. Much of the risk from mortgage-backed securi- ties had actually been taken by a small group of systemically important companies with outsized holdings of, or exposure to, the super-senior and triple-A tranches of CDOs. These companies would ultimately bear great losses, even though those in- vestments were supposed to be super-safe. As  went on, increasing mortgage delinquencies and defaults compelled the ratings agencies to downgrade first mortgage-backed securities, then CDOs. Alarmed investors sent prices plummeting. Hedge funds faced with margin calls from their repo lenders were forced to sell at distressed prices; many would shut down. Banks wrote down the value of their holdings by tens of billions of dollars.  FOMC20060808meeting--22 20,MS. YELLEN.," Thank you. I have a question for David and Karen, and it picks up on President Poole’s. My question has to do with what, if anything, we can learn about the role of energy-price increases as a factor raising core inflation here from the experience of other countries. Since we’re not the only country experiencing increases in energy and other commodity prices, my question is whether or not there is some econometric or other evidence that pertains to the degree of energy-price pass-through into core inflation in other developed economies. I’m thinking particularly of economies in which inflation expectations are reasonably well anchored—for example, the United Kingdom, Canada, and the euro area. What do we know about energy-price pass-through into core inflation? Is there evidence of that?" FOMC20060328meeting--149 147,MR. POOLE.," Okay. Mr. Chairman, it is a great delight to see a 200 percent increase in the number of beards around this table. [Laughter] Half of that was in my point forecast, and the other half was not. [Laughter] The contacts that I’ve talked to recently are very optimistic about activity—with one exception, which I’ll start with. My contact at a major trucking firm said that he sees what he called a little bit of a slowdown. Volume is essentially flat year over year across all regions and products. He doesn’t have an explanation, but he’s the only one of my contacts who had anything negative to say about the situation. My contact at UPS had some interesting comments. He said that both UPS and FedEx together have their networks operating at a higher level at this time of year than they have ever seen and that, at the fourth-quarter peak, they will not be able to meet demand without some new strategies. In particular, they’re going to use pricing and incentives, I guess, to try to reduce some demand that is less profitable. They will be working with customers to ship stuff out on Sundays that previously went on Mondays, that kind of thing. But he says that, unless they do that sort of thing, he anticipates that they will be unable to meet demand in the fourth quarter. Of course, they talk with their customers all the time, and they’re very optimistic. They have had very good earnings statements, as you may have seen. My contact with Wal-Mart said something that I thought was very interesting, which I’m going to try to explore in more detail. He said that their wages, and these are for hourly workers (possibly just for sales associates), are absolutely flat—no increases whatsoever in the last year and no increases planned going forward. Individual workers are getting some increases, which probably average about 1 percent, as a consequence of seniority. They have a pay scale by which workers are paid more after they have stayed there some months—I don’t know exactly how many. And I think they also have some productivity or performance bonuses built into their pay structure, but the structure has not changed at all, so wages are increasing about 1 percent year over year. He said that about 20 percent of their associates are part time and that they are going to be increasing that share to 40 percent so they can staff at peak times and get more productivity out of their workforce. On a national basis, the main thing I’d like to comment on is construction, and I’ll start with a local story. There is an absolutely tremendous boom in nonresidential construction going on in St. Louis. As a consequence of our own building project, we have close contact with the construction industry in St. Louis, and our people received a spreadsheet listing of projects in the city. I will start with the bottom line and give you some examples of the kind of thing that is taking place. The average St. Louis construction volume is $600 million to $700 million a year in nonresidential construction. Now, listed in this table are multiyear projects, some are two- and three-year projects, starting last year and this year. The total here is $5.681 billion. It is probably several times over the normal annual volume in St. Louis. To give you some examples, there’s $930 million worth of casino projects, including casinos and some casino hotels. So we’re building casinos. I guess in Dallas they’re building condos." CHRG-111hhrg51698--351 Mr. Neugebauer," Now you advocate for aggregate position limits for noncommercial traders. One of the things this body is struggling with is making sure that we don't push so many people out that we can't actually handle the appropriate amount of liquidity in the marketplace, so that our producers can use this as an effective price discovery and risk management tool. When I think about a bale of cotton in the 19th Congressional District, I think about all of the people who really have some commercial interest in that. All the way from the seed company to the fertilizer and the equipment company, the gins and merchants, and other people relying on the behavior of the cotton commodity price for their livelihood. So kind of two things begin to come to my mind there. When we start picking, who can and cannot participate in hedging a risk that they perceive, or putting together a business model where they can manage those risks? And, also, if we push too many people out of the marketplace, then if you have this many people trying to use a commodity as somewhat of a business hedge, that we don't have enough people to be on the other side. What is the right prescription of who you allow to play and who you don't allow to play? " fcic_final_report_full--61 The derivatives markets are organized as exchanges or as over-the-counter (OTC) markets, although some recent electronic trading facilities blur the distinctions. The oldest U.S. exchange is the Chicago Board of Trade, where futures and options are traded. Such exchanges are regulated by federal law and play a useful role in price discovery—that is, in revealing the market’s view on prices of commodities or rates underlying futures and options. OTC derivatives are traded by large financial institu- tions—traditionally, bank holding companies and investment banks—which act as derivatives dealers, buying and selling contracts with customers. Unlike the futures and options exchanges, the OTC market is neither centralized nor regulated. Nor is it transparent, and thus price discovery is limited. No matter the measurement—trad- ing volume, dollar volume, risk exposure—derivatives represent a very significant sector of the U.S. financial system. The principal legislation governing these markets is the Commodity Exchange Act of , which originally applied only to derivatives on domestic agricultural products. In , Congress amended the act to require that futures and options con- tracts on virtually all commodities, including financial instruments, be traded on a regulated exchange, and created a new federal independent agency, the Commodity Futures Trading Commission (CFTC), to regulate and supervise the market.  Outside of this regulated market, an over-the-counter market began to develop and grow rapidly in the s. The large financial institutions acting as OTC deriva- tives dealers worried that the Commodity Exchange Act’s requirement that trading occur on a regulated exchange might be applied to the products they were buying and selling. In , the CFTC sought to address these concerns by exempting cer- tain nonstandardized OTC derivatives from that requirement and from certain other provisions of the Commodity Exchange Act, except for prohibitions against fraud and manipulation.  As the OTC market grew following the CFTC’s exemption, a wave of significant losses and scandals hit the market. Among many examples, in  Procter & Gamble, a leading consumer products company, reported a pretax loss of  million, the largest derivatives loss by a nonfinancial firm, stemming from OTC interest and foreign exchange rate derivatives sold to it by Bankers Trust. Procter & Gamble sued Bankers Trust for fraud—a suit settled when Bankers Trust forgave most of the money that Procter & Gamble owed it. That year, the CFTC and the Securities and Exchange Com- mission (SEC) fined Bankers Trust  million for misleading Gibson Greeting Cards on interest rate swaps resulting in a mark-to-market loss of  million, larger than Gibson’s prior-year profits. In late , Orange County, California, announced it had lost . billion speculating in OTC derivatives. The county filed for bankruptcy—the largest by a municipality in U.S. history. Its derivatives dealer, Merrill Lynch, paid  million to settle claims.  In response, the U.S. General Accounting Office issued a re- port on financial derivatives that found dangers in the concentration of OTC deriva- tives activity among  major dealers, concluding that “the sudden failure or abrupt withdrawal from trading of any one of these large dealers could cause liquidity prob- lems in the markets and could also pose risks to the others, including federally insured banks and the financial system as a whole.”  While Congress then held hearings on the OTC derivatives market, the adoption of regulatory legislation failed amid intense lob- bying by the OTC derivatives dealers and opposition by Fed Chairman Greenspan. In , Japan’s Sumitomo Corporation lost . billion on copper derivatives traded on a London exchange. The CFTC charged the company with using deriva- tives to manipulate copper prices, including using OTC derivatives contracts to dis- guise the speculation and to finance the scheme. Sumitomo settled for  million in penalties and restitution. The CFTC also charged Merrill Lynch with knowingly and intentionally aiding, abetting, and assisting the manipulation of copper prices; it settled for a fine of  million.  FOMC20080430meeting--102 100,MS. PIANALTO.," Thank you, Mr. Chairman. Regardless to whom I talk with these days, the conversation quickly turns to both the fragile condition of financial markets and the spectacular rise in energy and commodity prices. I had hoped that one of these problems would have gone away by now, but clearly that is not how conditions have unfolded since our last meeting. The bankers with whom I talked are paying close attention to their capital and liquidity positions. They remain concerned about wide bid�asked spreads and low trading volumes in a broad array of securities markets. Indeed, the repercussions of financial turmoil appear to have touched every channel of credit intermediation. It appears that a rewiring of credit channels is simply going to take some time to work out. The most significant financial news coming out of the Fourth District is the $7 billion investment of new capital into National City Bank. National City is the country's tenth largest commercial bank, and its problems with mortgage-related credits are now well known. National City still has much work to do to clean up its balance sheet, just as many other financial institutions with impaired capital positions must do before they can stand on solid ground again. Although the fragile state of the financial sector represents a pretty sizable risk to my economic outlook, the National City situation, along with other stories I'm hearing, suggests that modest progress is being made. With regard to District business conditions, the stories I hear remain downbeat. Commercial builders are reporting mixed though generally positive first-quarter numbers. But their expectations for retail sales in the stores that they lease out across the country have deteriorated, and they are fairly pessimistic about 2008 growth prospects. One large national commercial developer whom I talked with told me that, for the first time in his 45-year career, his company has seen sales declines in March in every retail center that they own across the country. The manufacturers I talked with indicated moderate first-quarter revenue growth as export markets, especially in Asia and Eastern Europe, are still helping to sustain production despite weak domestic demand. At the same time, manufacturers report intense commodity price pressures, and they report little resistance as they attempt to pass along the rising cost of commodities to their customers. The projection I submitted for this meeting shows real GDP growth under 1 percent in 2008, with virtually all of that growth coming in the second half of the year. This is a decidedly more pessimistic projection than the one I submitted in January but not materially different from the outlook when we met just six weeks ago. I have, however, boosted my headline inflation projection for 2008 compared with what I submitted in January, and it is somewhat higher than what I was estimating when we met in mid-March. Although I am still projecting that the slack in the economy will be sufficient to bring the core inflation number under the 2 percent threshold sometime next year, I am now anticipating a little more pass-through of commodity prices into core measures than I thought probable six weeks ago. Indeed, every time I see commodity prices ratcheting up, I become less confident that slack alone will be able to prevent an upward drift in the inflation trend. To be clear, I think the downside risks that we face in the real economy remain substantial, and I am inclined to believe that some insurance against those risks is probably warranted. But in taking such a step, I am inclined to judge that the downside risks we face in the real economy will be roughly in balance with the upside risks that we face from a rising inflation trend. Thank you, Mr. Chairman. " CHRG-110hhrg46591--398 Mr. Ellison," My next question is, you know, we have been debating over whether or not deregulation was a causal factor in the financial circumstance that we find ourselves in. And I guess my question is, you know--and I think it was the year 2000--I think then-Senator Gramm introduced a piece of legislation, I think it was called the Commodity Futures Modernization Act. To what degree did the passage of this amendment exempt derivatives from regulation? Or in your view, Mr. Ryan, did they? Do you understand my question? " CHRG-111hhrg51698--403 Mr. Pickel," Well, let's look at the full range of the market. We focused a lot on CDS, and we will talk about that in a second. But if we look at interest rates, currency transactions, many commodity transactions, those are still very much custom tailored to the particular needs of the counterparties, the interest rate dates of the loans, or the delivery dates of the commodities. So in that area, yes, that continues to be the case. Custom tailored, the creditworthiness of the parties is very important. Collateral is used to address that credit exposure. In the credit default swap markets, it is fair to say that in our documentation and in market practices, yes, on the spectrum of standardization we have moved further down that spectrum to more standardized products. And, that is why at this point clearing for those products becomes very compelling. The major dealers have been working on developing a clearing initiative here, which is now housed within ICE. They have been working on that for at least 2 and maybe 3 or more years. It has taken on a greater urgency in the last few months with the credit crisis, but they have understood the need, the attractiveness of a clearing option for those contracts in part because they are more standardized. Ms. Herseth Sandlin. But you still continue to have concerns and perhaps oppose clearing provisions in the draft bill? " FinancialCrisisInquiry--478 BASS: When you look back—Mr. Mayo talked about loan growth doubling that of GDP growth. When you look back at the housing market—and you can go back through OFHEO’s raw data, all the way back to about I think it’s 1971, you look, you can go back and plot the housing price appreciation x inflation and chart that against median income. January 13, 2010 It only makes sense that as income moves up, housing prices should be able to move up in a perfectly parallel fashion—you make a little bit more money, you can afford a little bit more house. Those lines were parallel for the good part of 40 years. And what happened in 2001, when Dr. Greenspan traded the dot.com bust for the housing boom, he lowered rates down to 1 percent. He made money free, and encouraged all of the lending possible to try to restart the economy after the dot.com bust. I simply think he did a bad job. Other people think he did a great job. But I think that he enabled this housing market. So when you started seeing rates—rates started—they started raising rates in 2004? When rates started to be—started an increasing path, you saw prime mortgage origination in 2004 drop 50 percent. That just makes sense. Everybody refinanced their homes that could. Everyone got reset and settled, but subprime origination in 2004 doubled. And then it doubled again in ‘05, as prime originations fell off a cliff because rates were moving up. So what happened is Wall Street had these machines built to manufacture mortgages. We wanted affordable housing, so they could lower rates with exotic mortgages. And what you saw from 2001 on is you saw those two parallel lines, home price—median home price and median income—diverge. And not only did they diverge by—for those of you that are statisticians, it was an eight standard deviation divergence. OK? That doesn’t happen very often. I know we talk about once-in-a- lifetime calamities every 10 years, that one just hasn’t happened. CHRG-111hhrg51698--623 Mr. Boswell," You are very welcome. Anyone else? Mr. Marshall? I think that concludes our panel today. We cannot thank you enough for your time, your presence. I also think it is fair and reasonable to say we are going to need to continue the dialogue. As I think you may have heard earlier today, we have to do this right. We are counting on your input. So, again, thank you very much, and we will call this meeting adjourned. [Whereupon, at 3:18 p.m., the Committee was adjourned.] [Material submitted for inclusion in the record follows:] Submitted Statement of Hon. Bart Chilton, Commissioner, U.S. Commodity Futures Trading Commission I commend Chairman Peterson for his continued leadership and support his efforts to restore the public's confidence in U.S. futures markets by ensuring appropriate oversight. The proposal incorporates needed changes to our current regulatory structure that will greatly improve our ability to protect consumers and businesses alike. In a speech last week, I quoted the American folklorist Zora Neale Hurston, who said; ``There are years that ask questions, and there are years that answer.'' This year must be a year of answers. During my remarks, I went on to lay out what I see as necessary steps to healing our fractures in our regulatory system. I'm pleased that the Chairman's proposal also addresses several of these critical components. (1) Require OTC reporting and record-keeping. This will enable the CFTC to examine trading information, particularly information about sizable, look-alike or price discovery transactions that could impact regulated markets--markets that have a bearing on what consumers pay for products like gasoline or food, or even interest rates on loans. (2) Oversee mandatory clearing of OTC Credit Default Swap (CDS) transactions, and encourage clearing for other OTC products as appropriate. The stability and safety of our financial system is significantly improved by enhancing clearing systems for CDSs--in a manner that does not lead to cross-border arbitrage--as well as for other OTC derivatives. Such clearing would not only provide counterparty risk, but a data audit trail for regulators. (3) Regulate OTC transactions if the Commission determines that certain trades are problematic. The CFTC should be given the authority to determine and set position limits (aggregated with exchange positions, and eliminate bona fide hedge exemptions) to protect consumers. Congress should also extend CFTC anti- fraud, anti-manipulation and emergency authorities as appropriate to OTC transactions to allow greater openness, transparency and oversight of our financial markets. These provisions are included in the Chairman's proposal. I am hopeful that the Committee will also consider two other items, one within its jurisdiction--the other an appropriations matter. (4) Public Directors on Investment Industry Boards. Corporate boards would benefit greatly from the inclusion of public directors who bring a diversity of backgrounds and experiences to the boardroom. Such a provision would allow farmers, consumer representatives or other individuals to serve and provide different, yet important perspectives. All too often, these boards look more like an extension of the companies themselves than a group of individuals that are there to spot problems and deliver constructive criticism. Unfortunately, what we witnessed in the securities world is that this had to be mandated rather than simply encouraged. For that reason, I would urge Congress to consider a requirement that a third of board members be considered public directors. (5) Congress should appropriate immediate full funding ($157 million for Fiscal Year 2009) in additional resources, which would allow the CFTC to hire an additional 150 employees, and fund related technology infrastructure so that the agency can properly effectuate our duties under the Commodity Exchange Act, as amended by the farm bill. Many in Congress have joined together to call for increased resources for the Securities and Exchange Commission (SEC). By comparison, the CFTC oversees exchanges with significantly greater market capitalization than the SEC. For example the CME Group alone has a market capitalization of roughly $11 billion, while NYSE/Euronext (largest U.S. securities exchange regulated by the SEC) has a market capitalization of $5.5 billion. The SEC has 3,450 employees, while the CFTC struggles with roughly 450--fully 3,000 less staff. It is not a popular thing to call for more money for Federal employees, but cops on the beat are needed to detect and deter crimes. The CFTC needs these additional resources and we need them now. There are many other provisions in the Chairman's proposal that I support, such as closing the London Loophole and ensuring exclusive jurisdiction over environmental futures market regulation. Simply put, the success of a cap-and-trade system requires an experienced regulator. The Chairman's proposal, if enacted, will bring much needed transparency and accountability to both over-the-counter and certain overseas markets; provide the CFTC the authorities necessary to prevent market disruptions from excessive speculation; and give regulators a window into currently ``dark markets'' by requiring reporting and record-keeping. ______ Supplemental Material Submitted by Michael W. Masters, Founder and Managing Member/Portfolio Manager, Masters Capital Management, LLC Dear Congressman Marshall: Thank you for your insightful questions and your leadership on the issue of excessive speculation. I wanted to respond promptly to your request for written answers to the two questions you posed during the hearing. Your first question pertained to a scenario wherein the commodities derivatives markets are balanced, with an equal number of speculators seeking trading profits on the one hand, and physical producers and consumers hedging their real business on the other. What happens, then, if a large number of ``invesculators'' enter the markets? What problems would that pose and what solutions would we need? I believe the scenario you describe is precisely what has happened to our commodity markets in the last 5 years, culminating with the extreme price movements of the last 18 months. ``Invesculators,'' as you referred to them, are extremely damaging to the commodities derivatives markets, due to their belief that commodities are an ``asset class.'' Commodities are raw materials that are consumed by individuals and corporations. They are not an ``asset'' (like a stock or a bond) that can be bought and held for the long term. As much as institutional investors want to believe that commodities can be considered assets, they simply cannot. Physical hedgers--those who produce and consume actual commodities--never suffer from ``irrational exuberance.'' When prices rise, producers are motivated to produce more (that's their business), and consumers are motivated to consume less. In contrast, the ``Invesculator'' responds to an increase in price by thinking, ``oh, that would be a good investment,'' and jumps on the bandwagon by submitting their own buy orders. This is the dynamic that causes price bubbles to form. Every capital asset category has had its bubbles through history: the Japan bubble, the emerging markets bubble, the Internet bubble, the housing bubble, the credit bubble, etc. Eventually, wherever investors go, price bubbles appear. When physical hedgers dominate the commodities derivatives markets then traditional speculators, because they are outnumbered, will emulate the behavior of the physical hedgers. But when speculators rule these markets then they can drive prices to irrational heights that have nothing to do with supply and demand. In the scenario that you described, wherein five speculators and five physical hedgers are transacting in the derivatives market, and then 45 ``invesculators'' show up, the result is a bubble, just as if you put your house on the market, had an open house, and 45 people showed up with their checkbooks. You're going to get a much higher price than if no one, or even a couple of people, showed up. While bubbles in asset markets can be intoxicating, bubbles in commodities are devastating. Every human being around the globe suffers when we experience bubbles in food and energy prices. So what can Congress do about it? Fortunately, the solution is simple, and Congress has already done it since 1936: put a limit on the size of positions that speculators can hold in order to prevent them from dominating the market. This worked superbly from 1936 until about 1998. It is simple and proven, and carries no unintended consequences. Unfortunately in 1998 the CFTC began to let speculative position limits slide. For them the term ``excessive speculation'' came to mean basically the same as ``manipulation.'' At which point the CFTC decided position limits were only necessary to prevent manipulation. Then, in 2000 the Commodities Futures Modernization Act (CFMA) allowed the formation of the Intercontinental Exchange (ICE), and exempted over-the-counter (OTC) swaps dealers from all regulation. The result was that there were no longer any real speculative position limits in energy. Also, the OTC markets effectively rendered position limits in agricultural commodities meaningless. What ensued was rampant speculation, which led to the bubble that finally burst in the second half of 2008. It's easy to see why it is not only essential to reinstate a system of speculative position limits on the exchanges, but it is also critical for those limits to apply to ICE and other exchanges, as well as the OTC markets. When there is a clearly defined limit placed on the money flowing into a market, then prices cannot expand fast enough to cause a bubble. Your question seemed to also pose a more nuanced scenario: assuming a market in which the speculative position limit is, for example, 1,000 contracts, and further assuming that 50,000 contracts are held by speculators and 100,000 contracts are held by physical producers and consumers, what if 300 new speculators show up and they all stay below the 1,000 contract limit, they can still buy 300,000 contracts combined, what should be done then? The answer is that speculative position limits need to be adjusted as market conditions dictate. This scenario provides an excellent illustration of why we recommend the formation of a physical hedgers' panel that would serve to adjust speculative position limits every 3-12 months. If the ratio of speculators to physical hedgers becomes too high (like 350,000 : 100,000--which, for reference, was the approximate ratio in 2008), then the panel should lower the speculative position limit from 1,000 contracts down to, say, 500 contracts. Similarly, if the ratio of speculators to physical hedgers is too low and the markets need more liquidity, then the panel would have the ability to raise the limit to allow speculators to take larger positions. Think of speculative position limits like a valve that controls the level of speculative money in the markets, as well as the speed with which money flows into the markets. We believe that the optimal ratio of speculators to physical hedgers is one to two (34% speculative). The commodities futures markets operated efficiently with no liquidity issues for decades while open interest stayed generally in the range of one speculator for every four physical hedgers. So if the physical hedgers' panel would target a ratio of one speculator for every two physical hedgers that would give the commodities derivatives markets abundant liquidity. Your second question pertained to the possible challenges of implementing across-the-board speculative position limits. The simplest and most effective way to implement speculative position limits is to enforce an ``aggregate'' speculative position limit that a speculator will face regardless of the transaction venue (e.g., a CFTC-regulated futures exchange like NYMEX, a non-CFTC-regulated futures exchange like ICE, or in the OTC market). Let's say that the physical hedger panel determines that the speculative limit for oil should be 5 million barrels or 5,000 contracts. Speculators would be told that they can buy up to 5 million barrels anywhere they want as long as they do not exceed this limit. Consider the problems that can arise if a system of speculative position limits is not established on an aggregate basis and instead individual trading venues are assigned their own unique limits. No matter what system is used for assigning those limits it will run into problems. As an example, if the aforementioned 5,000 contract speculative position limit for crude oil is apportioned as follows: NYMEX: 1,000 ICE: 1,000 OTC: 1,000 contract equivalent (1 million barrels) IPE: 1,000 (International Petroleum Exchange) DME: 1,000 (Dubai Mercantile Exchange) Then, under this scenario, speculators will be forced to spread their trading around in order to access their entire 5,000 contract speculative position limit. Since the amount of liquidity varies from one exchange/venue to the next, it would not make sense to encourage an equal amount of trading on each venue. For example, ICE has half the volume of NYMEX, so should they have the same limit as NYMEX or half the limit of NYMEX? Different problems arise however if unequal speculative position limits are imposed. If the limits were set to match current liquidity like this: NYMEX: 1,000 ICE: 500 OTC: 2,500 IPE: 800 DME: 200 Then the growth of ICE and other exchanges would be stunted due to their low relative limits. This system has the further effect of forcing speculators to trade OTC in order to reach their 5,000 contract maximum. This is not something that I believe Congress wants to do. If limits are placed on some venues but not others, then trading will flow to the places that offer unlimited speculation (currently the OTC markets). This would fail to safeguard against future speculative bubbles, which is what the speculative limits are designed to do. The best system for implementing aggregate speculative position limits would entail the following: (1) All OTC commodity derivative transactions must clear through an exchange. (2) Each speculator would have a trader identification number which would be associated with every trade, just like a customer account number. (3) Foreign boards of trade would have to supply information to the CFTC on U.S. traders (looking at the parent entity level). Those who oppose exchange clearing will complain about ``chicken fat'' swaps and the like, but in reality, 99% of all commodity swaps are composed of futures contracts and basis trades, which would all clear. Congress should resist attempts by Wall Street to avoid exchange clearing by claiming that their derivatives are too exotic and that therefore large segments of the market need to be exempted from the clearing requirement. Almost all OTC commodity derivatives should clear. As part of the clearing process OTC derivatives are transformed into futures contract equivalents. Therefore the process of applying speculative position limits to OTC derivatives that have exchange cleared is as simple as applying limits to futures contracts. Under this system of speculative position limits and exchange clearing, the aggregate activity for an individual trader can be calculated simply by tracking the trader identification number and adding up how much each trader has bought through each venue in each commodity. A trader who exceeds their limit could face a stiff financial penalty (100% of which can go to the CFTC to fund their operations) and that trader's positions could be liquidated on a last-in, first-out basis. In order for this regulation to capture transactions on foreign boards of trade, they must be required to submit the necessary information to the CFTC on a real-time basis in exchange for the CFTC allowing them to place direct terminals in the United States. The CFTC has many ``hooks'' that would allow them to ensure that aggregate speculative position limits apply to foreign boards of trade as well. In summary, the idea is to give speculators one limit and let them ``spend'' it wherever they see fit. I hope I have clarified why aggregate speculative position limits and exchange clearing are the surest protection against a future commodity bubble. Please let me know if I can be of any further assistance. Best regards,Michael W. Masters,Portfolio Manager,Masters Capital Management, LLC. ______ FOMC20080805meeting--107 105,CHAIRMAN BERNANKE.," President Fisher, I'm going to ask you a very innocent question. You've given many chilling anecdotes over the last few meetings about increases in prices, but the official statistics just don't show anything like that outside of oil, gas, gasoline, and the direct commodity price increases. Do you believe that the CPI is not an accurate measure? " FOMC20050630meeting--338 336,MR. LEAHY.," Well, our forecast, obviously, is for import prices to decelerate. That’s based on forecasts that the dollar will flatten out, roughly, or decline only moderately going forward, and that commodity prices will also be relatively flat. So, to the extent you put a lot of confidence into those forecasts, I think you could transfer that to our outlook for import prices. That’s how we do the forecasts." CHRG-111hhrg51698--258 Mr. Roth," I mean, there are laws on the books right now against manipulation of markets; and there have been cases brought by the CFTC in which an integral part of the manipulation effort was a control over the delivery points, or the control of the delivery ability of the underlying commodity. So it is an interesting question that you pose, but there are anti-manipulation laws in effect that have been applied to the circumstances similar to those that you describe. " fcic_final_report_full--413 THE FORECLOSURE CRISIS CONTENTS Foreclosures on the rise: “Hard to talk about any recovery” ..............................  Initiatives to stem foreclosures: “Persistently disregard” .....................................  Flaws in the process: “Speculation and worst-case scenarios” ...........................  Neighborhood effects: “I’m not leaving” .............................................................  FORECLOSURES ON THE RISE: “HARD TO TALK ABOUT ANY RECOVERY ” Since the housing bubble burst, about four million families have lost their homes to foreclosure  and another four and a half million  have slipped into the foreclosure process or are seriously behind on their mortgage payments. When the economic damage finally abates, foreclosures may total between  million and more than  million, according to various estimates.  The foreclosure epidemic has hurt families and undermined home values in entire zip codes, strained school systems as well as community support services, and depleted state coffers. Even if the economy began suddenly booming the country would need years to recover. Prior to , the foreclosure rate was historically less than . But the trend since the housing market collapsed has been dramatic: In , . of all houses, or  out of , received at least one foreclosure filing.  In the fall of ,  in every  outstanding residential mortgage loans in the United States was at least one payment past due but not yet in foreclosure—an ominous warning that this wave may not have crested.  Distressed sales account for the majority of home sales in cities around the country, including Las Vegas, Phoenix, Sacramento, and Riverside, California.  Returning to the , borrowers whose loans were pooled into CMLTI - NC: by September , many had moved or refinanced their mortgages; by that point, , had entered foreclosure (mostly in Florida and California), and  had started loan modifications. Of the , still active loans then,  were seriously past due in their payments or currently in foreclosure.  The causes of foreclosures have been analyzed by many academics and govern- ment agencies. Two events are typically necessary for a mortgage default. First, monthly payments become unaffordable owing to unemployment or other financial  hardship, or because mortgage payments increase. And second (in the opinion of many, now the more important factor), the home’s value becomes less than the debt owed—in other words, the borrower has negative equity. “The evidence is irrefutable,” Laurie Goodman, a senior managing director with Amherst Securities, told Congress in : “Negative equity is the most important predictor of default. When the borrower has negative equity, unemployment acts as one of many possible catalysts, increasing the probability of default.”  FinancialCrisisInquiry--153 It only makes sense that as income moves up, housing prices should be able to move up in a perfectly parallel fashion—you make a little bit more money, you can afford a little bit more house. Those lines were parallel for the good part of 40 years. And what happened in 2001, when Dr. Greenspan traded the dot.com bust for the housing boom, he lowered rates down to 1 percent. He made money free, and encouraged all of the lending possible to try to restart the economy after the dot.com bust. I simply think he did a bad job. Other people think he did a great job. But I think that he enabled this housing market. So when you started seeing rates—rates started—they started raising rates in 2004? When rates started to be—started an increasing path, you saw prime mortgage origination in 2004 drop 50 percent. That just makes sense. Everybody refinanced their homes that could. Everyone got reset and settled, but subprime origination in 2004 doubled. And then it doubled again in ‘05, as prime originations fell off a cliff because rates were moving up. So what happened is Wall Street had these machines built to manufacture mortgages. We wanted affordable housing, so they could lower rates with exotic mortgages. And what you saw from 2001 on is you saw those two parallel lines, home price—median home price and median income—diverge. And not only did they diverge by—for those of you that are statisticians, it was an eight standard deviation divergence. OK? That doesn’t happen very often. I know we talk about once-in-a- lifetime calamities every 10 years, that one just hasn’t happened. THOMPSON: The Fed would have certainly seen that. Why, in your opinion was there no action taken there? BASS: You know, I mean, why—why do politicians not want to take the punch bowl away when things are going well is kind of what you’re asking me. It’s just a difficult decision. And, politically—even appointments at the Fed, right? Everyone’s on somewhat of a re- election cycle. If you make that difficult decision when things are good, you’re the bad guy. You’d rather be the guy that helps clean it up once it breaks. So you get into more of a—an ideological question when you ask. CHRG-110shrg46629--140 PREPARED STATEMENT OF SENATOR JIM BUNNING Chairman Bernanke, I watched your testimony yesterday with interest. Apparently the markets did too, but I am not sure if they did or did not like what they heard. You covered a lot of ground yesterday, but there is some new ground I will cover in the questions and some things that are worth repeating. First, it has been interesting to watch market reactions and expectations to Fed policy statements over the last few months. For a while, the markets did not believe your clear statements that the biggest concern was that inflation would not moderate as expected. Market indicators have moved more in line with your view in the last month or two, and I hope both the markets and you have learned about communication and the way each other think. While this is a monetary policy hearing, I think it is worth repeating that many of us believe the Fed and other regulators share some responsibility for the current state of the housing market. Low interest rates fueled the housing boom, and loose supervision of mortgage writing allowed it to proceed. The market is certainly punishing bad behavior by lenders, but some of the damage could have been prevented by more careful scrutiny of some of the most undisciplined lending. The Fed should have been especially careful because of the credit bubble it created with cheap money. I am glad you and your fellow regulators have taken action, and that you did not overreact and cause further damage. It is important for you to remain vigilant, but not to give in to pressure to over regulate. I would also say to Chairman Dodd that I hope we can quickly confirm the new nominees so that the Fed board will have more industry experience when tackling these issues. I continue to be impressed by the current economy, which seems to have passed through the worst of the slowdown caused largely by Fed tightening. My biggest concerns are rising food and energy prices, and the negative effects on the economy of the massive tax increases the new majority in Congress seems determined to allow. The current economic expansion is driven by the 2001 and 2003 tax cuts, and allowing a tax increase in 2010 will reverse years of gains in the economy and the stock markets. I look forward to hearing your responses. ______ CHRG-111hhrg51698--300 Mr. Masters," Chairman Peterson and Members of the Committee, thank you for the opportunity to appear before you to discuss this critical piece of legislation. As we witnessed in the last 18 months, what happens on Wall Street can have a huge impact on the average American. There are three critical elements that must be part of any effective regulatory framework. First, transparency. Effective regulation requires complete market transparency. In recent years, the big Wall Street banks have preferred to operate in dark markets where regulators are unable to see what is occurring. This limited transparency has enabled them to take on massive amounts of off-balance-sheet leverage, creating what amounts to a shadow financial system. Regulators cannot regulate if they cannot see the whole picture. Given the speed with which financial markets move, this transparency must be available on a real-time basis. The best way to bring transparency to over-the-counter (OTC) transactions is to make it mandatory for all OTC transactions to clear through an exchange. For that reason, I am very glad to see the sections of this bill that call for exchange clearing. This is a critical prerequisite for effective, regulatory oversight. The second thing that regulators must do is eliminate systemic risk. A lack of transparency was one of the primary factors in the recent financial meltdown. The other primary factor was the liquidity crisis brought on by excessive leverage at the major financial institutions. One of the most dangerous things about OTC derivatives is that they offer virtually unlimited leverage, since typically no margin is required. This is one of the reasons that Warren Buffett famously called them financial weapons of mass destruction. By mandating that OTC transactions clear through an exchange, your bill provides for the exchange to become the counterparty to all transactions. Since the exchange requires the posting of substantial margin, the risk to the financial system as a whole is nearly eliminated. When sufficient margin is posted on a daily basis, then potential losses are greatly contained and will prevent a domino effect from occurring. I do not know the specifics of the clearinghouse that ICE and the major swaps dealers are working to establish, but I would encourage policymakers to look very closely at the amount of margin the swaps dealers were required to post on their trades. If there is a substantial difference between what ICE requires and what CME Group requires, then swaps dealers, in a quest for maximum leverage will flock to the clearing exchange that has the lowest margin requirements. This is exactly opposite of what regulators and policymakers would want to see. The stronger the margin requirements, the greater will be the mitigation of systemic risk. The weaker the margin requirements, the greater chance we face of another systemic meltdown. The third thing that regulators must do is eliminate excessive speculation. Speculative position limits are necessary to eliminate excessive speculation and protect us from price bubbles. In commodities, if they had been in place across all commodity derivatives markets, then we would not have seen last year's spike and crash in commodities prices. The fairest and best way to regulate the commodities derivatives market is to subject all participants to the same regulations and speculative position limits, no matter where they trade. Every speculator should be regulated equally. The over-the-counter markets are dramatically larger than the futures exchanges. If speculative position limits are not imposed on all OTC commodity derivatives, it would be like locking one's doors to prevent a robbery, while leaving the windows wide open. This bill needs to include aggregate speculative position limits. If it does not, there is nothing protecting your constituents from another, more damaging bubble in food and prices. Once OTC commodity derivatives are cleared through an exchange, regulators will be able to easily see every trader's position; and the application of speculative limits will be just as simple for over-the-counter as it is for futures exchanges today. In summary, we have now witnessed how damaging unbridled financial innovation can be. The implosion on Wall Street has destroyed trillions of dollars in retirement savings and has required trillions of dollars in taxpayer money. Fifteen years ago, before the proliferation of OTC derivatives and before regulators become enamored with deregulation, the financial markets stood on a much firmer foundation. It is hard to look back and say that we are better off today than we were then. I think it is clear to everyone in America that this grand experiment, rather than delivering on its great promise, has in fact turned out to be a great disaster. Thank you. [The prepared statement of Mr. Masters follows:] Prepared Statement of Michael W. Masters, Founder and Managing Member/ Portfolio Manager, Masters Capital Management, LLC, St. Croix, U.S. VI Chairman Peterson and Members of the Committee, thank you for the opportunity to appear before you today to discuss this critical piece of legislation. As we have witnessed in the last 18 months, what happens on Wall Street can have a huge impact on Main Street. The implosion of Wall Street has destroyed trillions of dollars in retirement savings, has required trillions of dollars in taxpayer money to rescue the system, has cost our economy millions of jobs, and the devastating aftershocks are still being felt. Worst of all, this crisis was completely avoidable. It can be characterized as nothing less than a complete regulatory failure. The Federal Reserve permitted an alternative, off-balance sheet financial system to form, which allowed money center banks to take on extreme amounts of risky leverage, far beyond the limits of what your typical bank could incur. The Securities and Exchange Commission allowed investment banks to take on the same massive amount of leverage and missed many instances of fraud and abuse, most notably the $50 billion Madoff Ponzi scheme. The Commodities Futures Trading Commission allowed an excessive speculation bubble to occur in commodities that cost Americans more than $110 billion in artificially inflated food and energy prices, which in turn amplified and deepened the housing and banking crises.\1\--------------------------------------------------------------------------- \1\ See our newly released report entitled ``The 2008 Commodities Bubble: Assessing the Damage to the United States and Its Citizens.'' Available at www.accidentalhuntbrothers.com.--------------------------------------------------------------------------- Congress appeared oblivious to the impending storm, relying on regulators who, in turn, relied on Wall Street to alert them to any problems. According to the Center for Responsive Politics ``the financial sector is far and away the biggest source of campaign contributions to Federal candidates and parties, with insurance companies, securities and investment firms, real estate interests and commercial banks providing the bulk of that money.'' \2\ Clearly, Wall Street was pleased with the return on their investment, as regulation after regulation was softened or removed.--------------------------------------------------------------------------- \2\ ``Finance/Insurance/Real Estate: Background,'' OpenSecrets.org, Center for Responsive Politics, July 2, 2007. http://www.opensecrets.org/industries/background.php?cycle=2008&ind=F.--------------------------------------------------------------------------- So I thank you today, Mr. Chairman and Members of this Committee for your courageous stand and your desire to re-regulate Wall Street and put the genie back in the bottle once and for all. I share your desire to focus on solutions and ways that we can work together to ensure that this never happens again. I have included with my written testimony a copy of a report that I am releasing, along with my co-author Adam White, which provides additional evidence and analysis relating to the commodities bubble we experienced in 2008, and the devastating impact it has had on our economy (electronic copies can be downloaded at www.accidentalhuntbrothers.com). I would be happy to take questions on the report, but I want to honor your request to speak specifically on this piece of legislation that you are proposing. I believe that the Derivatives Markets Transparency and Accountability Act of 2009 goes a long way toward rectifying the inherent problems in our current regulatory framework and I commend you for that. While Wall Street will complain that the bill is overreaching, I believe that, on the contrary, there are opportunities to make this bill even stronger in order to achieve the results that this Committee desires. I am not an attorney and I am not an expert on the Commodity Exchange Act, but I can share with you what I see as the critical elements that must be part of any effective regulatory framework, and we can discuss how the aspects of this bill mesh with those critical elements.Transparency Effective regulation requires complete market transparency. Regulators, policymakers, and ultimately the general public must be able to see what is happening in any particular market in order to make informed decisions and in order to carry out their entrusted duties. In recent years, the big Wall Street banks have preferred to operate in dark markets where regulators are unable to fully see what is occurring. This limited transparency has enabled them to take on massive amounts of off-balance-sheet leverage, creating what amounts to a ``shadow financial system.'' Operating in dark markets has also allowed the big Wall Street banks to make markets with wide bid-ask spreads, resulting in outsized financial gains for these banks. When a customer does not know what a fair price is for a transaction, then a swaps dealer can take advantage of informational asymmetry to reap extraordinary profits. Regulators cannot regulate if they cannot see the whole picture. If they are not aware of what is taking place in dark markets, then they cannot do their jobs effectively. Regulators must have complete transparency. Given the speed with which the financial markets move, this transparency, at a minimum, must be available on a daily basis and should ideally be sought on a real-time basis. The American public, which has suffered greatly because of Wall Street's failures, deserves transparency as well. Individuals should be able to see the positions of all the major players in all markets on a delayed basis, similar to the 13-F filing requirements of money managers in the stock market. The best way to bring over-the-counter (OTC) transactions out of the darkness and into the light is to make it mandatory for all OTC transactions to clear through an exchange. Nothing creates transparency better than exchange clearing. All other potential solutions, like self-reporting, are suboptimal for providing necessary real-time information to regulators. For these reasons, I am very glad to see the sections of this bill that call for exchange clearing of all OTC transactions. This is a critical prerequisite for effective regulatory oversight. For that reason, it should be a truly rare exception when any segment of the OTC markets is exempted from exchange clearing requirements. I am further encouraged by sections 3, 4 and 5, which bring transparency to foreign boards of trade and make public reporting of index traders' and swaps dealers' positions a requirement. Lack of transparency was a primary cause of the recent financial system meltdown. Unsure of who owned what, counterparties assumed the worst and were very reluctant to trade with anyone. The aforementioned provisions in this bill will help ensure the necessary transparency to avoid a crisis of confidence like we just experienced. Wall Street would much prefer that the OTC markets remain dark and unregulated. They will push to keep as much of their OTC business as possible from being brought out into the light of exchange clearing. They will argue that we should not make major changes to regulation now that the financial system is so perilously weak. From my perspective this sounds like an intensive care patient that refuses to accept treatment. The system is already on life support. Transparency is the cure that will enable the financial system to recover. Congress must prioritize the health of the financial system and the economy as a whole above the profits of Wall Street. The profits of Wall Street are a pittance when compared with the cost to America from this financial crisis. We must clear all OTC markets through an exchange to ensure that this current crisis does not recur.Systemic Risk Elimination The other primary factor in the meltdown of the financial system was the liquidity crisis, brought on by excessive leverage at the major financial institutions. By mandating that OTC transactions clear through an exchange, the Derivatives Markets Transparency and Accountability Act of 2009 provides for the exchange to become the counterparty to all transactions. Since the exchange requires the posting of substantial margin, the risk to the financial system as a whole is nearly eliminated. When margin is posted on a daily basis, then potential losses are greatly contained and counterparty risk becomes virtually nil. To protect its interests, Wall Street will try to water down these measures. The substantial margin requirements will limit leverage, and limits on leverage, in turn, mean limits on profits, not only for banks, but for traders themselves. Because traders are directly compensated with a fraction of the short-term profits that their trading generates, they have a great deal of incentive to use as much leverage as they can to maximize the size of their trading profits. These incentives also exist for managers and executives, who share in the resulting trading profits. One of the most dangerous things about OTC derivatives is that they offer virtually unlimited leverage, since typically no margin is required. This is one of the reasons that Warren Buffet famously called them ``financial weapons of mass destruction.'' This extreme over-leveraging is essentially what brought down AIG, which at one time was the largest and most respected insurance company in the world. While by law they could not write a standard life insurance contract without allocating proper reserves, they were able, in off-balance-sheet transactions, to write hundreds of billions of dollars worth of credit default swaps and other derivatives without setting aside any significant amount of reserves to cover potential losses. If AIG were clearing its credit default swaps through an exchange requiring substantial margin, it would never have required well over $100 billion dollars in taxpayer money to avoid collapsing. I do not know the specifics of the clearinghouse that the IntercontinentalExchange (ICE) and the major swaps dealers are working to establish but I would encourage policymakers to look very closely at the amount of margin that swaps dealers will be required to post on their trades. If there is a substantial difference between what ICE requires and what CME Group requires then swaps dealers, in a quest for maximum leverage, will flock to the clearing exchange that has lower margin requirements. This is exactly opposite of what regulators and policymakers would want to see. The stronger the margin requirements, the greater will be the mitigation of systemic risk. The weaker the margin requirements, the greater chance we face of having to bail out more financial institutions in the future. I strongly urge Congress to resist all pressure from Wall Street to soften any of the provisions of this bill. We must eliminate the ``domino effect'' in order to protect the system as a whole, and exchange clearing combined with substantial margin requirements is the best way to do that.Excessive Speculation Elimination Speculative position limits are necessary in the commodities derivatives markets to eliminate excessive speculation. When there are no limits on speculators, then commodities markets become like capital markets, and commodity price bubbles can result. If adequate and effective speculative position limits had been in place across commodity derivatives markets, then it is likely we would not have seen the meteoric rise of food and energy prices during the first half of 2008, nor the ensuing crash in prices when the bubble burst. The fairest and best way to regulate the commodities derivatives markets is to subject all participants to the same regulations and speculative position limits regardless of whether they trade on a regulated futures exchange, a foreign board of trade, or in the over-the-counter markets. Every speculator should be regulated equally. If you do not, then you create incentives that will directly favor one trading venue over another. The over-the-counter (OTC) markets are dramatically larger than the futures exchanges. If speculative position limits are not imposed on all OTC commodity derivatives then there is a gaping hole that speculators can exploit. It would be like locking one's doors to prevent a robbery, while leaving one's windows wide open. The best solution is to place a speculative position limit that applies in aggregate across all trading venues. Once OTC commodity derivatives are cleared through an exchange, regulators will be able to see every trader's positions and the application of speculative limits will be just as simple for OTC as it is for futures exchanges today. This type of aggregate speculative position limit is also better than placing individual limits on each venue. For example, placing a 1,000 contract limit on ICE, a 1,000 contract limit on NYMEX and a 1 million barrel (1,000 contract equivalent) limit in the OTC markets will incentivize a trader to spread their trading around to three or more venues, whereas with an aggregate speculative position limit, they can trade in whichever venue fits their needs the best, up to a clear maximum. I applaud the provisions of your bill that call for the creation of a panel of physical commodity producers and consumers to advise the CFTC on the level of position limits. I believe it affirms three fundamental truths about the commodities derivatives markets: (1) these markets exist for no other purpose than to allow physical commodity producers and consumers to hedge their price risk; (2) the price discovery function is strengthened and made efficient by the trading of the physical hedgers and it is weakened by excessive speculation; and (3) speculators should only be allowed to participate to the extent that they provide enough liquidity to keep the markets functioning properly. Physical commodity producers and consumers can be trusted more than the exchanges or even the CFTC to set position limits at the lowest levels possible while still ensuring sufficient liquidity. I understand the legal problem with making this panel's decisions binding upon the CFTC. Still, I hope it is clear that this panel's recommendations should be taken very seriously, and if the CFTC chooses to not implement the recommendations they should be required to give an account for that decision. I further believe that the exchanges and speculators should not be part of the panel because they will always favor eliminating or greatly increasing the limits. CME and ICE may perhaps oppose speculative position limits in general out of a fear that it will hurt their trading volumes and ultimately their profits, but I believe this view is shortsighted. If CME, ICE and OTC markets are all regulated the same, with the same speculative position limits, then trading business will migrate away from the OTC markets and back to the exchanges, because OTC markets will no longer offer an advantage over the exchanges. I am glad that this bill gives the CFTC the legal authority to impose speculative position limits in the OTC markets, but I openly question whether or not the CFTC will exercise that authority. Like the rest of our current financial market regulators, they have been steeped in deregulation ideology. While I hope that our new Administration will bring new leadership and direction to the CFTC, I fear that there will be resistance to change. When Congress passed the Commodity Futures Modernization Act of 2000, they brought about the deregulation that has fostered excessive speculation in commodities derivatives trading. Now Congress must make it clear that they consider excessive speculation in the commodities derivatives markets to be a serious problem in all trading venues. Congress must make it clear to the CFTC that they have an affirmative obligation to regulate, and that a critical part of that is the imposition and enforcement of aggregate position limits to prevent excessive speculation.Summary We have now witnessed how damaging unbridled financial innovation can be. Wherever there is growing innovation there must also be growing regulation. Substantial regulation is needed now just to catch up with the developments on Wall Street over the last fifteen years. This bill is ambitious in its scope and its desire to re-regulate the financial markets, and for that I am encouraged. These drastic times call for bold steps, and I am pleased to support your bill. My sincere wish is that it be strengthened and not weakened by adding a provision for aggregate speculative position limits that covers all speculators in all markets equally. Fifteen years ago, before the proliferation of over-the-counter derivatives and before regulators became enamored with deregulation, the financial markets stood on a much firmer foundation. Today, with all of the financial innovation and the deregulation of the Clinton and Bush years, it is hard to look back and say that the financial markets are better off than they were 15 years ago. I think it is clear to everyone in America that this grand experiment, rather than delivering on its great promise has, in fact, turned out to be a great disaster. Attachment[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] " CHRG-111hhrg55811--166 Mr. Gensler," Our concern is overall to lower risk in the system and enhance transparency, to promote the competition that you, too, as well want. But we want to ensure that there then wouldn't be some regulatory arbitrage that a non-bank could have zero capital and all the banks have to have capital. So we do think it is appropriate to have some minimum amount of capital if you are holding yourself out to the public as a dealer. This is the dealers themselves. And that is generally only in, as I said, the energy commodity swaps. " FOMC20080318meeting--86 84,MR. KOHN.," Thank you Mr. Chairman. I agree with the others around the table who have said that the prospects for economic activity have taken another sizable leg down over the intermeeting period. I think we have been, for a time, in that adverse feedback loop between financial markets and spending that everybody--Governor Mishkin and others--has been talking about. That is not an unusual kind of loop to be in during a soft economic period. I think it is probably characteristic of a lot of slow growth and recessionary periods. But certainly it has been more intense this time because the financial turmoil has spread well beyond housing and has intensified significantly over the intermeeting period. The incoming data on spending, employment, and production were weaker than expected. House prices are moving lower by more than we or the markets expected. All of these data have accentuated concerns about the creditworthiness of households and businesses and, hence, about the creditworthiness of the people who lend to them, especially those who lend in the mortgage market. As perceptions of risk and risk aversion rose, there was a flight to safety and liquidity. I think we see that a little in the growth of M2 over the past couple of months, which has been very, very strong and suggests that households are retreating to money market funds, probably the ones that hold government securities, and to insured deposits. In wholesale markets there has been unwillingness to take positions and rising concerns about an array of intermediaries. Bill described this process much better than I could--illiquid markets, extreme volatility, deleveraging, margin calls, forced sales, especially in mortgage-backed securities, wider spreads, equity prices falling, and lending and funding tenors collapsing toward the overnight, again. So financial conditions have tightened for everybody but the government--and some of the European governments have seen them tighten, I guess. Mortgage rates have risen, and business bond yields have risen as well, even with Treasury rates going down. Tighter credit and declining equity and house prices are reducing wealth, and all of this weakens spending further. Now, to this process, the staff has judged that the economy has entered a recessionary state in which we can expect household and business spending to fall short of normal levels, given income and interest rates. I am not sure how much weight to put on this. I am a bit uncomfortable with constructs that don't have a clear story behind them. But I must say that, looking at the sentiment indicators and listening to what I have heard around the table today from almost every Federal Reserve District reporting, I now put more credence in Dave's recessionary state than I did before the meeting started. Obviously, something is going on that is undermining confidence and making people much more cautious than you would think, given the exogenous variables. I do think talking about the recessionary state underlines the extraordinary uncertainty we are dealing with. President Stern pointed out the 1990-91 precedent. There are some precedents for some aspects of this, but we don't have many; and I think it is really difficult to know how financial markets will evolve and how that will feed through to the variables that affect household and business spending--the reaction of households, businesses, and state and local governments to tighter credit conditions. I agree with President Stern, President Evans, and others who said they thought that the financial stresses are deeper and will last longer than we thought and will, therefore, put more restraint on spending. Until markets stabilize on a sustained basis, the risk to satisfactory economic performance by the U.S. economy will remain skewed very much to the downside. Now, Federal Reserve liquidity tools that we have used are necessary to reduce the odds on even more-intense, downward-spiral crises and market liquidity feeding back onto spending. So I think our innovations here have been useful to reduce the downside risks a little and thereby to promote spending. But I agree with the others who say that they don't directly deal with the underlying macro risk, which is really a story about capital, solvency, wealth, and prices. I think monetary policy easing is a necessary aspect of addressing these macroeconomic risks. I agree with President Fisher, President Plosser, and others that there is more going on and that monetary policy easing may not be a sufficient way of addressing these risks. But I do think, as long as the economy is weakening the way it is and we have these risks, that easing monetary policy will be helpful. It will help bolster asset prices. It will make the cost of capital lower than it otherwise would be. It may not be sufficient to turn the thing around, but I do think that without the easing that we have done-- and that I hope that we do today--the situation would be far worse than it otherwise would be. We need to ease to compensate for the substantial headwinds that we are facing. Now, the forecast for inflation has not been marked down despite the greater output gap. As others have remarked, this output gap is offset, to a considerable extent, by the upward pressure on prices from oil and commodities and import prices as the dollar has fallen and prices have risen in our exporting partners--China, for example. I have to confess that I don't really understand what has been happening to commodity prices in recent months. I don't think the rise has been justified by the news on the underlying conditions of supply and demand. It is much larger than the dollar weakness has been, and the dollar�commodity price has always been a weak relationship. So, in fact, commodity prices are rising in a bunch of currencies. This isn't just a dollar weakness problem. I have to believe that there is a speculative element here. Partly as a consequence, I am comfortable with the forecast of a flattening commodity price picture in the future--it might even decline, but at least a flattening out. I do think a shift from financial assets, especially dollar assets, into commodities is going on, and mostly this has been triggered by concerns about the U.S. economy and financial markets. In some sense, that shift is okay. It is driving down the dollar, and that is helping to stabilize the economy. The decline that we saw in oil prices yesterday suggests that, when people get more confidence about where those financial markets are going, some of those commodity prices will actually fall as the concerns about the U.S. economy are alleviated. It is sort of an upside-down relationship, but I do think we saw a bit of it that way. But I also sense that some of the rise in commodity prices and the fall in the dollar reflects concerns about the inflation outlook here. It is not surprising to me, in a very volatile and uncertain environment, that inflation expectations are not as well anchored and that they fluctuate a lot in response to new information. I expect that inflation will come down as commodity prices level off; then the output gap will increase, and that in turn will keep inflation expectations down. Still, navigating this appreciably weaker economic outlook for the real economy and the threats to financial stability, on the one hand, and the tenderness of inflation expectations, on the other, will require some discussion in the next section of our meeting, Mr. Chairman. " CHRG-110shrg50369--52 Mr. Bernanke," Well, Mr. Meltzer, who is an excellent economist and indeed who is a historian of the Federal Reserve, is concerned that the current situation will begin to look like the 1970s, with very high inflation and high unemployment. I would dispute his analysis on the grounds that I do believe that monetary policy has to be forward looking, has to be based on where we think the economy and the inflation rate are heading. And as I said, the current inflation is due primarily to commodity prices--oil and energy and other prices--that are being set in global markets. I believe that those prices are likely to stabilize, or at least not to continue to rise at the pace that we have seen recently. If that is the case, then inflation should come down, and we should have, therefore, the ability to respond to what is both a slowdown in growth and a significant problem in the financial markets. He is correct, however, that there is some risk, and if the inflation expectations look to be coming unmoored, or if the prices of energy and commodities begin to feed into other costs of goods and services, we would have to take that very seriously. I mentioned that core inflation last year was 2.1 percent, so it is food prices and energy prices, which are internationally traded commodities, which are the bulk of the inflation problem. Again, we do have to watch it very carefully, but I do not think we are anywhere near the 1970s type situation. Senator Bennett. Thank you. I wanted to get that on the record. As I look at the housing market and talk to some of my friends who are in the housing market, they tell me that the inventory is not monolithic, the inventory overhang--that is that the bulk of the overhang is in the higher-priced homes, because home builders wanted to build places where they would get the highest margin return, and if they built houses in the moderate housing area or affordable housing, their margins were not nearly as great and there were plenty of speculators willing to buy the bigger homes. And, indeed, they tell me that for affordable housing, there is, frankly, not a sufficient supply right now. They are urging me to do something on fiscal policy to stimulate people to build cheaper houses, that the housing construction would begin to catch up--not catch up. Construction levels would begin to pick up, whereas now they are dormant, waiting for the overhang to be worked off. Do you have any data that supports that anecdotal report? " CHRG-110shrg50369--30 Mr. Bernanke," Senator, we are facing a situation where we have simultaneously a slowdown in the economy, stress in the financial markets, and inflation pressure coming from these commodity prices abroad. And each of those things represents a challenge. We have to make our policy in trying to balance those different risks in a way that will get the best possible outcome for the American economy. Senator Shelby. Would you be trying to avoid stagflation, as some people call it? " CHRG-111hhrg51698--462 Mr. Hale," Chairman Peterson, Ranking Member Lucas, Committee Members, thank you. My name is Bill Hale. I have been in the grain merchandising business with Cargill for 35 years. I am joined this morning by David Dines, who has managed our OTC business for the past 15 years. As a merchandiser and processor of commodities, the company relies heavily upon efficient and well-functioning futures markets. First, I would like to thank the Chairman for holding this hearing and for his willingness to listen and address some of our concerns. We appreciate the changes made in the draft to better accommodate highly customized risk management products. Cargill encourages policymakers to develop regulatory systems that foster efficient, well-functioning, exchange-traded and OTC markets for agriculture and energy products. This can best be achieved by establishing better reporting and transparency for market participants, establishing and ensuring enforceable position limits. The existing draft of the Derivatives Markets Transparency and Accountability Act takes several positive steps, especially in the area of reporting, which will enhance the ability of the regulator to properly monitor market activities. However, the draft bill has two areas of concern. Section 6, position limits which are not constructed in the same manner for exchange-traded and OTC markets. This can be addressed by modifying how position limits are structured. This is not a question of whether they should apply. To put this in perspective, think in terms of highway speed limits. They apply to individual drivers. You do not send a car-maker a ticket when someone speeds. The same structure currently applies in the Chicago futures markets, and the same structure should apply in the OTC market. The other area of concern is section 13, mandatory clearing, which will stifle activity in the OTC market and reduce hedging opportunities in the agricultural and energy markets. This can be addressed by increased reporting requirements for OTC providers. While Cargill supports better reporting, transparency, and enforceable position limits, we urge caution and restraint for policymakers. We believe there is real danger in treating all over-the-counter products across all asset classes the same. In addition, the changes needed to improve some commodity-specific exchange-traded markets, particularly wheat and cotton, are often contract issues that have to be resolved between the exchanges and the market participants. Legislative measures are poor instruments to resolve these specific issues. Products provided by the OTC markets help hedgers, such as food, feed, industrial companies, meet risk management needs with tailored alternatives. Too often it is thought that the OTC market is solely used by speculators. However, it is critical to note that the majority of our OTC activity is for commercial and producer hedgers seeking tailored management solutions. Most critically during this unprecedented volatility, systemic risk was avoided because of the availability of both OTC and exchange-based hedging tools. Given the stress on the markets, some weaknesses were exposed, and the bill seeks to address those areas. But much of the basic functionality of the agriculture and energy markets performed well. It is important to remember that the dramatic volatility and price rise in 2008 was influenced by many variables. With strong fundamentals, commodity markets attracted many participants, both hedgers and speculators. Regarding section 6, Cargill supports enforceable position limits for noncommercial participants. However, as it was designed in the draft bill, position limits are not applied in the same manner for the OTC market as they are in exchange-traded markets. They should be structured in a similar manner for both markets. The draft bill seeks to apply the same position limit to the OTC provider as it does to the noncommercial participant. This is too restrictive to the OTC provider, since its role is to serve as an intermediary to more than one customer. This restriction will limit the size of the OTC market beyond the intended noncommercial position limits. The Committee will be able to achieve its objective of ensuring position limits in OTC transactions by applying position limits to the noncommercial participants. For section 13, we do not believe that mandatory clearing is needed. The stated benefits of central clearing are better transparency, reporting, and mitigation of counterparty risk. This can be accomplished efficiently by having standardized reporting requirements to the CFTC. The CFTC would have the ability to investigate and curtail any OTC customer whose position they believe is to large for the underlying commodity market. Centralized clearing has a role and should be encouraged for financially weaker market participants. However, financially strong food companies, industrials, commercials, and producers should have the flexibility to negotiate credit terms. Removing this flexibility from both simple and tailored OTC products will greatly reduce hedging activity through the working capital requirements of margin. Changes to the current system would be occurring at a time when liquidity and credit are already constrained, and at a time when hedging should be encouraged. Agriculture and energy OTC providers for many years have effectively used collateralized margining agreements and other credit support mechanism to manage credit and market exposures. This system works very well. It was simple OTC swaps on the grains that helped enable Cargill and other grain buyers to reopen deferred grain purchases from the farmer during 2008. Had the bill been in place in its current form, Cargill and other grain buyers would have been unable to use simple swaps to mitigate the margin requirements imposed on futures hedges. As a consequence, farmers would have been further burdened by the lack of pricing and liquidity for their crops. While the bill currently has provisions that allow for exceptions to centralized clearing for highly customized transactions, it is a little unclear to us what will and will not qualify for this exception. It is critical that no changes be made that would inhibit customized hedges, as this would also significantly reduce prudent hedging among market participants. If you think of the futures contract as one type of product, Cargill has over 130 different types of OTC products. The hedging customer can choose to further tailor the protection time frame, price level, and transaction size. Given this, no two 0TC transactions are identical, which is why centralized clearing is problematic. Clearing organizations do not have the systems and processes necessary to value and clear a wide range of products with a high degree of customization. In conclusion, Cargill appreciates the work of the House Agriculture Committee, ensuring that both exchange-traded and OTC markets perform well. These markets provide critical functions. This past year was clearly a volatile and difficult time for the commodity markets. Steps can and should be taken to improve market transparency and reporting, as well as ensuring that position limits are effectively enforced. We have serious concerns about sections 6 and 13 in the draft legislation, but we are confident that we can work constructively with Members of the Committee to develop policy alternatives that will help ensure the integrity of the markets. Thank you. [The prepared statement of Mr. Hale follows:]Prepared Statement of William M. Hale, Senior Vice President, Grain and Oilseed Supply Chain North America, Cargill, Incorporated, Wayzata, MN My name is Bill Hale, Senior Vice President, Grain and Oilseed Supply Chain North America. I am testifying on behalf of Cargill, Incorporated and have been in the grain merchandising business for 35 years. I am also joined this morning by David Dines, President of Cargill Risk Management. Cargill is an international provider of food, agricultural, and risk management products and services. As a merchandiser and processor of commodities, the company relies heavily upon efficient and well-functioning futures markets. Cargill is also active in the energy markets, offering risk management products and services to commercial customers. Cargill encourages policymakers to develop regulatory systems that foster efficient, well-functioning exchange-traded and over-the-counter markets for agricultural and energy products. This can be best achieved by: Establishing better reporting and transparency for market participants. Establishing and ensuring enforceable position limits. This past year was a period of remarkable volatility driven by many factors and, by large measure, the agriculture and energy commodity markets responded appropriately. The existing draft of the Derivatives Markets Transparency and Accountability Act of 2009 takes several positive steps, especially in the area of reporting which will enhance the ability of the regulator to properly monitor market activities. However, the draft bill has two areas of concern: Section 6: Position limits, which are not constructed in the same manner for exchange-traded and OTC markets. This can be addressed by modifying how the position limits are structured. This is not a question of whether they should apply. Section 13: Mandatory clearing, which will stifle activity in the OTC market and reduce hedging opportunities in the agricultural and energy markets. This can be addressed by increased reporting requirements for OTC providers and segmenting credit default swaps from traditional agriculture and energy contracts. While Cargill supports better reporting, transparency and enforceable position limits, we urge caution and restraint for policymakers. The agricultural and energy over-the-counter markets are not the source of systemic risk and abuse that the credit default swap market has been. We believe there is real danger in treating all over-the-counter products across all asset classes the same. In addition, the changes needed to improve some commodity-specific exchange-traded markets, particularly wheat and cotton, are very often contract issues that have to be resolved between the exchanges and the market participants. A well-informed regulator can be helpful in making sure balanced decisions are made that ensure contract functionality and market integrity, but broad legislative measures are poor instruments to resolve these specific issues.Role of Commodity Futures Markets and Over-the-Counter Markets The objective of a commodity futures market is to provide a price discovery mechanism and allow for effective risk transfer. For a commodity futures market to meet this objective, there must be both convergence with the futures price relative to the underlying cash value of the commodity at the time of delivery and a balanced range of market participants to provide adequate liquidity and efficiency. In addition to buyers and sellers with a physical interest in the underlying commodity, speculators also play a vital role in enhancing liquidity and futures contract performance. In effect, they help bridge the gap between buyers and sellers and ensure that contracts are quickly filled with the least possible transaction costs. Beginning with farmers and other commodity producers, and extending all the way through the supply chain to end-users, it is critical to have well-performing futures markets. Futures products allow farmers to know what their product is worth and to better manage their risks by setting a price for the commodity that is close to their actual delivery time. For consumers or processors, the same is true in allowing them to hedge their risks and gain greater certainty over their costs. Products provided by the over-the-counter (OTC) markets help hedgers meet risk management needs with tailored alternatives that cannot realistically be provided by traditional commodity futures and options markets. Too often is it thought that the OTC market is solely used by speculators, however it is critical to note that a majority of our OTC activity is for commercial and producer hedgers seeking risk management solutions tailored for their business needs.Unprecedented Commodity Market Volatility During 2008 During 2008, we experienced an unprecedented increase in commodity prices, only to be immediately followed by a decline of the same historical magnitude. This in itself has been tough for market participants to bear, but we now know that this has been followed by one of the worst economic crises in 80 years. In the world of risk management, we often talk of stress events and this was one of epic proportions. No risk manager could have ever contemplated what the markets have just gone through. I mention this because if there was ever a test for the agricultural and energy futures and over-the-counter markets it was these past twelve months. Fortunately, in many ways, these markets performed well as demonstrated by limited credit issues and limited contract defaults. Most critically, during this unprecedented volatility, systemic risk was avoided because of the availability of both OTC and exchange-based hedging tools. Given the stress on the markets, some weaknesses were exposed and the bill seeks to address those areas, but much of the basic functionality of the agriculture and energy markets performed well.Fundamental Factors Influencing Market Behavior and Speculation It is important to remember that the dramatic volatility and price rise in 2008 was influenced by many variables. Ending stocks for many of the key commodities were tight. In wheat, for example global supplies had been reduced by 2 years of major drought in Australia, a major wheat exporter. Global stocks of grain and key oilseeds[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Source: USDA. Foreign Agricultural Service. The ethanol mandate increased demand for corn. In response, producers planted more corn acres during the 2007 crop year and fewer soybeans, resulting in a very tight carryout balance for soybeans prior to the 2008 harvest. Also on the demand side, projections for continued growth in China, India and much of the developing-world showed growing needs for many of the basic agricultural and energy commodities. These factors were widely known within the farming, trading, processing, and investing communities. USDA Ag Outlook 2008 Projected Demand Growth 1996 = 100[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Source: USDA. With strong fundamentals, commodity markets attracted many participants, both hedgers and speculators, who believed commodity prices would rise. These fundamentals did not only attract capital to futures markets, but also attracted resources toward physical commodity production. Land costs increased for good quality farmland and producers stepped up investments in production technology through equipment, seeds and fertilizer. It is also important to note that even exchange-traded markets with no index fund participation also experienced extreme volatility this year. The volatility and price movements of the Hard Red Spring Wheat contract traded at the Minneapolis Grain Exchange were especially dramatic. Prices rallied 500% from May 2007 through February 2008, reaching a high of $25 per bushel.Derivatives Markets Transparency and Accountability Act of 2008 Cargill supports many of the components of the draft bill before the Committee today and appreciates the work of the Chairman. The bill would improve reporting and transparency. However, we are concerned with two specific areas under consideration by the Committee: Section 6, regarding how position limits may be applied to OTC product providers. Section 13, regarding mandatory clearing of OTC transactions through a derivative clearing organization. Both provisions have negative unintended consequences.Section 6: Application of Position Limits Cargill supports enforceable position limits for noncommercial participants. However, as designed in the draft bill, position limits are not applied in the same manner for the OTC market as they are in the exchange-traded markets. They should be structured in a similar manner for both markets.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] In exchanged traded markets, the clearing broker serves as an intermediary or aggregator of positions, just like the dealer does in the OTC market. Position limits are applied to noncommercial participants in exchange-traded markets and not to the clearing broker. Limits in the OTC market should be categorically applied in the same manner, only to the noncommercial participant and not the OTC provider. The draft bill seeks to apply the same position limit to the OTC provider as it does to the noncommercial participant. This is too restrictive to the OTC provider since its role is to serve as an intermediary to more than one customer. This restriction would limit the size of the OTC market beyond the intended noncommercial position limits. The Committee will be able to achieve its objective of ensuring position limits in OTC transactions by applying position limits to only the noncommercial participants. Addressing this issue in this manner will ensure enforceable position limits and continue the functionality of this segment of the market.Section 13: Clearing of Over-the-Counter Transactions Substantial benefits can be achieved through better reporting by OTC providers. Segment the OTC market to focus on areas with the greatest challenges. Tailored risk management OTC contracts for hedgers cannot be cleared. Standardized swaps convey substantial benefits to a wide range of market participants and these benefits will be lost if clearing is mandatory. A stated benefit of central clearing is better transparency and data reporting. However, this is a restrictive and expensive means for collecting data about OTC market positions and participants. Cargill believes that this can accomplished efficiently by having standardized reporting requirements to the CFTC by the OTC provider community. Other sections of the draft bill directly address the issue of better data and reporting, and will achieve the needs of the Commodity Futures Trading Commission and Congress. One solution would be to have the CFTC restrict OTC activity to approved OTC providers. These approved OTC providers would have a reporting requirement to the CFTC in a standardized format and on a regular basis of all OTC transactions by customer that exceed a certain size threshold. The CFTC would have the ability to investigate and curtail any OTC customer whose position they believe is too large for the underlying commodity markets. The CFTC has this existing authority for investigating customer positions at the clearing broker on listed futures and it works well. Another stated benefit of centralized clearing is the mitigation of counterparty credit risk, since it requires both initial margin and the daily settlement or margining of 100% of the mark-to-market differences between the two parties. While centralized clearing has a role and should be encouraged for financially weaker market participants, financially strong food companies, industrials, commercials and producers should have flexibility to negotiate their own credit terms. As they stand today, the agriculture and energy OTC markets allow for efficient and prudent extension of credit by the OTC provider to financially strong hedging customers. Removing this flexibility for both simple and tailored OTC products will greatly reduce hedging activity due to the working capital requirements of margining. Changes to the current system would be occurring at a time when liquidity and credit are already critically constrained, and at a time when hedging should be encouraged, given the volatility in today's commodity markets. Agricultural and energy OTC product providers for many years have effectively used margining agreements and other credit support mechanisms to manage credit exposures. OTC product providers, including Cargill, have developed processes and built systems that enable us to value our customers' OTC positions and send position statements daily with updated and transparent product valuations. Based upon these valuations and statements, the parties pay or receive margin collateral daily once a credit threshold is reached. This system works very well. Again, if there was ever a test for this it was during the past year. Changing this flexibility in setting credit terms will have the perverse effect of reducing the hedging activity across financially stronger customers since they are the ones currently receiving margining credit from the OTC provider community. Financially weaker customers are either not receiving the margining credit from the OTC provider or they are already using futures because it is their only option. It must be recognized that centralized clearing penalizes participants with strong financial positions.Mandatory Clearing Can Impact Producer Pricing Opportunities Within the agriculture and energy markets, simple OTC swaps convey many benefits through the flexibility in setting credit terms. In the physical grain business, cash flow mismatches exist for grain buyers since they are required to meet the daily margining requirements of futures hedges and are not able to collect an offsetting margin payment from the farmer since physical grain purchase contracts are typically not margined with the farmer. Last Spring, many U.S. grain buyers, including Cargill, curtailed their deferred purchases of grain from farmers because of the historic run-up in commodity prices and the significant amounts of working capital that were needed for operational inventories and to fund the margin requirements of the underlying futures hedges for deferred contracted grain. This was an extremely difficult time for farmers and for grain buyers. Critically, it was simple OTC swaps on the grains that helped enable Cargill and other grain buyers to reopen deferred purchases of grain from the farmer during 2008. Using simple OTC swaps, grain buyers were able to move their hedging for contracted bushels from futures to OTC swaps with OTC providers that put in place margin credit thresholds on the mark-to-market exposure. The bill in its current form only grants an exception to centralized clearing for highly customized swaps, but not for simple swaps. Had the bill been in place in its current form, Cargill and other grain buyers would not have been able to use simple swaps to help mitigate the margin requirements imposed on futures hedges. As a consequence, farmers would have been further burdened by a lack of pricing and liquidity for their crops.Mandatory Clearing Is Extremely Difficult for Customized Products While the bill currently has provisions that allow for exceptions to centralized clearing for highly customized transactions, it is unclear what will and will not qualify for this exception. It is critical that changes are not made that would in any way inhibit customized hedges, as this would also significantly reduce prudent hedging among market participants. A key attribute of the OTC markets in agricultural and energy is the broad menu of product choices, as well as specific tailoring of the hedging instrument to precisely meet the hedger's needs. The advantages of product choices and tailoring are that they deliver both a more efficient hedge and a more cost-effective hedge because the hedger is not paying for something that they do not need. It also allows for diversification of products, which is so critical in today's marketplace. OTC product choices include protection size, protection periods, protection levels, and types of protection. If you think of a futures contract as one type of product, Cargill has over 130 different types of OTC products that we are offering our hedging customers. From these 130 different product types, the hedging customer can choose to further tailor the protection timeframe, price level and transaction size. Given this, no two OTC transactions are identical, which is why centralized clearing is problematic. Clearing organizations do not have the systems and processes necessary to value and clear a wide range of products with a high degree of customization. If this were the case, tailored risk management services would have become available on exchanges years ago. OTC providers such as Cargill create new products by having strong customer relationships, listening to and understanding our customers' commodity risks, and developing products to address these risks. This requires a significant investment of time, human and technological resources, and financial capital. Centralized clearing will put intellectual property in the public domain immediately which will eliminate any economic incentive that OTC providers have for new product development. Now more than ever, customers need new and better products to help them hedge.Summary Cargill appreciates the work of the House Agriculture Committee in ensuring that both the exchange-traded and OTC market perform well. These markets provide critical functions in allowing open price discovery and enhance risk management opportunities. Well performing markets benefit all participants across the supply chain. This past year was clearly a volatile and difficult time for the commodity markets. Steps can and should be taken to improve market transparency and reporting, as well as ensuring that position limits are effectively enforced. We have serious concerns about sections 6 and 13 in the draft legislation, but we are confident that we can constructively work together with Members of this Committee to develop policy alternatives that will help ensure the integrity of the markets, while minimizing the unintended consequences. Thank you for the opportunity to testify before the Committee today and we look forward to working together as the legislation continues to develop. " CHRG-111hhrg51698--585 Mr. Marshall," Thank you, Mr. Chairman. I guess we are trying to address here two related but different problems. One, the recent economic crisis that seems to have been compounded by systemic risk caused by an interwoven relationship that is very difficult to understand, as a result of the fact that this is a very opaque market. There are a lot of people that are involved in the market, and there would be lots of different ways of addressing that. Certainly clearing could be one. You have heard, I guess over the couple days, the different discussions we have had about clearing and compromises with regard to clearing. We started this legislation last summer though, because we were quite concerned about the volatility of commodity markets. And we passed legislation in the late summer or early fall that was designed to address that problem. I guess I would like to hear Mr. Kaswell and Mr. Rosen's thoughts, but I am going to have to make it a hypothetical question to you. I would like you to assume that we have concluded that passive investment money, it has been described as index fund money, et cetera, is a culprit in the sharp rise in commodity prices. Not necessarily all, some of it is demand-driven. But let's assume that we have concluded that a substantial amount of the upswing, and now a substantial amount of the downswing, is explained by the presence of this money in these markets that hasn't been there before. It is a fairly recent phenomena. And what we would like to do is figure out a way to have the markets go back to functioning appropriately as they had, or at least functioning as well as they did, not perfectly, of course, but as well as they did prior to the presence of this money. A number of different suggestions have been made. One is aggregate position limits across all markets, so OTC, on-exchange. Other suggestions have been position limits that apply only to the exchange-traded commodities and not to the OTC market. Others have suggested that the CFTC needs to be given some tools that would be a combination of maybe position limits and possible exemptions, and directed to minimize the inappropriate impact as we find it to be, of this kind of passive money or index money, or whatever you want to call it, in the futures markets, rather than directing the CFTC to set equal position limits, et cetera. I would like to hear you guys, your thoughts, if we are trying to accomplish this, how we would best go about accomplishing this without otherwise messing up the market? " CHRG-111hhrg74855--96 Mr. Waxman," If market manipulation or fraud occurred in a FERC regulated marketplace under CFTC's jurisdiction, would the exclusivity clause of the Commodities Exchange Act prevent FERC from exercising its anti-market manipulation authorities? In other words, would FERC regulation be displaced by CFTC regulation? You don't think so but that is what we are concerned about. I think it needs to be clarified if you don't think--if you agree with us. " CHRG-111hhrg55811--178 Mr. Gensler," Well, I was going to say it depends on the market today, but in the rates-based various estimates, close to 80 percent of the market is already standard in some regard. In the commodity and the credit default space, it is lower, but still probably 60 or 70 percent. These is anecdotal evidence of that. But we are not trying to homogenize the other 20 to 40 percent. There is no goal in the Administration proposal or in the discussion draft to do that. " FOMC20060131meeting--60 58,MR. STOCKTON.,"2 As we see it, the recent configuration of data suggests that, to the extent that there was any noticeable weakness in the fourth quarter, it was short-lived, and we are Thank you, Mr. Chairman. A few years back, I noted that my briefings could largely be characterized as a collection of confessions and excuses. This morning I would like to add a new element to that list: denial. As you know, the BEA’s advance estimate for the growth in real GDP in the fourth quarter—shown in the top left panel of your first exhibit—came in last Friday at an annual rate of 1.1 percent, about half the pace that we had projected. But at this point, we don’t believe that this estimate should be taken as a signal that the economy has fundamentally weakened. To be sure, after a first round of sorting through the details of that report, we haven’t found a smoking gun that gives us any strong reason to override the BEA’s estimate. But we have assumed that there will be a bounceback in some areas that were surprisingly weak last quarter, most notably motor vehicle output and federal spending. 2 The materials used by Messrs. Stockton, Struckmeyer, and Sheets are appended to this transcript (appendix 2). heading into the first quarter on a reasonably solid trajectory. As seen in the top right panel, after spiking up this autumn, initial claims quickly returned to pre-hurricane levels and have dropped even further in recent weeks, giving no suggestion of any softening in the labor market. Industrial production (line 1 of the middle left panel) actually peaked in the fourth quarter, driven by a sharp acceleration in manufacturing output (line 2). Moreover, as shown to the right, recent manufacturing surveys are supportive of our forecast of moderate gains in production as we move into the new year. Consumer spending and capital outlays have also remained solid. Setting aside the effects of the large swings in motor vehicle purchases that occurred in the second half of last year, consumer spending, shown in the bottom left panel, has been on a steady uptrend. And yesterday’s reading on real PCE excluding motor vehicles in December suggests that the first quarter started on a strong note. Shipments of nondefense capital goods (plotted as the red line in the bottom right panel) were released last week after the Greenbook was published, and they were stronger than we had projected. Moreover, new orders (the black line) have remained above shipments, suggesting that equipment spending should be buoyant in coming months. The top left panel of your next exhibit lays out our longer-term outlook for real GDP. As seen by the blue bars, the growth of real GDP is projected to step up this year to 3.9 percent before falling back to 3 percent in 2007. That pattern is influenced importantly by our assumed hurricane effects, and as shown by the red bars, aside from those effects we are expecting a gradual deceleration in activity over the next two years. Our inflation projection is shown to the right. Overall PCE prices are expected to decelerate over the next two years as consumer energy prices slow sharply. We continue to expect a small bump-up in core inflation this year as higher prices for energy, nonfuel imports, and commodity prices are passed through into the prices of final goods and services. But we expect core inflation to edge back down in 2007 as these influences abate. Although this story is pretty much the same as the one in December, we did have, in addition to last Friday’s GDP excitement, a few other developments to deal with over the intermeeting period. As shown in the middle left panel, crude oil prices rose further in recent weeks and are now projected to average $6.50 per barrel higher than in the December Greenbook. As Nathan will be discussing shortly, we also revised up a bit our projection for foreign activity, lowered our projection for the dollar, and—as shown in the middle right panel—raised our forecast for nonfuel import prices. With oil and imports providing a little more upward pressure on costs, we nudged up our forecast for core PCE prices this year and, along with it, our fed funds assumption over the next year—plotted as the black line in the bottom left. We made no substantive changes to our fiscal policy assumptions. As shown in the bottom right panel, fiscal policy provides some impetus to activity this year, related largely to hurricane spending and the implementation of the prescription drug benefit, but is expected to be a nearly neutral influence next year. The principal source of slowing in aggregate activity in our forecast continues to be the housing sector, the subject of exhibit 3. The accumulating data have made us more confident, though far from certain, that we are reaching an inflection point in the housing boom. The bigger question now is whether we will experience the gradual cooling that we are projecting or a more pronounced downturn. I’ll be interested to hear your reports this morning. As for the recent data, sales of existing homes (the red line in the top left panel) have dropped sharply in recent months and by more than we had expected. New home sales (the black line) have also moved off their peaks of last summer but are more consistent with our expectation of a gradual softening. That expectation receives some further support from the more-timely mortgage bankers’ purchase index—plotted to the right. Purchase applications also are off their highs but are not indicating any sharp retrenchment through January. With respect to house prices, the recent data and anecdotes also have pointed to some weakening. As a result, our forecast of a sharp deceleration in home prices— shown in the middle left panel—seems less of a stretch than it did a while back. As shown to the right, the bottom line is that, after contributing importantly to the growth of real GDP over the past four years, residential investment is expected to decelerate sharply this year and to turn down a bit in 2007. As we have noted before, our house- price forecast also has implications for consumer spending. Slower growth of house prices is the chief factor causing the wealth-to-income ratio (the black line in the bottom left panel) to drift down over the projection period. That downdrift, along with the lagged reaction to higher interest rates, results in a gradual rise in the personal saving rate over the next two years. As shown to the right, although spending growth falls short of that of income, overall PCE receives considerable support from the strong gains in disposable income that result from the projected flattening of energy prices, ongoing employment gains, and a step-up in the pace of hourly compensation. Business investment is the subject of exhibit 4. Spending on equipment and software, plotted as the black line in the top left panel, slows gradually over the projection period, largely because the accelerator effects that propelled the earlier recovery in capital outlays begin to wane. Nevertheless, with the cost of capital remaining moderate and corporate balance sheets strong, we are forecasting solid increases in real E&S spending this year and next. Our projection for total nonresidential structures, shown in the panel to the right, reflects some divergent patterns in the components. We expect outlays for drilling and mining (line 2) to increase sharply further this year in response to the run-up that has occurred in the prices for crude oil and natural gas. Although those prices are expected to level off, the lagged effects of the earlier gains should result in some further, albeit diminished, increase in drilling activity in 2007. Excluding drilling and mining (line 3) we are projecting a modest recovery in nonresidential construction activity in response to ongoing gains in employment and gradually declining vacancy rates in the office and industrial sectors. One of the reasons that we are reasonably optimistic about the investment outlook is that the total return to capital—plotted in the middle left panel—remains quite favorable. And although we expect that return to recede a bit as labor costs pick up, it would still remain elevated by historical standards over the forecast period. The remainder of the exhibit is something of a going-away present to the Chairman. While he always seemed to have a grip on where productivity was headed in the future, we always seemed to be struggling to explain what had happened in the past. Most recently, those struggles have centered on understanding the continuing strong gains in productivity in the first half of this decade. One important element of our story has been that the investment boom of the late 1990s was at least partly responsible for sowing the seeds of the further acceleration in multifactor productivity that we have experienced this decade. That capital equipment embodied rapidly improving technologies and allowed firms to sometimes radically restructure business processes. More broadly, as adjustment costs associated with absorbing those investments waned, the productivity advantages showed through more clearly. The bottom panel provides some modest support for the proposition that some of the improved performance of multifactor productivity of the first half of the decade can be traced to the earlier investment boom. That panel employs a new data set based on research spearheaded by my colleagues Carol Corrado, Paul Lengermann, and Larry Slifman that calculates multifactor productivity for detailed industries. Along the x-axis, we measure for each of 60 industries the average rate of growth in investment over the 1995-to-2000 period relative to that industry’s historical norm. On the y-axis, we plot the acceleration in MFP experienced by each industry from the 1995-to-2000 period to the 2000-to-2004 period. As seen by the red regression line, those industries for which the growth of equipment and software was unusually high in the late 1990s were more likely than others to experience a subsequent acceleration in multifactor productivity in the first part of this decade. Obviously, this is not a structural relationship and is meant to be impressionistic. But the recovery in equipment spending over the past few years leaves us optimistic that multifactor productivity can continue to grow at a rapid clip, though perhaps not quite at the pace registered over the first half of the decade. Sandy will now continue our presentation." CHRG-110shrg50369--15 Chairman Dodd," Thank you very much, Mr. Chairman. We will make these 7 to 8 minutes, and, again, I will not be rigid about the time constraints. Let me begin, Mr. Chairman, by going back to that old question that was asked more than, I guess, 30 years ago. I will sort of paraphrase on it, and that is, are we better off today to respond to this situation than we were--in this case I want to ask 7 years ago. The question that Ronald Reagan asked, I think, in 1980 in that campaign, Are we better off today than we were yesterday? And the reason I raise that is because I have been struck by the similarities between 2001 and that period going into, potentially falling into a recession, and here we are in 2008. The parallel seems striking to me in some ways, and I want you to comment on this, if you could. At both moments in this 7-year period, we are on the brink of a recession--at least it seems so. The Fed was cutting interest rates very aggressively. A major asset bubble--in this case, it was the high-tech community rather than housing--was bursting. Yet despite those similarities, the differences in the basic economic information seems to be very, very different as well. Americans had just experienced the greatest economic boom in a generation. Real wages had gone up substantially. Income inequality had narrowed. The Federal Government was in a surplus. In fact, on this very Committee, your predecessor came to a hearing--I do not know who else was on the Committee in those days, but he came and talked about the things we ought to think about by retiring the national debt entirely. There were some downsides to that, and we actually had a very good hearing with Alan Greenspan about that very question in 2001. The dollar was at record highs as well, and, of course, today we are in the opposite position, with the dollar at its lowest level since we began floating currencies in 1973. Inflation is at a 17-year high. Real wages are falling, and we are faced with record Government debt and deficits. A very different fact situation than was the case in 2001. In 2001, as well, one might argue that there were deliberate actions taken by the Federal Reserve to deal with rising inflation. So the steps were in response to inflation here. Obviously, what is provoking, I think, the action--and you can certainly comment on this--is a different fact situation. So the question appears in a sense: Are we in a--what would be your analysis? Are we in a--comparing these two periods in time of history, relatively close to each other, faced with similar situations, it would appear to me that we are not in as strong a position to respond to this as we were in 2001. And so the question is, Are we better off? And if so, I would like you to explain why. And if not, what should we be doing and what different steps should we be taking if we cannot rely on these basic underlying strengths that occurred in 2001 that helped us at that time as opposed to where we are today? " FOMC20080430meeting--54 52,MR. SHEETS.," Much as Dave just described for the domestic economy, our forecast for economic activity abroad also is little changed from the last Greenbook. Recent data have come in consistent with our view that the slowdown in U.S. activity and the ongoing financial turbulence will leave an unmistakable imprint on economic growth abroad. But the extent of this imprint appears to be somewhat less pronounced than was the case in the high-tech-led recession earlier this decade, particularly for the emerging market economies. Thus we continue to see foreign growth stepping down from last year's 4 percent pace to near 2 percent during the second and third quarters of this year, as foreign activity is constrained by the weakening U.S. economy and headwinds from the ongoing financial turmoil. With these factors projected to abate, we see growth abroad rising back to near its trend rate of around 3� percent in 2009. Suffice it to say, the risks around this forecast remain significant. On the upside, China's surprisingly strong first-quarter GDP growth--which we estimate was nearly 11 percent at an annual rate--highlights the possibility that growth in emerging Asia, and perhaps elsewhere as well, may remain more resilient than we anticipate. On the downside, the softer-than-expected German IFO data last week and the negative tone of the Bank of England's recent credit conditions survey suggest that growth in Europe may slow more than we now project. The exchange value of the dollar, after falling sharply in the month before the March FOMC meeting, has rebounded somewhat during the intermeeting period. Against the major currencies, the dollar is up almost 2� percent, with a particularly sizable gain against the yen. Going forward, we continue to see the broad real dollar depreciating at a 3 percent pace, reflecting downward pressures associated with the large (albeit narrowing) current account deficit. This depreciation is expected to come largely against emerging market currencies (including the Chinese renminbi), which have moved less since the dollar's peak in early 2002. Turning to the U.S. external sector, we now see the arithmetic contribution from net exports to first-quarter U.S. real GDP growth as likely to be around 0.3 percentage point, down a few tenths from the last Greenbook. Recent readings on exports have continued to point to strength, but imports in February bounced back from their December and January weakness more vigorously than we had expected. For 2008 as a whole, we continue to believe that the demand for imports will be significantly restrained by the weak pace of U.S. activity and, to a lesser extent, by the depreciation of the dollar and rising prices for imported commodities. We thus see imports contracting nearly 2 percent this year. In contrast, exports are expected to post 7 percent growth this year, supported by the weaker dollar. The projected contraction of imports, coupled with still-strong export growth, suggests that net exports will contribute nearly 1� percentage points to U.S. GDP growth this year-- the largest positive contribution from net exports to annual growth in more than 25 years. In 2009, import growth is expected to bounce back to around 4 percent as the U.S. economy recovers, and the positive contribution from net exports should accordingly decline to just under � percentage point. Oil prices have continued their apparently relentless march upward, with spot WTI now trading at $115 per barrel. Since your last meeting, the spot price of WTI has increased $6 per barrel, and the far-futures price has moved up almost $5 per barrel. Over the past year, spot oil prices have risen a staggering 80 percent. While the high level of oil prices appears to be taking a bite out of oil demand in the United States and other industrial countries, the demand for oil in the emerging market economies--particularly in China and India--has been supported by the resilience of GDP growth there. In addition, fuel subsidies in some countries (including India) have sheltered consumers from the effects of higher oil prices. In line with these observations, India's state-owned oil company recently released projections indicating that oil demand in the country will increase 8 to 10 percent this year. The supply-side response to the rising demand for oil has been only tepid. Stated bluntly, OPEC remains unwilling--or unable--to increase its supply to the market. Indeed, OPEC has actually cut its production over the past two years. In addition, oil production in the OECD countries has been on a downward trajectory, primarily reflecting the decline in the North Sea fields and in Mexico's giant Cantarell field. Mexico's state-owned oil company recently indicated that, for the sixth consecutive year, additions to its reserves had failed to keep pace with production. The grim outlook for Mexico's oil industry has prompted the government to consider allowing foreign investment in the country's energy sector, a move that would require constitutional reform. Finally, although the potential supply from non-OECD nonOPEC countries is substantial, production continues to be hampered by inadequate infrastructure and by uncertainties about property rights and the stability of tax regimes. In the absence of any better approach, we continue to base our forecast on quotes from futures markets, which see oil prices as likely to remain high--at or above $110 per barrel--through the end of the forecast period. But the confidence bands around this forecast are exceptionally wide given uncertainties surrounding the outlook for oil supply and demand. Nonfuel commodity prices have also been on a wild ride of late. The prices of many of these commodities increased particularly sharply in January and February, before peaking in early March. On balance, our index of nonfuel commodity prices rose at a hefty annual rate of 50 percent during the first quarter. We project a further 13 percent rise in the second quarter, but--again in line with quotes from futures markets--we see these prices flattening out thereafter. The underlying drivers of the sustained run-up in the prices of nonfuel commodities have been broadly similar to those for oil--sharp increases in demand (particularly from emerging-market economies) coupled with typically lagging and often muted supply responses. Notably, however, moves in nonfuel commodity prices since the March FOMC meeting have been quite varied. For example, copper and aluminum prices are up whereas nickel and zinc prices are down. For foods, corn, rice, and soybean prices have risen while wheat prices have declined substantially. The overall strength of commodity prices continues to put upward pressure on inflation in many countries and to complicate life for central banks. Notably, in the euro area, 12-month headline inflation in March rose further, to 3.6 percent, well above the ECB's 2 percent ceiling. In the United Kingdom, inflation pressures stemming from rising utility, gasoline, and food prices are likely to push inflation toward 3 percent during the summer, raising the risk that Mervyn King will be required to write another letter to the Chancellor of the Exchequer explaining why inflation has deviated from the 2 percent target. Concerns about the inflation outlook have limited the willingness of both the ECB and the Bank of England to cut policy rates to address slowing growth. Perhaps even more striking, faced with upward pressures on inflation from rising food and energy prices coupled with still-solid economic growth, central banks in a broad array of emerging market economies tightened policy over the intermeeting period. This group included China, Singapore, India, Brazil, Russia, Poland, Hungary, and South Africa. In addition, some countries have recently responded to social unrest and other strains brought on by higher food prices by restricting exports of foodstuffs, particularly rice, and this has exacerbated upward pressure on the global prices of these commodities. The run-up in commodity prices, coupled with the weaker dollar, has pushed up U.S. core import price inflation of late. Core import prices are now estimated to have increased at a 7� percent annual rate in the first quarter, more than twice the pace of increase in the second half of last year. Prices of material-intensive imports (including industrial supplies and foods) are seen to have surged at a surprisingly rapid pace of 20 percent in the first quarter, on the back of the rapid rise in commodity prices. Prices of imported finished goods (including consumer goods, capital goods, and autos) are estimated to have risen at a comparatively muted rate of 3� percent, but this also was up sharply compared with recent quarters. The acceleration in finished goods prices seems well explained by recent moves in the dollar, however, and does not suggest any notable increase in the extent of exchange rate pass-through. Going forward, we see core import price inflation remaining elevated in the second quarter, at around 6 percent. Thereafter, core import price inflation should abate, given the projected flattening out of commodity prices and the slower pace of dollar depreciation. " CHRG-110shrg50409--93 Mr. Bernanke," Yes, of course. With almost no exceptions, speculators in commodities never take delivery. They have to sell their position when it comes due, and so they are not in any way using up the physical resource that underlies the contract. So there has always to be two sides to every transaction. Senator Crapo. And the liquidity that we are talking about, am I correct, is primarily being provided for those who are not actual users of petroleum. This liquidity is primarily coming from pension funds. Is that not correct? " fcic_final_report_full--419 On November , , a bankruptcy court ruled that the Bank of New York could not foreclose on a loan it had purchased from Countrywide, because MERS had failed to endorse or deliver the note to the Bank of New York as required by the pooling and servicing agreement. This ruling could have further implications, be- cause it was customary for Countrywide to maintain possession of the note and re- lated loan documents when loans were securitized.  Across the market, some mortgage securities holders have sued the issuers of those securities, demanding that the issuers rescind their purchases.  If the legal challenges succeed, investors that own mortgage-backed securities could force the is- suers to buy them back at the original price—possibly with interest. The issuers would then be the owners of the securities and would bear the risk of loss.  The Congressional Oversight Panel, in a report issued in November , said it is on the lookout for such risks: “If documentation problems prove to be pervasive and, more importantly, throw into doubt the ownership of not only foreclosed prop- erties but also pooled mortgages, the consequences could be severe.”  This sentiment was echoed by University of Iowa law professor Katherine Porter who has studied foreclosures and the law: “It is lack of knowledge of how widespread the problems may be that is turning the allegations into a crisis. Lack of knowledge feeds specula- tion and worst-case scenarios.”  Adam Levitin, a Georgetown University associate professor of law, has estimated that the claims could be in the trillions of dollars, ren- dering major U.S. banks insolvent.  NEIGHBORHOOD EFFECTS: “I ’M NOT LEAVING ” For the millions of Americans who paid their bills, never flipped a house, and had never heard of a CDO, the financial crisis has been long, bewildering, and painful. A crisis that started with a housing boom that became a bubble has come back full cir- cle to forests of “for sale” signs—but this time attracting few buyers. Stores have shut- tered; employers have cut jobs; hopes have fled. Too many Americans today find themselves in suburban ghost towns or urban wastelands, where properties are va- cant and construction cranes do not lift a thing for months. Renters, who never bought into the madness, are also among the victims as lenders seize property after landlords default on loans. Renters can lose the roof over their heads as well as their security deposits. In Minneapolis, as many as  of buildings with foreclosures in  and  were renter-occupied, according to sta- tistics cited in testimony by Deputy Assistant Secretary Erika Poethig from the U.S. Department of Housing and Urban Development to the House of Representatives Subcommittee on Housing and Community Opportunity.  FOMC20080625meeting--34 32,MR. FISHER.," If I may, I would like to ask Nathan, Mr. Chairman, about exhibit 4 and exhibit 5. Particularly noteworthy is that exhibit 4 is the forecast period showing a significant decline in inflation in the emerging market economies. I am wondering what that is based on. Do we have a sense of capacity utilization or slack, if it is all reliable, or is it based on a sense of commodity prices? What is that noticeable down-swoop? " CHRG-111hhrg55811--303 Mr. Bachus," We didn't really have any problem with commodity derivatives. What we had problems with was basically the subprime market, that it was junk, and they put junk in derivatives, and if you put junk in, then the derivative is junk. And so if you regulate, if you put rules which the Congress has on subprime loans, and you--we have regulations on underwriting, and we had unregulated subprime lenders, but if we regulate those, and we try to have some credit-rating reform, and we have had subprime lending reform, that wouldn't be repeated hopefully, would it? " CHRG-111hhrg51698--349 Mr. Neugebauer," Mr. Taylor, I know that I heard from a number of my producers when we had the anomalies in the cotton market, and everybody was scrambling as they wanted to certainly find a way to sell at the prices the commodity contracts moved to. Since then, things have seemed to have stabilized some. Can you kind of give me a quick snapshot? Currently, are the markets behaving in a more normal way and are producers able to cover or put in place the risk management that they need to do? " CHRG-111shrg54589--10 Chairman Reed," Thank you very much. Let me at this juncture introduce our witnesses. We are very pleased to be joined today first by the Honorable Mary Schapiro, Chairman of the Securities and Exchange Commission. Prior to becoming SEC Chairman, she was CEO of the Financial Industry Regulatory Authority, FINRA, the largest nongovernmental regulatory for all securities firms doing business within the United States. Chairman Schapiro previously served as a Commissioner of the SEC from December 1988 to October 1994 and then as Chairman of the Commodity Futures Trading Commission from 1994 until 1996. Thank you, Chairman. Next is the Honorable Gary Gensler. Gary Gensler is the Chairman of the Commodity Futures Trading Commission. He previously served at the U.S. Department of the Treasury as Under Secretary of Domestic Finance from 1999 to 2000 and as Assistant Secretary of Financial Markets from 1997 to 1999. Prior to joining the Treasury, Chairman Gensler worked for 18 years at Goldman Sachs, most recently as a partner and cohead of finance. Our third witness is Ms. Patricia White, Associate Director of the Federal Reserve Board's Division of Research and Statistics. Ms. White has oversight responsibilities for sections that analyze risk and process microeconomic data, and she has participated in domestic and international working groups on central counterparties, securities settlement, and financial regulation. I very much thank all of you joining us here this afternoon, and, Chairman Schapiro, would you begin your testimony? CHRG-110shrg50409--95 Mr. Bernanke," Well, as I have indicated, I think that it is worthwhile making sure that, there is some transparency, that we are doing all we can to make sure these markets are as liquid and as efficient as possible. CFTC has the primary responsibility for that. We are happy to work with them and try to support that. So I am not saying there cannot be improvements made in these markets, but my best guess, as I have indicated a few times now, is that I do not think that speculative activity per se, or particularly manipulation, is the principal cause of the increases in energy and other commodity prices that we have been seeing. Senator Crapo. Thank you. " CHRG-111hhrg74855--52 Mr. Markey," Thank you, Mr. Chairman, very much. Our next witness is Gary Gensler. He is the chairman of the Commodity Futures Trading Commission. Chairman Gensler previously served at the United States Department of Treasury as Undersecretary of Domestic Finance during the Clinton Administration and prior to joining Treasury he worked for 18 years at Goldman Sachs where he was a partner and co-head of finance. He was sworn in as chairman of the Federal, of the CFTC in May by President Obama. We welcome you back to the committee actually, Mr. Chairman. Whenever you feel comfortable, please begin. CHRG-110hhrg46591--98 Mr. Seligman," The system has to be comprehensive. That means it has to address some gaping holes such as right now like credit default swaps. Second, there has to be some sort of risk avoidance or crisis manager at the top. This could be the same agency that would address things like financial holding companies. Third, you have to have sufficient expert knowledge to address a series of specialized industries including securities and investment banks, insurance, and commodities. " CHRG-111hhrg48875--195 Mr. Minnick," Mr. Secretary, two questions. As you are aware, the House Agriculture Committee passed H.R. 977, which conveys to the Commodities Futures Trading Commission, the SEC, and other qualified regulatory authorities some of the oversight, the clearing, and the regulatory authority that you were talking about that would be subordinate to those exercised guidelines from a systemic regulator. Do you think that the regimen proposed by that legislation would be consistent with the regimen you are attempting to--that the Administration will be attempting to implement? " CHRG-111hhrg63105--55 Mr. Johnson," Back in the heartland, a lot of people believe, rightly or wrongly, that prices don't always reflect supply and demand. I think you have expressed that too. I have a question and then kind of an unrelated comment. In your judgment, either witness's judgment, do you think the level of prices that ag commodities are at today is a result of the supply and demand factors and/or speculation? And how would you allot each in terms of what impact you think those respective forces are having in our market prices? " CHRG-109hhrg31539--124 Mr. Castle," Thank you, Mr. Chairman. Chairman Bernanke, let me just agree with Mr. Baker on the GSE's and leave that at that. Let me also agree with the gentleman from Iowa, Mr. Leach, on the clarity of your comments and on your statements. I spent many a day up here listening to Chairman Greenspan, trying to figure out what he had written and never quite understanding it, trying to figure out what he had said, but never understanding it, but having great admiration for him because the economy always did well under him. And I understand you with clarity, and I hope this does as well--I don't know if clarity is good or not. But I would like to have some reassurance here, because I listened to and read your comments as you were reading them with respect to the area of inflation, and when it is all said and done, that is what people really look at. And you can't comment on what seems to drive the stock market, what you are going to do with interest rates, or whatever. And I am not saying I see it differently, I just want to be reassured--and you may even say it in the same words, or perhaps in different words--but with energy prices and other commodity prices, even by your statement, we are probably not through with increases. And it is highly unpredictable, as you have indicated and as we all know. But it is beyond just oil prices; I mean, there are a whole lot of commodity prices that are up tremendously, and it is a trickle-down effect. For example, in Delaware we entered into some cockamamie agreement whereby we didn't increase electric rates for 7 years or something, and now all of a sudden there is about a 50 percent jump at one time. But that is maybe atypical, but those kinds of things are happening out there. So all commodity prices concern me. Labor costs, I think, are definitely--I mean, we see it here--there is definitely going to be a push as far as labor costs are concerned, which I think is going to be a major issue before it is all said and done. I am going to ask you a question later if I have time on housing, because I am not sure where that is going with respect to this. Plus this sort of public expectation in terms of inflation is there as well. I am taking most of this, at least I am summarizing, from what is written here. So I am not saying anything is wrong, I just, based on what we see and know and sort of the uncertainty--and I realize economics is an uncertain practice, as you also said in your testimony. What reassurance can you give us that these projections of inflation being somewhat more in control than they have been in recent months, which has been of--well, maybe not the last couple of months, but before that was pretty significantly higher than anticipated, I think, by anybody, what reassurance can you give us that these projections are correct, that the inflation rate will hopefully stay where it is now or even decline slightly? " FinancialServicesCommittee--13 So it is important that we listen to you: The Securities and Ex- change Commission, you have to make it work; the Commodities Trading Commission; NASDAQ; the Chicago Mercantile Exchange; and, of course, the New York Stock Exchange. But we have a very complex system. We have nearly 50 markets. We have hundreds of millions of computers that are making these sales in megaseconds, far outpacing our human capacity to deal with it. If we do get the circuit breaker concept, we have to make sure how that is going to work. Will it do the job? What is impor- tant here is to move carefully and thoughtfully to get the right cor- rection to this problem. The American investors and the world in- vestors are depending on us. Chairman K ANJORSKI . Thank you, Mr. Scott. We will now hear from Mr. Perlmutter for 2 minutes. Mr. P ERLMUTTER . Thank you, Mr. Chairman. I just would like to remind the committee and the panelists that in the financial re- form bill that we passed to the Senate, we were sort of directed to this nanotrading high-frequency trading issue by some of our prior hearings; and there is a section of the bill, section 7304, asking the SEC and other regulators to take a look at high-frequency trading and its impact upon the markets. The good news is, it is in the bill. The bad news is that Thursday hit us before there was any action on the bill. I know that the regulators have been looking at this under their own authority, and I would encourage them to continue to do this. I am surprised by my friends on the other side of the aisle who question whether it is too early to look at this. We should be look- ing at this high-frequency trading; 5,000 trades per second, how do you manage something like that? That is the real question. In the blink of an eye, by a mistake or by an intentional act, whatever it might be, boom, this country lost $1 trillion over 20 minutes. My friends on the other side of the aisle complain about the spending and all this stuff by the Obama Administration; when, be- cause of failures in the market, because of sales and failure of the uptick rule, not having those kinds of things, we lost $17.2 trillion in the last 18 months of the Bush Administration. Since the Obama Administration has come in, we have gained about $6.5 trillion back. We lost $1 trillion last Thursday, and then have gained most of that back. There has to be a real good understanding of the algorithm-driv- en nanotrading that we have. It has benefits, Mr. Hensarling is right, the liquidity that it brings. But certainly if you were on the wrong side of that sale, you lost a lot of money, and we can’t have that in this system. I yield back, Mr. Chairman. Chairman K ANJORSKI . Now, the last presenter, Mr. Foster, for 2 minutes. Mr. F OSTER . Thank you. I want to thank the chairman for hold- ing this important and timely hearing. As a high-energy particle physicist, I spent many years program- ming and debugging large systems of high-speed digital logic com- puters. So the fact that large interconnected processing systems, in- dividually programmed by very smart individuals, exhibit complex and erratic behavior when they are simply thrown together, does not surprise me at all. However, the fact that these complex sys- tems are put in control of a large and important section of our economy, without sufficiently robust testing of their interoper- ability and immunity to coherent instabilities is an outrage. The absence of systemwide circuit breakers to limit the damage when a single element or set of elements malfunctions is indefen- sible, as is the absence of uniform legal clarity when it comes time to bust trades that have been made on a clearly erroneous basis. Part of the problem that we are facing is the mismatch between the time scales of human thought and machine action. While the logic of circuit breakers and market pauses to restore liquidity has been understood for decades, we see now that it must be imple- mented on a time scale of computer trading and it must be imple- mented uniformly across a wide variety of trading platforms. The race towards lower latencies and higher-speed trading shows no sign of abating. Startup companies are already developing trad- ing and matching engines based not on clusters of computer serv- ers, which will be too slow to compete, but on dedicated pipeline logic based on field-programmable data arrays that will typically perform a dedicated calculation 100 times faster than a dedicated computer processor. fcic_final_report_full--245 EARLY 2007: SPREADING SUBPRIME WORRIES CONTENTS Goldman: “Let’s be aggressive distributing things” .............................................  Bear Stearns’s hedge funds: “Looks pretty damn ugly” .......................................  Rating agencies: “It can’t be . . . all of a sudden” .................................................  AIG: “Well bigger than we ever planned for” ....................................................  Over the course of , the collapse of the housing bubble and the abrupt shutdown of subprime lending led to losses for many financial institutions, runs on money mar- ket funds, tighter credit, and higher interest rates. Unemployment remained rela- tively steady, hovering just below . until the end of the year, and oil prices rose dramatically. By the middle of , home prices had declined almost  from their peak in . Early evidence of the coming storm was the . drop in November  of the ABX Index—a Dow Jones–like index for credit default swaps on BBB- tranches of mortgage-backed securities issued in the first half of .  That drop came after Moody’s and S&P put on negative watch selected tranches in one deal backed by mortgages from one originator: Fremont Investment & Loan.  In December, the same index fell another  after the mortgage companies Ownit Mortgage Solutions and Sebring Capital ceased operations. Senior risk officers of the five largest investment banks told the Securities and Exchange Commission that they expected to see further subprime lender failures in . “There is a broad recogni- tion that, with the refinancing and real estate booms over, the business model of many of the smaller subprime originators is no longer viable,” SEC analysts told Di- rector Erik Sirri in a January , , memorandum.  That became more and more evident. In January, Mortgage Lenders Network an- nounced it had stopped funding mortgages and accepting applications. In February, New Century reported bigger-than-expected mortgage credit losses and HSBC, the largest subprime lender in the United States, announced a . billion increase in its quarterly provision for losses. In March, Fremont stopped originating subprime loans after receiving a cease and desist order from the Federal Deposit Insurance Corporation. In April, New Century filed for bankruptcy.  CHRG-109shrg30354--93 Chairman Bernanke," We could try to do an evaluation with our models and the like. I am not sure how accurate it would be. In addition, the interesting thing about the energy price increases is that if you go back for 3 or 4 years and you look at each month at what the futures market was expecting, it was always expecting these things. We have had these increases, the energy prices are going to finally stabilize. And every single month it has been wrong. And so this increase in energy prices and commodity prices certainly has been a significant contributor. And I think that we would not really be talking about this now if energy prices were still $30 or $40 a barrel. Senator Sununu. Thank you, Mr. Chairman. " FOMC20060629meeting--8 6,MR. KOS.," It’s reasonable that all of those factors would have had some influence. I suppose another factor would be the extent to which some market participants may have seen not only positioning but also future weakness from the global tightening that is occurring, especially in the industrial countries but also in China—that such tightening will at some point affect the demand for commodities and for resources. Some of those positions and adjustments may have been fundamentally based. If one had to explain the scale of the price moves, that would probably be a secondary factor." FOMC20060808meeting--66 64,MR. HOENIG.," Mr. Chairman, thank you. Obviously we are dealing with a difficult set of circumstances. We have information that the growth of the economy is slowing and inflation is rising, not something we particularly like to see. We have seen slowing consumption nationally, and certainly our District has seen some of it. The one exception is in some areas where we have an energy boom going on, which is not necessarily advantageous to other parts of the country. We also have slowing residential investment in our District. Inventories are building up rapidly, both in the eastern side of the District and in the Denver western side, and we have some pretty sharp increases in bankruptcy levels in the Denver area. The shocks of energy costs have affected consumption, and I think that effect will carry through. We have been more optimistic about manufacturing. Even though our surveys have shown some slowdown recently, the six-months-ahead forecasts are still fairly optimistic. There is no denying that the inflation level is up, and I think that increase reflects past policy accommodation that is still in play. I also think that some of the supply shocks are having their effects, and the shocks themselves are continuing forward. That situation is being aggravated a bit for our District, and perhaps will be even more for the nation, by the drought that we are experiencing, which is reducing some of the crop output in the area. The outlook, therefore, is not particularly encouraging. I think consumption will show some further slowing going forward, especially as we see further shocks in the economy related to energy. Some of the wealth effects related to the housing industry will also affect consumption going forward. The outlook in terms of business fixed investment is unclear. BFI has been pretty good. The outlook seems fairly good right now, but it is slowing to some degree. Policy is moderately, not significantly, restrictive, but it seems to be working its way through fairly slowly. While these factors are in place, we worry about whether the real rate will decline, which I think Mike Moskow mentioned. I also worry that the decline will affect inflation expectations and cause them to shift—that is an upside risk to the economy in terms of the inflation that I do worry about. Still, I suggest that we are moving as expected. We have some short-term inflationary pressures that are going to continue, that are “baked in the cake,” as they say. And I do worry that—as we move forward and if the economy slows, as I suspect it will—our big challenge will be not to ease too soon. Thank you." CHRG-111hhrg63105--25 The Chairman," Well thank you. I thank both of you. I think the main purpose of what we are doing here today is to get daylight on what the process is, how it is going, and for us to understand better as we talk to our constituents who are out there and trying to fulfill our obligation. A couple of questions and we will right go right down the line. But first, Mr. Peterson, do you have any questions? Mr. Lucas? Mr. Gensler, what impact, since we are talking what you just said, would a delay in the January energy and metals position limit rule have on the agricultural commodities rule expected in April? " CHRG-109hhrg31539--188 Mr. Bernanke," Well, I will answer your question indirectly. One of the reasons we pay attention to the core inflation rate, which excludes energy, is we don't have a lot of control, obviously, over the price of energy, and so one of our concerns is that higher energy commodity raw materials costs don't get passed through into other goods and services. If we can sort of stop it at the first round, that will lead us to a more stable inflation situation when energy prices level off. " CHRG-111hhrg63105--207 Mr. Marshall," And it may, again, I don't know, I just don't think that we here in this Committee or in Congress are competent to judge this. That is why we defer to the CFTC and specifically told the CFTC, ``Don't do it if it is not appropriate to do it. Figure out whether or not you have a problem and then tailor the solution to that specific problem.'' But we did hear this testimony that maybe the influx of commodities money into the market could pull--force prices to go up for a period of time and then there would be a stable state that you have described where they are just rolling and they are not really affecting price. " CHRG-111hhrg55811--375 Mr. Cleaver," Yes. You are segregated. Earlier today, Mr. Gary Gensler, the Chairman of the Commodities Futures Trading Commission was here. He actually delivered a speech last month. And in his speech, he said that he believed that institutions are becoming ``too-interconnected-to-fail'' and not ``too-big-to-fail,'' that the real problem is that we are developing a pyramid financial system in this country and so everybody is connected and so if one block falls it could conceivably knock down all the other blocks because of their connectivity. None of you agree with that, do you? " CHRG-111hhrg53021--7 Mr. Minnick," First we should merge the SEC and the Commodity Futures Trading Commission. Financial derivatives whether they originate in a commodity, a security, or neither, like weather futures are functionally identical and must be traded, cleared and settled subject to the same rules. Bifurcated responsibility might be made to work temporarily, but is a poor long-term solution which will discourage bold action when crises arise and will encourage regulatory arbitrage. Second, banking regulation should be removed from an already overburdened Federal Reserve and the remaining three Federal depository institution regulators, the OTS, the FDIC and the OCC should be combined into a single Federal bank regulator; which should also be given broad consumer protection responsibility and resolution authority for both banks and all other entities deemed systemically risky. Powerful global institutions like Citibank, Bank of America, or AIG should not be allowing to shop for the weakest Federal regulator. Finally, the proposed systemic risk oversight counsel should have the highest quality permanent staff if it is to respond appropriately as future dangers arise. Because the Federal Reserve is the more institutionally independent Executive Branch agency, and has increasing global responsibilities, that staff should be housed in the Fed and the counsel should be chaired by the Fed Chairman. I thank both chairs and yield back. " CHRG-111hhrg53021Oth--7 Mr. Minnick," First we should merge the SEC and the Commodity Futures Trading Commission. Financial derivatives whether they originate in a commodity, a security, or neither, like weather futures are functionally identical and must be traded, cleared and settled subject to the same rules. Bifurcated responsibility might be made to work temporarily, but is a poor long-term solution which will discourage bold action when crises arise and will encourage regulatory arbitrage. Second, banking regulation should be removed from an already overburdened Federal Reserve and the remaining three Federal depository institution regulators, the OTS, the FDIC and the OCC should be combined into a single Federal bank regulator; which should also be given broad consumer protection responsibility and resolution authority for both banks and all other entities deemed systemically risky. Powerful global institutions like Citibank, Bank of America, or AIG should not be allowing to shop for the weakest Federal regulator. Finally, the proposed systemic risk oversight counsel should have the highest quality permanent staff if it is to respond appropriately as future dangers arise. Because the Federal Reserve is the more institutionally independent Executive Branch agency, and has increasing global responsibilities, that staff should be housed in the Fed and the counsel should be chaired by the Fed Chairman. I thank both chairs and yield back. " fcic_final_report_full--434 The Commission heard convincing testimony of serious mortgage fraud prob- lems. Excruciating anecdotes showed that mortgage fraud increased substantially during the housing bubble. There is no question that this fraud did tremendous harm. But while that fraud is infuriating and may have been significant in certain ar- eas (like Florida), the Commission was unable to measure the impact of fraud rela- tive to the overall housing bubble. The explosion of legal but questionable lending is an easier explanation for the creation of so many bad mortgages. Lending standards were lax enough that lenders could remain within the law but still generate huge volumes of bad mortgages. It is likely that the housing bubble and the crisis would have occurred even if there had been no mortgage fraud. We therefore classify mortgage fraud not as an essential cause of the crisis but as a contributing factor and a deplorable effect of the bubble. Even if the number of fraudulent loans was not substantial enough to have a large im- pact on the bubble, the increase in fraudulent activity should have been a leading in- dicator of deeper structural problems in the market. Conclusions: • Beginning in the late s and accelerating in the s, there was a large and sustained housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by more rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida. • There was also a contemporaneous mortgage bubble, caused primarily by the broader credit bubble. • The causes of the housing bubble are still poorly understood. Explanations in- clude population growth, land use restrictions, bubble psychology, and easy fi- nancing. • The causes of the mortgage bubble and its relationship to the housing bubble are also still poorly understood. Important factors include weak disclosure standards and underwriting rules for bank and nonbank mortgage lenders alike, the way in which mortgage brokers were compensated, borrowers who bought too much house and didn’t understand or ignored the terms of their mortgages, and elected officials who over years piled on layer upon layer of gov- ernment housing subsidies. • Mortgage fraud increased substantially, but the evidence gathered by the Com- mission does not show that it was quantitatively significant enough to conclude that it was an essential cause. FinancialCrisisInquiry--563 BORN: You know, in 2000, Congress passed a statute called the Commodity Futures Modernization Act that virtually deregulated the over-the-counter derivatives market and also preempted most state laws from governing over-the-counter derivatives. And I was struck, Mr. Solomon, by your discussion and your written testimony about the impact of deregulation on the financial situation and as a cause of financial crisis. And I wondered—I gathered from your written testimony that you attributed part of the deregulation that we’ve seen in the last 20 years to the political power of large financial institutions. Is that right? CHRG-111hhrg51698--398 Mr. Masters," I think common sense says that is not the case. We have plenty of studies that we can show that say that index funds were in fact an issue, and excessive speculation was a driver in creating the commodity markets bubble. There are studies from MIT, from the World Bank, from the United Nations. I saw one a couple days ago from the Austrian Ministry of Finance. There is one from the Japanese Ministry of Trade. There have been a lot of studies that have come to the opposite conclusion. So I could submit those if you would like to see them. " FinancialCrisisReport--224 In addition to a policy of deference to management, weak standards, and demoralized examiners, OTS employed an overly narrow regulatory focus that allowed WaMu’s short term profits to excuse its risky practices and that ignored systemic risk. For a time, its short term profits masked the problems at Washington Mutual, and regulators allowed practices which they knew to be risky and problematic to continue. Because it mishandled its responsibilities, OTS gave the illusion to investors, economists, policy makers, and others that the bank was sound, when in reality, it was just the opposite. Unfortunately, the truth of the matter was not revealed until it was too late, and the bank collapsed. Using Short Term Profits to Excuse Risk. OTS justified not taking enforcement action against WaMu in part by pointing to Washington Mutual’s profits and low loss rates during the height of the mortgage boom, claiming they made it difficult to require the bank to reduce the risks threatening its safety and soundness. In 2005, when faced with underwriting problems at WaMu, the OTS Examiner-in-Charge put it this way: “It has been hard for us to justify doing much more than constantly nagging (okay, ‘chastising’) through ROE [Reports of Examination] and meetings, since they [WaMu] have not been really adversely impacted in terms of losses. It has been getting better and has not recently been bad enough to warrant any ratings downgrade.” 854 The OTS Handbook was explicit, however, in stating that profits should not be used to overlook or excuse high risk activities: 853 10/7/2008 emails from OTS examiner Thomas Constantine to OTS Examiner-in-Charge Benjamin Franklin, “West Region Update,” Franklin_Benjamin-00034415_002, Hearing Exhibit 4/16-14. 854 9/15/2005 email from Examiner-in-Charge Lawrence Carter to Western Region Deputy Director Darrel Dochow, OTSWMS05-002 0000535, Hearing Exhibit 4/16-6. “If an association has high exposure to credit risk, it is not sufficient to demonstrate that the loans are profitable or that the association has not experienced insignificant losses in the near term.” 855 CHRG-111hhrg63105--149 Mr. Duffy," Chairman Boswell, Ranking Member Moran, and Members of the Subcommittee, thank you for inviting us to testify regarding the implementation of Dodd-Frank's provisions relating to position limits. I am going to focus on the requirements of Dodd-Frank and then briefly discuss this theory that speculators are distorting futures markets. Dodd-Frank requires the Commission to make a finding that position limits are necessary to diminish, eliminate, or prevent burdensome excessive speculation before imposing such limits. The CFTC is not permitted to act on the basis of assumptions or political demands. Core principle 5, section 5 of the CEA also demonstrates that position limits are not required in every case since it permits exchanges to adopt accountability levels as an alternative to rigid position limits. Dodd-Frank also requires that CFTC wait to impose limits on futures exchanges until it can simultaneously impose limits on economically equivalent swaps. The purpose of this provision is to prevent a flight of trading from regulated exchanges with no limits to unregulated markets with limits. Given these requirements, it is clear that the CFTC lacks sufficient data to impose limits on swaps and therefore may not act against futures. The Commodity Exchange Act allows limits to be imposed only on excessive speculation, not speculation generally. This is a clear recognition that futures markets cannot operate without the participation of speculators. Arbitrary position limits distort markets, increase cost to hedgers, and increase cost to consumers. Position limits are unnecessary unless burdensome excessive speculation is present or is likely. Academic literature and all the studies produced by the CFTC's economists demonstrate that position limits in futures trading are not the means to deal with real supply-demand issues. It is my firm belief that efforts to focus on position limits rather than the underlying issues are certain to divert attention from the real problems and do more harm than good. Worse yet, position limits in derivatives markets that preclude investors from seeking economic exposure to particular asset classes drive those investors to speculate in physical commodities. This, in turn, has a significant and often detrimental impact on the flow of commodities in commercial channels. We have already seen the beginnings of such distortions in the metals and energy markets in anticipation of the imposition of limits on derivatives. This is not a development that any of us should favor but one that is an unfortunate result of position limits based on bad economics. CME Group is not opposed to position limits and other similar measures if used correctly. For example, we employ limits on most of our physically delivered contracts. However, we use limits and accountability levels, as permitted by the Core Principles, to mitigate potential congestion during delivery periods and to help us respond in advance to any effort to manipulate our markets. CME Group believes that the core purpose that should govern Federal and exchange-set position limits, to the extent such limits are necessary and appropriate, should be to reduce the threat of price manipulation and other disruptions to the integrity of prices. Such activity destroys public confidence in the integrity of our markets and harms the acknowledged public interest in legitimate price discovery. CME Group appreciates the opportunity to offer the foregoing comments regarding the implementation of Dodd-Frank provisions for position limits on certain contracts involving exempt and agricultural commodities. We hope that the views expressed today are helpful, and we look forward to answering any questions the Committee will have. [The prepared statement of Mr. Duffy follows:]Prepared Statement of Terrance A. Duffy, Executive Chairman, CME Group Inc., Chicago, IL I am Terrence A. Duffy, executive Chairman of CME Group Inc. Thank you, Chairman Boswell, and Ranking Member Moran for inviting us to testify today. You asked us to discuss the implementation of provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act relating to position limits. CME Group is the world's largest and most diverse derivatives marketplace. We are the parent of four separate regulated exchanges, including Chicago Mercantile Exchange Inc. (``CME''), the Board of Trade of the City of Chicago, Inc. (``CBOT''), the New York Mercantile Exchange, Inc. (``NYMEX'') and the Commodity Exchange, Inc. (``COMEX'') (collectively, the ``CME Group Exchanges''). The CME Group Exchanges offer the widest range of benchmark products available across all major asset classes, including futures and options on futures based on interest rates, equity indexes, foreign exchange, energy, metals, agricultural commodities, and alternative investment products. CME Clearing, a division of CME, is one of the largest central counterparty clearing services in the world, which provides clearing and settlement services for exchange-traded contracts, as well as for over-the-counter derivatives contracts through CME ClearPort'. Using the CME ClearPort' service, eligible participants can execute an OTC swap transaction, which is transformed into a futures or options contract that is subject to the full range of Commodity Futures Trading Commission (the ``Commission'' or ``CFTC'') and exchange-based regulation and reporting. The CME ClearPort' service mitigates counterparty credit risks, provides transparency to OTC transactions and enables the use of the exchange's market surveillance monitoring tools. The CME Group Exchanges serve the hedging, risk management and trading needs of our global customer base by facilitating transactions through the CME Globex' electronic trading platform, our open outcry trading facilities in New York and Chicago, as well as through privately negotiated CME ClearPort' transactions. The theory that speculators in futures markets cause unwarranted price volatility and excessively high and/or low prices is not new; Congress has dealt with that notion since the late 1800s. The Commodity Exchange Act (``CEA''), however, does not limit speculation, but only ``excessive speculation.'' This is an implicit recognition that futures markets cannot operate without the participation of speculators. The so-called ``speculators,'' such as index funds and swap dealers, who are the focus of recent intense criticism, are not engaged in traditional speculative activity, i.e., trying to beat the market. Rather, swap dealers use futures markets to facilitate the hedging of more complex and specific risks accepted in connection with swap transactions with commercial customers and others. Denying or limiting their access to the futures markets will simply impede hedging activity by commercial market participants. Index funds aggregate the buying and selling decisions of many thousands of investors, most of whom are doing what they have been taught for decades to do: diversifying their investment portfolios and hedging inflation risks to their investment returns in order to maximize their retirement savings and their individual wealth. Position limits are not a costless palliative. Position limits, when improperly calibrated and administered, can easily distort markets, increase the costs to hedgers and effectively increase costs to consumers. Unfortunately, many demands for speculative limitations assume that severe limits on speculation will bring prices to some favored level. On the contrary, position limits on futures contracts will not and do not control cash market prices. There is a complete disconnect between the implied promise to drive prices down or up, whichever the most vocal constituency desires, and the ability of position limits to deliver on that promise.Introduction We disagree with those who contend, in contravention of the clear academic evidence and of the clear intent of Congress, as expressed in Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203, July 21,2010) (``DFA'' or ``Dodd-Frank''), that speculative positions must be limited in order to eliminate price volatility and/or high prices or low prices for essential commodities. Some of the proponents for limits are well intentioned, but have no credible evidence to support their claims. Some contend for example that strict limits on silver futures will allow the price of silver to go up to levels that they think is appropriate. Other proponents of strict position limits contend that limits on oil positions will cause the price of gasoline to fall to levels that are ``better'' for the economy or their constituents. The Wall Street Journal reported on December 8, 2010, that: ``[T]he latest data also show an increase in speculation doesn't necessarily bring with it an increase in prices. Natural gas, for example, is down 21% this year despite a surge in speculative bets. In opposite circumstances with sugar, prices rallied despite a withdrawal of speculative bets.'' The Wall Street Journal--Investors Pile Into Commodities, Carolyn Cui and Susan Pulliam. All of the serious academic literature, including all of the studies produced by the CFTC's economists demonstrate that position limits in futures trading are not the means to deal with real supply and demand issues that are prevalent in markets for many physical commodities. It is my firm belief that efforts to focus on position limits rather than the underlying economic issues are certain to divert attention from the real supply and demand dynamics and do more harm than good. Worse yet, position limits in derivative markets that preclude investors from seeking economic exposure to particular asset classes drives those investors to speculate in physical commodities, which has a significant and often detrimental impact on the flow of commodities in commercial channels. We have already seen the beginnings of such distortions in metals and energy markets in anticipation of the imposition of limits on derivatives. This is not a development that anyone should favor, but one that is the logical result of even the threat of position limits based on bad economics. CME group is not opposed to position limits and other similar measures in all circumstances; we employ limits in most of our physically delivered contracts. However, we use limits and accountability levels, as contemplated by the Congressionally-approved Core Principles for Designated Contract Markets, to mitigate potential congestion during delivery periods and to help us identify and respond in advance to any threat to manipulate our markets. CME Group believes that the core purpose that should govern Federal and exchange-set position limits, to the extent such limits are necessary and appropriate, should be to reduce the threat of price manipulation and other disruptions to the integrity of prices. Such activity destroys public confidence in the integrity of our markets and harms the acknowledged public interest in legitimate price discovery. CME Group is therefore vigilant in seeking to deter and prevent price manipulation or other illegitimate distortions of market prices. Speculation, however, is not manipulation, nor is it an abusive practice. As CME Group observed in its response to the Commission's January 2010 energy position limits proposal, speculation is essential to the orderly functioning of futures markets--it provides market liquidity which promotes more effective commodity price discovery and allows for the efficient transfer of price risk. See CME Group Comments, 10-002 Comment CL-02714, at 2 (Apr. 26, 2010) (``CME Comments''). The Commission's responsibility and challenge is not to restrict speculation per se, but to act when necessary to prevent ``excessive speculation'' from burdening interstate commerce through what the Commodity Exchange Act (``CEA'') calls ``unreasonable'' and ``unwarranted'' fluctuations in the price of a commodity. To this end, Congress has granted to the Commission the authority to impose speculative position limits under Section 4a of the CEA, as amended by DFA. CME Group understands the extensive demands being made on the Commission's limited resources. However, the Commission must gather critical data regarding swap markets and individual traders' swap positions. Without a thorough understanding of such data, the Commission runs the risk of inappropriately setting position limits. CME Group appreciates the great challenge this presents to the Commission.I. Statutorily Required Basis for Imposing Position Limits Section 4a(a)(1) provides in pertinent part: ``For the purpose of diminishing, eliminating, or preventing such burden [of unwarranted or unreasonable price fluctuations resulting from excessive speculation], the Commission shall . . . fix such limits on the amount of trading which may be done or positions which may be held . . . as the Commission finds are necessary to diminish, eliminate, or prevent such burden.'' (emphasis added) By its terms, DFA requires the Commission to make a finding that position limits ``are necessary to diminish, eliminate, or prevent'' burdensome excessive speculation before imposing such limits. Dan Berkovitz, CFTC General Counsel, confirmed that Section 4a(a)(1) sets forth a conditional mandate during the CFTC's July 2009 hearings on energy position limits. In response to Chairman Gensler's question, ``What does the word `shall' mean in 4a?,'' Berkovitz replied, ``If the Commission finds that position limits are necessary to prevent, diminish, or eliminate such burdens, then there is a directive that it shall establish position limits.'' Transcript of July 28, 2009 CFTC Hearing on Energy Position Limits at 35-36 (emphasis added). The above quoted language from Section 4a(a)(1) was not deleted or in any way altered by DFA. New CEA subsection (a)(2) (``Establishment of Limitations'') even reaffirms that any position limits must be established ``[i]n accordance with the standards set forth in paragraph 1 of this subsection,'' which include the requisite ``necessary'' finding. Core Principle 5, Section 5(d)(2)(5) of the CEA as amended by DFA, also recognizes that ``accountability levels'' are an alternative to rigid position limits: (5) Position limitations or accountability.-- (A) In general.--To reduce the potential threat of market manipulation or congestion (especially during trading in the delivery month), the board of trade shall adopt for each contract of the board of trade, as is necessary and appropriate, position limitations or position accountability for speculators. (emphasis supplied) Moreover, the Commission must publish the statutorily required finding and the information in support thereof in any notice of proposed rulemaking to comply with the Administrative Procedure Act (``APA''). The APA requires that the notice of a proposed rule include ``sufficient detail on its content and basis in law and evidence to allow for meaningful and informed comment.'' See, e.g., Am. Med. Ass'n v. Reno, 57 F.3d 1129, 1132 (D.C. Cir. 1995). Absent a finding with supporting evidence that position limits are ``necessary,'' this APA requirement cannot be met because the public will not know the Commission's specific reasoning for the essential finding that triggers its proposed rulemaking. DFA indicates that such limits would be ``unnecessary'' where burdensome excessive speculation does not exist or is unlikely to occur in the future. CME Group's comment letter on the Commission's energy position limits proposal discussed at length the absence of any credible empirical evidence of the existence of burdensome excessive speculation or its likely future occurrence. See CME Comments at 17-24. The weight of empirically sound analysis and research demonstrates that movements in commodity prices are attributable to fundamental market conditions rather than speculative trading. CFTC studies, for example, have found that supply and demand factors were largely responsible for the 2008 rise in oil prices and that, far from harming the market, speculators serve as an important source of liquidity for other participants. See, e.g., CFTC Interagency Task Force on Commodity Markets, Interim Report on Crude Oil at 3-4 (July 22, 2008); Michael Haigh et al., Market Growth, Trader Participation and Pricing in Energy Futures Markets (Feb. 7, 2007), available at http://web.uvic.ca/econ/research/seminars/robe.pdf. Like CFTC staff, the Government Accountability Office (``GAO'') has not identified a causal relationship between speculation in the futures market and changes in commodity prices. See GAO, GAO-09-285R, Issues Involving the Use of the Futures Markets to Invest in Commodity Indexes at 5 (Jan. 30, 2009). The conclusions of these governmental studies and reports are consistent with those of academic and private sector economists. See, e.g., Paul Krugman, The Oil Nonbubble, N.Y. Times, May 12, 2008, http://www.nytimes.com/2008/05/12/opinion/12krugman.html (``[T]he rise in oil prices isn't the result of runaway speculation; it's the result of . . . the growing difficulty of finding oil and the rapid growth of emerging economies like China.''). To the extent there are any legitimate concerns with the potential for excessive speculation to cause unwarranted or unreasonable price fluctuations, CME Group believes that futures exchanges effectively address such concerns through their existing market surveillance programs. CME Group provided a detailed account of the futures exchanges' capabilities in its April 26, 2010 comments filed with the CFTC. See CME Comments at 8-12. Briefly stated, the exchanges independently have the ability to establish position limits as warranted by the characteristics of their traded contracts, and to employ position accountability provisions as appropriate given particular market constructs and market conditions. This flexible regulation is a much more appropriate and effective means of addressing potentially manipulative or disruptive positions than are blunt position limits that fail to account for variability in specific contract months, market conditions, and market participation. Insofar as the existing exchange programs are and have been proven to be effective, CME Group believes the Commission would lack the statutory basis for establishing new Federal position limits on certain contracts involving exempt and agricultural commodities.II. Mechanics of Imposing Position Limits Assuming the Commission is able to find that position limits ``are necessary to diminish, eliminate, or prevent'' burdensome excessive speculation, CME Group offers the following views on how to impose those limits:A. The Imposition of Limits Should be Deferred Until the Commission Can Properly Determine and Ensure Compliance with Appropriate Limits Dodd-Frank sets forth several seemingly inconsistent timing requirements for the exercise of the Commission's position limit authority. New CEA 4a(a)(2)(B) directs the Commission to impose limits for certain contracts, within 180 days for exempt commodities and within 270 days for agricultural commodities, respectively, of Dodd-Frank's enactment. Meanwhile, new CEA 4a(5)(A) requires that limits for swaps that are economically equivalent to futures and options be established simultaneously with the limits under Section 4a(a)(2)(B). The statute, however, also vests the Commission with discretion to establish limits ``as appropriate,'' thereby indicating that the Commission is not bound by the aforementioned dates. CME Group believes that DFA requires the Commission to defer imposing limits until doing so would be ``appropriate''--that is, when it has the data needed to accurately set and enforce those limits and when it is in a position to impose limits simultaneously on futures (and options on futures) and swaps.B. Position Limits Should Be Set with Due Regard for Legislative Objectives and Considerations Under Dodd-Frank, the Commission is required to take into account several factors when setting position limits. New CEA 4a(a)(3) provides that, to the maximum extent practicable, the Commission should use its discretion to establish limits to: (i) diminish, eliminate, or prevent ``excessive speculation''; (ii) deter and prevent market manipulation, squeezes, and corners; (iii) ensure sufficient market liquidity for bona fide hedgers; and (iv) ensure that the price discovery function of the underlying market is not disrupted. Additionally, new CEA 4a(a)(2)(C) states that the Commission must act to avoid shifting the price discovery function to FBOTs in establishing limits. In mandating these considerations, Congress recognized that limiting trading positions has the potential to reduce liquidity and adversely affect the hedging and price discovery functions of U.S. commodity markets. The Commission is obliged to give due weight to each consideration in setting any position limits and may not focus solely on imposing limits to diminish, eliminate, or prevent ``excessive speculation.''C. The Commission's Exemptive Authority Should Be Interpreted Broadly To Accommodate All Non-Speculative Positions New CEA 4a(a)(7) gives the Commission authority to exempt from any position limit rule, with or without conditions, ``any person or class of persons, any swap or class of swaps, any contract of sale for future delivery or class of such contracts, any option or class of options, or any transaction or class of transactions.'' Under this provision, the Commission's statutory power to exempt any person or class of person from position limits is greater than it has ever been before. CME Group believes that DFA authorizes the Commission to use its broad new exemption authority under 4a(a)(7) to grant exemptions to market participants who use futures, options, or swaps when economically appropriate to the reduction of the risks they face in their enterprises. Although it is impossible to enumerate the breadth of exemptions that should be permitted in order to ensure that entities are able to effectively manage exposure that is highly correlated to fluctuations in the price of exempt and agricultural commodities, an application for exemption should be judged on its merits in terms of the specific risks to be hedged, the relevant price relationships, the proposed position sizes, and the operational procedures for establishing and lifting the hedge. If the Commission were to narrowly construe its 4a(a)(7) exemptive authority to exclude non-speculative trading activity, then market participants could be forced to either actually speculate on those price risks (i.e., not establish any positions to mitigate the risk), and potentially increase costs to consumers, or hedge their risks through transactions that lie outside the CFTC's position limit authority. Either strategy would undermine the Commission's mission to promote liquidity and protect the price discovery function of its regulated markets. The Commission should thus broadly interpret its exemptive powers and grant exemptions to market participants who are not seeking to establish positions in the futures market for speculative purposes but rather to serve their legitimate commercial and financial hedging needs.III. Conclusion CME Group appreciates the opportunity to offer the foregoing comments respecting the implementation of DFA's provisions respecting position limits on certain contracts involving exempt and agricultural commodities. We hope that the views expressed herein prove to be helpful and we are available to answer any questions the Committee may have. " CHRG-111hhrg53246--66 Mr. Neugebauer," Thank you, Mr. Chairman. Chairman Gensler, I understand that the CFTC is going to have some public hearings regarding hedge exemptions and position limits in the energy markets. As you are aware, in the 2008 farm bill we had quite a bit of discussion about that, and we expanded some of the CFTC's authority in that area. There is a lot of disagreement about the role of speculators in the marketplace. And my opinion is that they provide liquidity and price discovery by the fact that they are in the marketplace. But what do you think might be the impact if you move to limit, and in some cases prohibit, some institutional investors from actually being in the energy commodities? " CHRG-111shrg54675--77 PREPARED STATEMENT OF CHAIRMAN TIM JOHNSON It is no exaggeration to say that our economy is currently experiencing extraordinary stress and volatility. As Congress and the Administration look at corrective policy changes, I am pleased to hold this hearing today to take a closer look at the role smaller financial institutions, specifically community banks and credit unions, play in our economy, especially in many rural communities. Throughout our Nation's economic crisis there has often been too little distinction made between troubled banks and the many banks that have been responsible lenders. There are many community banks and credit unions that did not contribute to the current crisis--many rural housing markets that didn't experience the boom that other parts of the country did, and community lending institutions didn't sell as many exotic loan products as other lenders sold. Nonetheless, small lending institutions in rural communities and their customers are feeling the effects of the subprime mortgage crisis and the subsequent crisis in credit markets. Jobs are disappearing, ag loans are being called, small businesses can't get the lines of credit they need to continue operation, and homeowners are struggling to refinance. Smaller banks play a crucial role in our economy and in communities throughout our Nation; we need to be mindful that some institutions are now paying the price for the risky strategies employed by some larger financial institutions. In coming weeks, the Banking Committee will continue its review of the current structure of our financial system and develop legislation to create the kind of transparency, accountability, and consumer protection that is now lacking. As this process moves forward, it will be important to consider the unique needs of smaller financial institutions and to preserve their viability as we come up with good, effective regulations that balance consumer protection and allow for sustainable economic growth. I would like to welcome our panel of witnesses, and thank them for their time and for their thoughtful testimony on how small lending institutions in rural communities have been affected by our troubled economy. I would also like to thank Senator Kohl for his interest in today's hearing topic. I will now turn to Senator Crapo, the Subcommittee's Ranking Member, for his opening statement. ______ FOMC20081029meeting--218 216,MR. HOENIG.," Thank you, Mr. Chairman. Let me just briefly say that, in our region, we have continued to do actually better than the national average, but that is beginning to wane. We are seeing, obviously, the energy effect show itself as rigs are being put out of production and you see a slowing there. We are seeing some concerns being raised about agricultural prices and the boom that has been going on in that part of the economy. That said, there's still a reasonable amount of business going on that they haven't frozen up. We asked our directors and our other advisers how they were seeing things, and it varies. There were some organizations that say that our non-investment-grade borrowers from the banks, if they had credit already, are still able to access those lines. If they lost some portion because of a bank problem or something like that, they cannot get new credit, so it is cut off in that way. I think that's important to keep in mind. Businesses themselves are beginning to pull back on their capital plans. They've said that. Their balance sheets--obviously outside the auto industry--are still decent, but they're saying, ""We're looking at this, and we're pulling back until we see how it plays out."" You are beginning to hear more of that. They feel that they can get credit. Some of them are talking about actually trying to pull down their lines to make sure they have the money, and the only thing keeping them from doing that is they don't know what to do with it once they get it. So that's their dilemma. They're afraid of losing their credit, but they also know that it costs if they pull it down. So the dynamics there are interesting. On the national outlook, I'll be brief. I think that obviously the projections for recession are in place. Down is where we're going. How much, though, is speculation right now. I don't know. I don't know that anyone does until we begin to see things settle out. Inflation should be down as well. Obviously, when you have a recession, you will back off from that, but how much? That's not clear at this point. There is a lot in play, and that's why we don't know the answers to those questions. We have these liquidity facilities and an enormous amount of liquidity out. We have the TARP that is now in process but not completed. That's going to have an impact, and I think those are very important. As we discuss our own policy, we are very close to the point of the quantitative easing discussion that we had, as you said, in 2003. Pulling that material out and taking a look at that is important as we decide what we're going to put our money into as we try to stimulate this economy. Right now we're subject to waiting and seeing. There's been a lot done, and attitudes are a critical part of this now, and we just have to wait to see how those change over the next quarter or two. Thank you. " FOMC20050322meeting--107 105,MS. MINEHAN.," Thank you, Mr. Chairman. Economic activity seems definitely on the upswing in New England. As we discussed conditions with our Beige Book contacts, met with our small business advisory group, and talked in some depth with local temporary-help agencies and software developers—as we did our usual round of contacts—the themes of solid growth and increasing confidence were repeated with some frequency. Manufacturers, especially those that have some defense business, report very good sales, and, at least in the case of one large manufacturer, an inability to keep up with demand. Labor markets have strengthened as well, and benchmark revisions to employment data indicate that 2004 was a better period for job growth in New England than previously thought. Temporary help agencies report good demand for labor, and help-wanted is stronger, as judged by both traditional measures and the indexed data on the region that are available from Monster.com. Housing remains strong, though we don’t see much sign of speculation and there is some softness at the upper end of the price range. Retail business is reported to be good, and both business and consumer confidence has increased. Contacts in the regional economy appear to be moving from a focus on concerns about March 22, 2005 45 of 116 of small businesses in the period since our February meeting, and they almost uniformly report rising costs of raw materials and labor that are starting to impact their prices. In a growing number of cases, these firms have been able to make price increases stick, even to big buyers like Wal-Mart, though, largely, the price increases have been in the form of surcharges. Skilled workers are becoming difficult to find. Businesses report that they’re in a hiring mode and have to pay up to get the people they need. Some companies have begun to hire in advance of need, simply to have a pool of available workers. Capital spending plans seem quite solid, and now there is a mixture of firms spending not only to further increase productivity but also to expand to handle increased business. Two areas of concern emerged beyond those related to rising costs. The first involves tourism in northern New England. Evidently, while this was a snowy year in the southern part of our region, the northern areas have suffered from both too little snow and the timing of storms, which created weekend travel problems. The second is a continued sluggishness in commercial real estate markets. Given the number of large mergers affecting the region, both in the financial services industry and elsewhere, and the reduction of headquarters staff that has resulted, commercial vacancy rates remain high and rents low—especially in downtown and suburban Boston. I should say the rents are relatively low, since Boston rents tend to be high anyway. This has not, however, seemed to put much of a crimp in the market for purchasing commercial buildings, which continues to be quite strong. Turning to the national scene, I’ve been struck by the strength of the incoming economic data, as has everyone else. We in Boston have adjusted our forecast upward, especially in the near March 22, 2005 46 of 116 Greenbook over the forecast horizon, though our calculations suggest some greater economic capacity and less downward pressure on the unemployment rate. However, there is not a lot to argue about here, given the continuing upside surprises in overall economic growth and in price pressures. Indeed, it seems clear to me that the underlying rationale we have used in moving policy slowly and gradually to a less accommodative place is becoming questionable. Unlike last year when growth seemed fragile and uncertain, economic growth now seems solid and resilient and in less need of policy accommodation. Overall credit and financial conditions are supportive, if not encouraging, to spending and growth. Business investment is not taking a breather with the ending of the tax incentive, and consumers aren’t either, except in their post-holiday purchases of autos. Surely it is possible to see downside risks from a rise in the saving rate, from an untoward increase in oil prices that impacts demand, or from an impact arising out of the external deficit. But I think it’s even easier to imagine upside inflation surprises as rising energy, raw material, import, and labor costs get embedded into economic activity. In that regard, I found the Greenbook alternatives focused on a spending boom and on a boom with rising inflation expectations very interesting. I should also note that while my admiration for the FRB/US model is enormous, I think it’s difficult for any model to correctly anticipate the full interplay of economic factors once the unexpected happens. The baseline, I think, is still pretty much a good, solid forecast. Continued solid productivity growth will keep nascent cost pressures and inflation expectations under control. However, the risks that this will not happen seem to me to have grown and to have become a bit more one-sided. That is, I think we need to be more focused on the risks that rising cost pressures will get out of hand. March 22, 2005 47 of 116 case could be made for moving faster rather than slower toward that so-called neutral place. Taking larger steps now would have the benefit of affecting market attitudes toward risk in a positive way, largely because it is not what markets expect us to do. That option has some attraction to me. But it could be too much of a surprise and indicate too much concern about future prospects than perhaps is necessary. However, we could take advantage of this point in time by preparing the markets for greater policy flexibility. That is, we could change the language of the announcement by following the Chairman’s example in taking out the reference to a measured pace. In my view, anyway, that would have two benefits. It would continue the process of removing policy accommodation, and it would focus markets better on the uncertainties of the future." CHRG-111hhrg53021--37 Secretary Geithner," I do believe that. And I have a stack of letters here in my book from companies across the country in the power business, in the commodities business, in the business of producing large-scale machinery, that speak to the importance of maintaining that option. But I want to underscore that, because those products come with a lot of risk--and a lot of the losses that were so conspicuous in the monoline insurance companies and AIG were from institutions writing protections against the customized products. And, therefore, it is important that there be, as I said, a comprehensive framework of oversight and authority over those instruments, as well. " FOMC20050630meeting--345 343,MR. FISHER.," I just have a quick question, going back to the oil issue. There are some 770,000 outstanding futures contracts on the NYMEX. If you look at the CFTC [Commodity Futures Trading Commission] data, 11 percent of those are noncommercial players—what they call June 29-30, 2005 108 of 234 as to what percentage of the spot price or of futures prices do you consider to be weighted by the nonfinancial players? Are they a driving force or are they inconsequential?" CHRG-111hhrg53021Oth--37 Secretary Geithner," I do believe that. And I have a stack of letters here in my book from companies across the country in the power business, in the commodities business, in the business of producing large-scale machinery, that speak to the importance of maintaining that option. But I want to underscore that, because those products come with a lot of risk--and a lot of the losses that were so conspicuous in the monoline insurance companies and AIG were from institutions writing protections against the customized products. And, therefore, it is important that there be, as I said, a comprehensive framework of oversight and authority over those instruments, as well. " CHRG-110hhrg34673--185 Mr. Bernanke," Well, it is certainly true that where we are today is that there are a lot of immigrant workers, many of them undocumented, who are working in various industries ranging from manufacturing to agriculture to leisure and hospitality and construction and other areas, and if they were all to leave immediately then there would be obviously a disruption in those industries and labor shortages in those industries. Mr. Davis of Tennessee. I ask that mainly to make a point. We have a lot of folks out here today who have a lot of ideas about America's economy, and we have a lot of ideas about some of the comments that have been made by many about the illegal immigration situation. My real question to you is this: As I go back from about the 1970's, late 1960's, up through about right now, we have gone from having a balance of trade in our favor to where we have gradually gone to a whole other level, over $700 billion for the last 2 or 3 years in deficits in trade. Now that means that we are sending $700-some billion more out of America's economy to other nations of the world that are holding that money. They are our dollars. It is a part of our capital assets of this country that is showing that up, and when I look at that, I get kind of frightened at it, and I look at the district that I represent and I see a Saturn plant in Spring Hill that has temporary layoffs, perhaps, and I fear that they may become more permanent than temporary, those 5,000 or 6,000 jobs that we may be losing. The Carrier Corporation just left my district. So when I look at my Congressional district, which is the fourth most rural in America, this great booming economy that we seem to have throughout America does not exist in my district, and it does not exist I believe, perhaps, in most rural areas of America. As to the trade deficits and the budget deficits that we continue to elevate, are we just looking for a train wreck to happen, and are we sitting here in Congress kind of like Nero did in Rome as it burned, doing nothing about it? How do we stop this bleeding of huge deficit spending? Because we have seen us grow from 18.5 percent in a gross domestic spending percentage of government to about 20 percent in the last 5 or 6 years. We have seen an increase in spending, a dramatic increase, and our revenues have gone down to fund government as the Congress for the last 5 or 6 years has seen fit to spend. So, in essence, there are two or three problems that I have, and I think it is hurting a lot of the more rural areas and maybe not the more urban areas, but we have lost 3 million industrial jobs. We are no longer producing. In export and production, we are consuming someone else's production. So how do the trade deficits, the budget deficits impact us, and when will we be in a situation where we no longer enjoy the great economy supposedly that we have, and when will it become a threat even to the world economy if that does happen? " fcic_final_report_full--11 Unfortunately—as has been the case in past speculative booms and busts—we witnessed an erosion of standards of responsibility and ethics that exacerbated the fi- nancial crisis. This was not universal, but these breaches stretched from the ground level to the corporate suites. They resulted not only in significant financial conse- quences but also in damage to the trust of investors, businesses, and the public in the financial system. For example, our examination found, according to one measure, that the percent- age of borrowers who defaulted on their mortgages within just a matter of months after taking a loan nearly doubled from the summer of  to late . This data indicates they likely took out mortgages that they never had the capacity or intention to pay. You will read about mortgage brokers who were paid “yield spread premiums” by lenders to put borrowers into higher-cost loans so they would get bigger fees, of- ten never disclosed to borrowers. The report catalogues the rising incidence of mort- gage fraud, which flourished in an environment of collapsing lending standards and lax regulation. The number of suspicious activity reports—reports of possible finan- cial crimes filed by depository banks and their affiliates—related to mortgage fraud grew -fold between  and  and then more than doubled again between  and . One study places the losses resulting from fraud on mortgage loans made between  and  at  billion. Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities. As early as September , Countrywide executives recognized that many of the loans they were originating could result in “catastrophic consequences.” Less than a year later, they noted that certain high-risk loans they were making could result not only in foreclosures but also in “financial and reputational catastrophe” for the firm. But they did not stop. And the report documents that major financial institutions ineffectively sampled loans they were purchasing to package and sell to investors. They knew a significant percentage of the sampled loans did not meet their own underwriting standards or those of the originators. Nonetheless, they sold those securities to investors. The Commission’s review of many prospectuses provided to investors found that this crit- ical information was not disclosed. T HESE CONCLUSIONS must be viewed in the context of human nature and individual and societal responsibility. First, to pin this crisis on mortal flaws like greed and hubris would be simplistic. It was the failure to account for human weakness that is relevant to this crisis. CHRG-110hhrg34673--197 Mr. Castle," I have last year introduced legislation about transparency in hedge funds. I am concerned about hedge funds. You answered this yesterday in Senate testimony and basically indicating that the liquidity of hedge funds could be very important. I don't have a problem with that either, but I do have a problem in terms of what hedge funds could do with respect to commodity markets and a variety of things they get into because of the enormity of it and the number of them that have opened in recent years and where they are going. I am not one who looks for overregulation or overtransparency, if there is such an expression, but I think proper transparency is in order. I would like your thoughts, if you could, about where we are with respect to hedge funds, and what do you think the role of the--regulatory role or perhaps our committee role in this area should be. " CHRG-111hhrg63105--213 Mr. Jones," I would say all or at least most of our members would fall into the qualified hedger category. What we are referring to there is, as I said early on, the majority of and particularly in the enumerated commodities of corn, soybeans, wheat, the majority of the trading that goes on, the price discovery occurs on the exchange and most of it is hedged. And so, unlike the energy markets, which I am no expert in, but there is a much larger OTC portion of that that occurs. So if we were combined with the OTC, it actually would create a much larger position limit that specs could have if they combined the two than what exists right now, if it were to flow into the futures market. " CHRG-111hhrg63105--104 Mr. Chilton," Certainly Congress told us to put the limits in. We had the authority actually before this, but we didn't have support to do this. So we were instructed in the Dodd-Frank bill to put limits in. And the original purpose in the Commodity Exchange Act doesn't say that you have to jump some hurdle that proves beyond a shadow of a doubt in a court of law that speculators moved gas prices ten percent. The law says that we are to prevent and deter fraud, abuse, and manipulation; and so that is sort of the guiding onus that I look at, sir. " FOMC20080805meeting--175 173,MR. PLOSSER.," Thank you, Mr. Chairman. As you can imagine, as we've discussed, this meeting presents a difficult policy position for us--and for me in particular. I think we must pay careful attention to the financial market volatility; and to the extent that it has consequences for the real economy, I'm certainly sensitive to that concern. I had a similar experience with my board of directors that President Evans did. I went into my board recommending no change and got considerable push-back in discussion about how we dissent and what the consequences of doing that are. They are concerned about inflation, and I'm concerned about our mandate to keep longerterm and intermediate-term inflation in check. We're unlikely, in my view, to get confirming or convincing evidence about whether expectations have become unanchored until well after the fact. I agree there has been very little wage�price pressure to date. But that will be the last shoe to drop in this sequence of raising expectations, and by the time we get to that, I'm afraid it will be too late. I think in the near term we might see some relief in headline inflation; but as has been discussed, whether that will persist is highly dubious. My real concern is that I believe that monetary policy is accommodative, and with all due respect, Mr. Chairman, when I look at the data comparing the levels of borrowing rates of consumers and businesses, both the levels in real and nominal terms and the spreads, what we see in this period looks remarkably similar to what we've seen in lots of other recessionary, slow growth periods. So, again, following the analogy that President Lacker was using, I see this period as less atypical and more typical of what we see in slow-growth periods. I think it's important that we begin to prepare the markets for an impending shift to a tighter policy. I agree with President Hoenig. The request here is not for tight policy but somewhat less accommodative policy; and if we choose to go with no funds rate increase today, I think the language must help prepare the markets going forward. I'm pleased with a lot of the discussion around the table. We are actually beginning to talk, I think, about what our exit strategy is going to be from this. I think it's very important to have those conversations, and I appreciate them. I, too, share the observations that President Evans had about talking with people who say, ""Well, we can't possibly remove accommodation until we get rid of the facilities."" I think that is wrong. As you said, Mr. Chairman, actually having the facilities might make it easier for us to correct monetary policy, and I think that's very, very important. I guess my bottom line is that I can accept leaving the funds rate unchanged today as long as our language is sufficiently strong about inflation. To that end, I was actually a little more comfortable with the draft table 1. I didn't like the addition of the word ""also."" I thought that weakened the statement. I would prefer paragraph 4 without the ""also."" I also have one other, minor observation about paragraph 3, and that's the first sentence, which says that ""inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities."" Well, I think that's partly true, but I'm concerned that somehow it conveys the impression that the problem with inflation is oil and commodities, when in fact more correctly my concern about inflation is not just oil. My concern is about the stance of policy. So I would put on the table the possibility of saying that ""inflation has been high, partly spurred by high oil and commodity prices"" to say that it's more than just the short-term behavior of commodity prices. I think the word ""also"" means that inflation concerns there are added as an afterthought, which is my reading of the change from the draft table 1 to paragraph 4. So I prefer that ""also"" be eliminated. Thank you, Mr. Chairman. " CHRG-110hhrg44901--136 Mr. Bernanke," I know that they work very closely, and there are areas where there is some overlap of responsibility and jurisdiction. The Treasury Blueprint for reform envisions that we would merge at some point. I don't really have a recommendation to make on that. I think it would depend in part on the overall plan for regulatory reform if, in fact, that takes place in the context of that broader plan. Ms. Moore of Wisconsin. Well, I just only say that because so many of these commodities are paper transactions and futures contracts versus bringing your hog to the marketplace to sell. It seems to me that the modern thing would be to bring these together and have perhaps a better regulatory framework. I yield back. " CHRG-111shrg52966--21 Mr. Sirri," I think we all--I won't speak for others. I think we understood, and my impression was all of these regulators understood, that we were limited in part. We had dialog amongst ourselves. Staff on the ground talked to staff from other regulators. In addition, the firm--it is not like the firms drew up walls and said, we won't give you information on that bank, or we won't give you information on that thrift. They would provide such information. But in the sense of integrated enterprise risk management, I think it was not what it could be. Senator Reed. Senator Bunning, and take as much time as you want. Senator Bunning. Thank you, Mr. Chairman. Welcome back from your vacations that you have been on for the last 5 years, and I say that not kiddingly. I say that as meaningful as I can, because if we would have had good regulators, we wouldn't be in the crisis we are in right now. Ms. Williams, at the bottom of page 24, you said the Fed did not identify many of the issues that led to the failure of some large institutions. Can you tell us what some of these issues that they are, what they missed? Ms. Williams. Absolutely. I would direct your attention to a couple of pages later, on page 26. We note that the Fed began to issue risk committee reports, and in February of 2007 they issued perspectives on risk, and we list a number of issues that we pulled from that report. For example--the report stated that there were no substantial issues of supervisory concern for large financial institutions; that asset quality across the systemically important institutions remains strong; in spite of predictions of a market crash, the housing market correction has been relatively mild and while price appreciation and home sales have slowed, inventories remain high and most analysts expect the housing boom to bottom out in mid-2007. Overall, the impact on a national level will likely be moderate. However, in certain areas, housing prices have dropped significantly. They also noted that the volume of mortgages being held by institutions or warehouse pipelines had grown rapidly to support collateralized mortgage-backed securities and CDOs and noted that the surging investor demand for high-yield bonds and leveraged loans, largely through structured products such as CDOs, was providing a continuing strong liquidity that resulted in continued access to funding for lower-rated firms at relatively modest borrowing costs. So those are some of the---- Senator Bunning. Would you like to comment on counterparty exposures, particularly to hedge funds? Ms. Williams. This was another area that was identified. The regulators had focused on counterparty exposures, particularly to hedge funds. Senator Bunning. Mr. Cole, would you like to respond? " FOMC20060328meeting--107 105,MS. MINEHAN.," Next meeting, okay. [Laughter] We’ve had a wide range of contacts in New England since our last meeting, so what I’m going to do is try to summarize five or six different things that came out as a result of this range of contacts. The first point is basically driven by the data. New England continues to grow more slowly than the nation. Actually, employment growth year over year is about a third of the pace of the nation as a whole—sort of normal, in a way. New England tends to have a slower-growing population and labor force than the rest of the nation. But the recent pace of job growth is decidedly slower than the long-run average. Nonetheless, regional businesses seem to be broadly participating in the growth of the overall economy, and even the pace of losses in manufacturing jobs seems to be slowing. Indeed, merchandise exports for the region were quite strong despite continuing manufacturing job losses, suggesting that regional manufacturers have figured out a way to enjoy some productivity growth and to keep their output relatively high. Almost all contacts have been quite upbeat about sales and revenue expectations for this year. Most state corporate tax collections have been booming, and retail sales and state sales tax revenues are at or above budget almost everywhere except Rhode Island. Rhode Island seems to be going through a kind of flattening of growth. I’m not exactly sure why. At a recent conference of regionwide Realtors, optimism was expressed by heads of state Realtor groups that, so far, home sales and prices, although they are certainly moderating, have held up fairly well. And that’s even considering the fact that in the fourth quarter of last year, sales in the Northeast, unlike for the nation, declined for both new and existing homes. But ’06 was viewed by this group as proceeding fairly well. There is some evidence of tight labor markets for certain skilled jobs. We have in one of our advisory groups a CEO of a software firm that does software and consulting services oriented toward recruitment for Global 2000 customers. She reported that their clients around the world are having difficulty hiring health care, technology, finance, and professional-level sales personnel. So she was seeing some real uptick in labor market tightness at the high end. And I must say that when you look at commercial vacancy rates, which have declined for Class A downtown and suburban space, not just in Boston but elsewhere, you seem to get the impression that maybe businesses haven’t started to hire yet but they do have plans to hire and they do have plans to hire at the high end. Finally, local measures of price growth remain quite contained, though headline CPI data indicate that the region has suffered more than the nation from high energy and utility costs, even with the quite mild winter. In assessing the reaction of contacts about cost increases, we heard a bit less complaining this time around. Maybe people have just given up complaining, or perhaps they have found ways—and I think this is probably more true than not—to offset high commodity and energy costs through rising productivity. The picture for the nation is even better than it is for New England. We, like the Greenbook authors, have been a bit surprised and pleased at the strength of the incoming data after the bump in the fourth quarter. David mentioned all the good reasons to be pleased—strong employment, solid consumer spending, not much evidence yet of a large drag from housing, solid business investment and production, very favorable financing conditions, faster growth than the rest of the world, and through it all, moderating headline and rather flat core inflation, whether you look at the CPI or the PCE, reflecting a leveling-out of energy prices and continued strong productivity growth. True, some luck has been involved, particularly the rather temperate winter weather in the Northeast, with its good news for overall energy and electricity costs. And the drop in new home sales may be a harbinger of worse to come. But the first quarter is over, and it was stronger than we expected, even allowing for a bounceback from Q4. Looking ahead, we agree with the general trajectory of the Greenbook forecast, as we have for some time. However, we have penciled in a somewhat greater effect in ’06 on growth from the expected falloff in housing—that is, an actual small decline in residential investment in every quarter this year and a related effect on consumption from a flattening of the growth in household wealth. So our GDP forecast for ’06 is somewhere between three- and four-tenths lower than the Greenbook’s, though ’07 is just about the same. We also see a smaller uptick in core inflation this year, largely because we see labor markets as having a bit more capacity than does the Greenbook, which we believe accounts for some of the moderation in wage and salary growth, at least by some measures. It may be splitting hairs to mention what in the end are small differences between Boston’s forecast and the Greenbook’s. After all, we don’t have the same number of resources in Boston focusing on making a forecast as you do here for the Greenbook. But I think we are at a point where small differences in outlook really do affect how each of us sees the policy choices. Now, what are the risks around this benign, if not rosy, outlook? Will they continue to revolve around growth that is higher than expected, prompted by a continuation of consumer strength—if, for example, housing takes less of a bite out of growth than we expect—and by financial conditions that could remain more stimulative as well? Indeed, when we look both at where we’ve been off in evaluating the outlook over the past couple of years and at our own Boston forecast, the surprises have mostly been the result of rising household wealth and a related set of very favorable financial market conditions. If these conditions continue, greater inflationary pressure than we expect could well result, given where we are in terms of resource utilization. And of course, new energy shocks are possible, given the possible geopolitical unrest and tight supply conditions. Alternatively, looking at risks on the other side, a greater-than-expected slowdown in housing, with a related larger pickup in saving rates, could put an unexpected damper on growth. Absent new energy shocks, this would act to moderate both growth and inflationary pressures more than expected. So we see housing as integral to both upside risks and downside risks. As I see it right now, the risks to the forecast appear relatively well balanced, maybe a touch to the side of inflation. That’s mostly because we’ve had a lot of recent experiences with surprises on the upside relative to growth, with rising energy and commodity prices, and overall resource capacity is hard to be very precise about. However, I really don’t see large upside inflation risks, mostly because of what we’ve seen in terms of ongoing productivity growth. It remains solid, and it continues to act as a powerful buffer. Indeed, despite the temporary drop-off in Q4, I have not seen or heard anything from my contacts that suggests the underlying business drive to be ever more productive will slow, or slow anytime soon. So although my assessment of risks has a small upside tilt and I am concerned about how expensive being very wrong on the inflation side would be, I don’t see the situation as significantly unbalanced." CHRG-111shrg57322--411 Mr. Sparks," Can I just, Dr. Coburn, I thought you said we were changing our positions. We were oftentimes changing our positions. I thought you meant did---- Senator Coburn. I understand, but there has never been a position change like what took place in the last 4 years in this country in the mortgage markets. There has never been anything like that. Maybe when we shut off exports of commodities to the Russians during the Afghanistan invasion, but there has never been a change like that before in this country. So I understand you change positions all the time, but there has never been anything to compare to what happened in terms of the collateralized debt obligations and the residential mortgage-backed securities in this country. Would you agree with that? Do you know anything in your history? I am 62 years old. I have never seen anything like it. " fcic_final_report_full--171 All along the assembly line, from the origination of the mortgages to the creation and marketing of the mortgage-backed securities and collateralized debt obligations (CDOs), many understood and the regulators at least suspected that every cog was reliant on the mortgages themselves, which would not perform as advertised. THE BUBBLE: “A CREDITINDUCED BOOM ” Irvine, California–based New Century—once the nation’s second-largest subprime lender—ignored early warnings that its own loan quality was deteriorating and stripped power from two risk-control departments that had noted the evidence. In a June  presentation, the Quality Assurance staff reported they had found severe underwriting errors, including evidence of predatory lending, legal and state viola- tions, and credit issues, in  of the loans they audited in November and December . In , Chief Operating Officer and later CEO Brad Morrice recommended these results be removed from the statistical tools used to track loan performance, and in , the department was dissolved and its personnel terminated. The same year, the Internal Audit department identified numerous deficiencies in loan files; out of nine reviews it conducted in , it gave the company’s loan production depart- ment “unsatisfactory” ratings seven times. Patrick Flanagan, president of New Cen- tury’s mortgage-originating subsidiary, cut the department’s budget, saying in a memo that the “group was out of control and tries to dictate business practices in- stead of audit.”  This happened as the company struggled with increasing requests that it buy back soured loans from investors. By December , almost  of its loans were going into default within the first three months after origination. “New Century had a brazen obsession with increasing loan originations, without due regard to the risks associated with that business strategy,” New Century’s bankruptcy examiner reported.  In September —seven months before the housing market peaked—thou- sands of originators, securitizers, and investors met at the ABS East  conference in Boca Raton, Florida, to play golf, do deals, and talk about the market. The asset- backed security business was still good, but even the most optimistic could read the signs. Panelists had three concerns: Were housing prices overheated, or just driven by “fundamentals” such as increased demand? Would rising interest rates halt the market? And was the CDO, because of its ratings-driven investors, distorting the mortgage market?  CHRG-111hhrg51698--122 Mr. Fortenberry," Thank you, Mr. Chairman, for holding this very important hearing and for delving very deeply into this complex issue, and I thank the panel as well for the lively and informative exchange. It has been very productive. When gasoline went over $4 in Nebraska last year, I stopped in to see Bill Sapp. He does something similar to you, Mr. Cota. Any of you who have gone down Interstate 80 right outside of Omaha might see a big coffee pot sitting 100 feet in the air. That is Bill's business. I said, Bill, what is going on, and he said, speculation. I want to follow up with your comments, Mr. Cota, talking last year when we hit $140 or so on oil futures, and now we are back down to $40. Your suggestion that this is being driven by greed and fear, being untethered from any supply or demand conditions, simply being accelerated because of artificial factors, outside, again, of the underlying fundamentals, led to such disruption not only in terms of gasoline prices, but all of the other commodities. And you, sir, had mentioned consequences for the other agricultural markets. If we presume that is true, and last year we held numerous hearings on this with the CFTC to figure out what systemically was potentially failing, where has regulation gone wrong. Their conclusion was we can't find a smoking gun, but we need more time and more help to potentially find a smoking gun. Let us unpack the reasons for, again, that rapid spike in speculation that everyone agrees has been terribly disruptive and not normal. Mr. Gooch, you alluded to it, to a portion of the reason, maybe the significant portion, in terms of credit and credit bubbles and investing in commodities as an inflationary hedge or for other reasons, because people were just getting on this accelerating train. If we can get to that underlying question, and then we know a lot more as to how to potentially prevent this type of systemic failure, disruption into the future, which has been, again, underlying a big portion in this economic malaise that we are in. " FOMC20060629meeting--47 45,MR. KAMIN.," I will answer the small question. Then Larry can answer the big one. [Laughter] I agree with you that there is actually a certain disjuncture, if you will, between the fact that steel prices have stayed up and the growing capacity in China. I don’t have a full answer to your question, but I would offer just a couple of thoughts. The first is that, unlike a homogeneous primary commodity, steel comes in many forms, and there are different markets. So the very substantial increases in Chinese capacity in some products don’t necessarily lead to price declines in other products that may be particularly important to the United States. The second point to mention, which is much more obvious, is that iron ore prices actually have gone up very significantly. According to the data that we’re looking at, basically they are 18 percent higher than they were a year earlier. What seems to be going on is some tension between increases in ore prices, on the one hand, and improvements in capacity, on the other hand, which might reduce the margin between the ore and the final steel products. Perhaps those circumstances will go some way toward explaining the anomaly." FOMC20050630meeting--11 9,MR. RUDEBUSCH.," I will review some general issues related to monetary policy and asset prices. Let me start—at the top of page 1—by assuming that an asset price can, in theory at least, be separated into a component determined by underlying economic fundamentals and a non-fundamental or bubble component. An asset price may be in line with its fundamentals, so the bubble component is zero, or bubbles could be positive or negative—perhaps representing irrational euphoria or pessimism. June 29-30, 2005 15 of 234 of monetary policy. For example, a booming stock market is usually followed by higher demand and increased inflationary pressures, so tighter policy would be needed to offset these consequences. Even for the Standard Policy response, it will likely be useful to identify, if possible, the separate components of the asset price. In particular, the bubble component may exhibit more volatile dynamics and be a pernicious source of macroeconomic risk, so optimal policy would likely react more to bubbles than to movements in the fundamental component. The second type of response, the “Bubble Policy,” follows the Standard Policy as a base case, but, in certain circumstances, it also takes steps to contain or reduce the asset price bubble. Proponents of a Bubble Policy argue that movements in the bubble component can have serious adverse consequences for macroeconomic performance that monetary policy cannot readily offset after the fact, so it is preferable to try to eliminate this source of macroeconomic fluctuations directly. Furthermore, because bubbles often seem to display a self-reinforcing behavior, a little preemption and prevention early on can avoid later excesses. A best-case scenario for these two policies is illustrated in the lower half of the first page. Under ideal circumstances, the policymaker knows the fundamental and bubble components, and as history unfolds, the Standard Policy would likely recommend higher interest rates to offset any economic stimulus generated by the bubble before the crash and lower rates afterward. A Bubble Policy would go further and try to mitigate the fluctuations in the bubble and achieve an asset price path like AP′t . This would likely require higher interest rates than the Standard Policy before the crash and lower rates afterward, and it will likely trade off near- term deviations from the central bank’s macroeconomic goals for better overall macroeconomic performance later on. The fundamental difference between the two policies is that the Standard Policy takes the bubble component essentially as given or exogenous, while the Bubble Policy takes into account the endogenous nature of the bubble component—specifically, a linkage between the policy instrument and the bubble. A decision tree for choosing between the Standard and Bubble Policies is shown on page 2. In brief, it asks three questions: (1) Can policymakers identify a bubble? (2) Will fallout from a bubble be significant and hard to rectify ex post? and (3) Is monetary policy the right method to use to deflate the bubble? The answer to the first question—can policymakers identify a bubble?—is “no” if the particular asset price appears aligned with fundamentals. Some have argued that this is nearly always the case because estimates of fundamentals are so imprecise and because asset prices reflect the collective information and wisdom of professional traders in organized markets. If policymakers cannot discern a bubble, then the Standard Policy is the only feasible response. June 29-30, 2005 16 of 234 policy cannot readily offset after the fact. A negative answer to this question is appropriate in two situations. First, if the bubble is in an asset market that is small in domestic economic terms—for example, a localized real estate market—then a central banker should avoid attempts at asset price realignment. Second, even when there are significant macroeconomic consequences from an asset price bubble boom and bust, if they occur with a sufficient lag so the policymaker can adopt a wait-and­ see attitude, then the Standard Policy is again appropriate. This second case seems relevant if fluctuations in the bubble component have only conventional effects on aggregate demand and supply through changes in wealth, the cost of capital, and balance sheets. Then, to a first approximation, the lags involved in these channels are about as long as the lags in the monetary transmission mechanism; therefore, the Standard Policy should suffice. For example, fluctuations in equity prices will affect wealth and consumer demand, but a nimble central banker can essentially offset these consequences by changing interest rates in reaction to—that is, after—the equity price movements. Now to the case where asset price movements have significant macroeconomic consequences and those consequences are hard to clean up after the fact through monetary policy. The most often mentioned possibility is that a bursting asset price bubble will lead to a broad financial crisis and credit crunch. Such financial instability is likely to be transmitted to the economy much more quickly than can be offset by interest rate policy. This may set the stage for invoking a Bubble Policy. Another example is when the asset price misalignment results in significant misallocations of resources, which distort aggregate demand and supply across sectors and over time and impede the achievement of the highest possible long-run economic growth. For example, the dot-com bubble spurred overinvestment in fiber optic cable and decimated the provision of venture capital for new technology startups for years. Of course, after the fact, it is difficult to unwind these problems with the blunt instrument of monetary policy, and, depending on the specifics, it is possible to conceive of a situation in which reducing the bubble in advance is a preferred policy strategy. The final hurdle before invoking a Bubble Policy involves assessing whether monetary policy is the right way to deflate the asset price bubble. Ideally, for the Bubble Policy, a moderate adjustment of interest rates could constrain the bubble and greatly reduce the risk of severe future macroeconomic dislocations. However, bubbles, even if identified, often do not appear influenced by monetary policy actions in a predictable way. Furthermore, even if changing interest rates could alter the bubble path, such a strategy may involve substantial costs, including near-term deviations from the macroeconomic goals of the central bank as well as potential political or moral hazard complications. Finally, even if monetary policy can affect the bubble, alternative strategies to deflate it, such as changes in financial regulations or supervision, may be more targeted and have a lower cost. June 29-30, 2005 17 of 234 questions for two historical episodes. The first episode is the run-up in the stock market during the late 1990s. In 1999 and 2000, one could have made the case that there was an equity price bubble in the high-technology sector and perhaps in the overall market as well. Also, during that time, the possible capital misallocation from the run-up in prices and the possible financial instability that might have followed a bursting of the bubble may have appeared difficult to rectify. However, it was also unlikely that monetary policy could have deflated the equity price bubble without substantial costs to the economy. In the event, of course, a Bubble Policy was not followed, but arguably, the consequences from any bubble boom and bust have been manageable. A different example is provided by the bond market collapse in 1994. One could argue that this “inflation scare,” which pushed up yields on 30-year bonds by over 2 percentage points, resulted in an asset price misalignment that was fairly apparent to the FOMC during the second half of 1994. If this bond bubble had persisted, the widespread propagation of the associated fears of higher inflation could have had severe consequences that would have been costly to unwind with monetary policy later on. Finally, with regard to deflatability, it did appear likely that monetary policy could guide bond prices back to fundamentals. Indeed, one interpretation of the FOMC’s actions in 1994 is that it purposefully and successfully contained a bond market bubble with sizable increases in the funds rate. It is an open question which of these two episodes is the more relevant one today. That concludes my remarks." FOMC20080318meeting--101 99,CHAIRMAN BERNANKE.," Thank you very much. Thank you for all of your comments. Let me just briefly summarize and add a few points. To summarize the discussion, incoming data have been weak, and some view the economy as having entered recession. Housing demand and construction have continued to decline sharply, and house-price declines have been somewhat greater than expected. Housing weakness has implications for employment, for consumer spending, and for credit conditions. It also leads to 21 miles of empty boxcars. [Laughter] Financial conditions have worsened considerably, reflecting weakness in housing prices, and credit markets in particular are highly stressed and illiquid. Wider spreads have offset some or all of the decline in safe rates for many credit products, and credit conditions are tighter for most borrowers. Financial conditions are likely to be a significant drag on economic growth. Some noted the risk that continued financial turmoil could lead to a more serious and prolonged recession, implying possibly large downside risk to growth. With respect to households, consumption growth has flattened out, and there was generally greater pessimism about the labor market and economic prospects. Consumer credit quality may be worsening. Payroll employment growth has turned negative. There was little expectation expressed of strong help from the fiscal stimulus package. Firms are generally more pessimistic and cautious but also remain concerned about cost pressures. Inventories look to be in balance. Exports continue to be an important source of final demand and will continue to contribute significantly to growth, although it's possible that growth abroad may slow. Readings on core inflation have been mixed. Increases in energy and commodity prices are important sources of increased headline inflation, and some producers have adopted a cost-plus mentality. Agricultural prices, in particular, are up a good bit. Inflation breakevens are up somewhat, especially at the five-by-five horizon. The dollar has depreciated, potentially adding to longer-term inflation pressures and adding some risks. However, nominal wage increases are moderate, as are unit labor costs, and U.S. and global economic weakness could moderate gains in commodity prices and create domestic economic slack. Several members warned about the risk of losing inflation credibility. Any comments, thoughts? Let me make just a few comments. Again, I'm very sympathetic to what almost everyone has said around the table, in particular the fact that we're facing a three-front war, if you will, which makes this extraordinarily difficult and delicate. I thought in January that we were in recession. That was my view at that time, and I certainly believe it now. The Greenbook has done a good job of trying to factor in the data and the other types of evidence. I think I'm actually slightly darker on growth than the Greenbook is. The reason is that I don't see where the recovery is coming from in the beginning of next year. In particular, we won't have a recovery until financial markets stabilize, and the financial markets won't stabilize until house prices stabilize, and there is simply no particular reason to choose a time for that to happen. So I do think that the downside risks are quite significant and that this so-called adverse feedback loop is currently in full play. At some point, of course, either things will stabilize or there will be some kind of massive governmental intervention, but I just don't have much confidence about the timing of that. I would like to say a word. I would just agree with Governor Mishkin about the efficacy of our policy. I think that it has had an effect and it has been beneficial. We obviously affect shortterm rates, including commercial paper rates and the like, which have implications for financing and for borrowing. We affect the dollar, which has mixed effects, but on the growth side has some positive effects. It's true, as President Fisher pointed out, that medium-term and long-term rates have not fallen because lower Treasury rates have been offset by higher spreads, but again, the question is the counterfactual. Where would we be if we had not lowered rates? I think that lower rates have both lowered safe rates and offset to some extent the rising concerns about solvency, which have caused the credit spreads to widen. I think this argument can go either way. You can say that our policy is less effective and, therefore, we should do more of it. So there are two ways of looking at that. In addition, there may be some benefits for capital formation of low financing rates and a steep yield curve in keeping bank share prices from entirely collapsing. On inflation, I agree with much of what's been said, and I'm very concerned about it. Let me make one simple point, though, which I don't think has been adequately discussed. Ninety-five percent of the inflation that we're seeing is either the direct or the indirect effect of globally traded commodity prices--food, energy, and other commodities. What is happening is that there is a change in the relative price of, say, oil and the wage of an Ohio manufacturing worker. There's a relative price change going on. That has to happen one way or the other. It can happen either by overall increases in the nominal price of oil, which are reflected in overall increases in headline CPI inflation, or by lower or negative growth in nominal wages. Now, if we have temporary movements in these relative prices, I think all the theory tells us that the best way to let that relative price change happen is to let the shock feed through; let the prices of energy, commodities, and so on rise; accept a temporary increase in headline inflation; and focus on making sure that the increase in headline inflation doesn't feed through into domestic core inflation, say, through wages or domestic prices. A good response to that is, well, we've had a lot of ""temporary"" shocks here and they have gone on for a long time. That's certainly true. But again, it was very difficult to anticipate how these prices have moved. Looking forward, the futures markets have been wrong and wrong, but they are the best we have. In my view, if we think about the likely slowdown in the U.S. economy and the global economy, there are going to be some forces that will prevent commodity prices from continuing to rise the way they have been rising, which ought to take the pressure off the inflation process. That being said, I fully recognize that there has been a bit of movement in some of the indicators. I think I like the use of the index measure. It uses lots of different indicators. I don't think we should overemphasize inflation compensation. For example, the one-year inflation compensation three and four years out has moved up less than the five-by-five, and I think for good reasons. The five-byfive could reflect, again, general uncertainty. It could also reflect more volatility in the relative price changes of oil, for example. If we think there's more volatility in that, if it's up or down, that would create more uncertainty about headline inflation and would feed through into that spread. Frankly, in thinking about inflation, I am concerned about inflation expectations and the general psychology. I'm hopeful at least that it will moderate as commodity prices moderate although, of course, no one can know for sure. I agree with Governor Warsh that, from a financial perspective on the inflation side, the greater dangers are in the currency area. Exchange rates are very poorly tied down by fundamentals, except over very long periods of time--I think Ken Rogoff had a paper in which he said that over maybe 600 years or so the PPP finally works. [Laughter] So a lot of psychology is there. I think that it is an important issue. We need to think about what the Treasury will say and those sorts of things. That is a concern, and I consider that in some sense a greater risk at this point. So there are risks on both sides. I think that the downside risks, including the financial risks, at this point are greater--not to belittle inflation risks, which I think are quite significant. We are obviously going to have to make tradeoffs about how to deal with these. Using both our policy tools and our communication is very important. I agree with Vice Chairman Geithner that we need and I need--and I have a very important role here--to maintain clarity in communication about our attention to inflation, that we are not ignoring that side of the mandate. Finally, let me just say, as I said last night at the dinner with the presidents, that I think we are getting to the point where the Federal Reserve's tools, both its liquidity tools and its interest rate tools, are not by themselves sufficient to resolve our troubles. More help, more activity, from the Congress and the Administration to address housing issues, for example, would be desirable. We are certainly working on those issues here at the Board, and I will be talking to people in Washington about what might be done to try to address more fundamentally these issues of the housing market and the financial markets. So those are my comments. Why don't we turn now to Brian for an introduction to the policy round. " CHRG-110hhrg44901--134 Mr. Bernanke," Well, with respect to possible steps, as I indicated, the Federal Reserve is part of a task force being led by the CFTC, which is trying to get as much clarity as we can on exactly this question, and that includes right now we and the CFTC in particular has been gathering information from other petroleum futures exchanges like the ones in U.K., has been gathering information on the activities of swaps dealers and index traders who invest in these economies. We are trying to understand how these investments are made and how they relate to price movements, those sorts of things. So we are looking at that seriously. It is possible that the CFTC may decide, and, of course, it is their province to do so, that changes in the information requirements or in positions, limits or things of that sort might be justified under certain circumstances. There is a lot of evidence, though, on which I base my earlier statement in the testimony that makes it seem unlikely that speculation or, better termed, manipulation is driving up energy prices. I mentioned the absence of inventories. There are a number of other things. For example, there seems to be no empirical relationship between long, open positions by noncommercial traders and movements in prices. It is striking that there are many or at least some commodities which are not even traded on future markets which have had big price run-ups, like coal and iron ore, for example. So it doesn't seem to us to be the central issue. It does mean that energy prices in the very short run can respond quite sensitively to news that comes in because they begin to trade like a stock price, for example. But that is not necessarily a bad thing; that means that information is being incorporated into those prices, and that helps suppliers and demanders know how better to respond. Ms. Moore of Wisconsin. Mr. Chairman, thank you for that. Is the SEC a part of this committee that is looking at the commodities irregularities? " CHRG-111hhrg49968--50 Mr. Hensarling," If the Fed will not monetize the debt and if the Congress refuses to deal with the spending curve, which will average about 23 percent of GDP for the next 10 years, that is either going to leave us with a massive tax increase or massive borrowing. But yet, apparently, as we send representatives to China to encourage them to continue to buy our debt, they are shifting to commodities; they are indicating concerns about the level of our debt. Recently, as I believe you know, S&P downgraded UK's debt on May 21st from stable to negative. So what is going to happen if the U.S. loses its AAA rating, or what happens if we have a 60 percent tax increase over the next 10 years to deal with this massive infusion of debt? " CHRG-111hhrg53021--273 Secretary Geithner," I would be happy to respond. The overall estimates of magnitude of the total face value of these markets are in the $600 trillion range. The market value of those contracts, my testimony, says are more in the $20 trillion range. That still itself doesn't really capture the risk. It probably substantially overstates it. But these are enormously large markets, enormously important to how our markets function. These markets include interest rate risk, exchange risk, equity derivatives, commodity derivatives, energy, food, et cetera. And the way this happened in credit derivatives was very similar to what happened in commodity derivatives and others, which is that decades ago people figured out a way to offer a company the ability to hedge against a particular risk, the cost of energy, cost of seeds, cost of movement in exchange rates, cost of a change in interest rates, and over time products emerged to meet that economic demand. What we did not do in our country is stay abreast of that innovation and put in place the framework of protections over those markets that was commensurate with the risk they proposed. We were behind that curve. And we had a lot of institutions, including regulated institutions like the monoline insurance companies and AIG that wrote a huge amount of protections without the capital to back it, and that combination of factors helped bring us to the edge of this very severe crisis. And it is an obligation we all share to make sure that we not just address those principal causes of this crisis, but we have a stronger framework to address future vulnerabilities, and that our framework adapts more quickly in the future. And that is what we are trying to do. " CHRG-111hhrg53021Oth--273 Secretary Geithner," I would be happy to respond. The overall estimates of magnitude of the total face value of these markets are in the $600 trillion range. The market value of those contracts, my testimony, says are more in the $20 trillion range. That still itself doesn't really capture the risk. It probably substantially overstates it. But these are enormously large markets, enormously important to how our markets function. These markets include interest rate risk, exchange risk, equity derivatives, commodity derivatives, energy, food, et cetera. And the way this happened in credit derivatives was very similar to what happened in commodity derivatives and others, which is that decades ago people figured out a way to offer a company the ability to hedge against a particular risk, the cost of energy, cost of seeds, cost of movement in exchange rates, cost of a change in interest rates, and over time products emerged to meet that economic demand. What we did not do in our country is stay abreast of that innovation and put in place the framework of protections over those markets that was commensurate with the risk they proposed. We were behind that curve. And we had a lot of institutions, including regulated institutions like the monoline insurance companies and AIG that wrote a huge amount of protections without the capital to back it, and that combination of factors helped bring us to the edge of this very severe crisis. And it is an obligation we all share to make sure that we not just address those principal causes of this crisis, but we have a stronger framework to address future vulnerabilities, and that our framework adapts more quickly in the future. And that is what we are trying to do. " fcic_final_report_full--67 DEREGULATION REDUX CONTENTS Expansion of banking activities: “Shatterer of Glass-Steagall” ............................  Long-Term Capital Management: “That’s what history had proved to them” ....................................................  Dot-com crash: “Lay on more risk” .....................................................................  The wages of finance: “Well, this one’s doing it, so how can I not do it?” .............  Financial sector growth: “I think we overdid finance versus the real economy” ...................................  EXPANSION OF BANKING ACTIVITIES: “SHATTERER OF GLASS STEAGALL” By the mid-s, the parallel banking system was booming, some of the largest commercial banks appeared increasingly like the large investment banks, and all of them were becoming larger, more complex, and more active in securitization. Some academics and industry analysts argued that advances in data processing, telecom- munications, and information services created economies of scale and scope in fi- nance and thereby justified ever-larger financial institutions. Bigger would be safer, the argument went, and more diversified, innovative, efficient, and better able to serve the needs of an expanding economy. Others contended that the largest banks were not necessarily more efficient but grew because of their commanding market positions and creditors’ perception they were too big to fail. As they grew, the large banks pressed regulators, state legislatures, and Congress to remove almost all re- maining barriers to growth and competition. They had much success. In  Con- gress authorized nationwide banking with the Riegle-Neal Interstate Banking and Branching Efficiency Act. This let bank holding companies acquire banks in every state, and removed most restrictions on opening branches in more than one state. It preempted any state law that restricted the ability of out-of-state banks to compete within the state’s borders.  Removing barriers helped consolidate the banking industry. Between  and ,  “megamergers” occurred involving banks with assets of more than  bil- lion each. Meanwhile the  largest jumped from owning  of the industry’s assets  to . From  to , the combined assets of the five largest U.S. banks—Bank of America, Citigroup, JP Morgan, Wachovia, and Wells Fargo—more than tripled, from . trillion to . trillion.  And investment banks were growing bigger, too. Smith Barney acquired Shearson in  and Salomon Brothers in , while Paine Webber purchased Kidder, Peabody in . Two years later, Morgan Stanley merged with Dean Witter, and Bankers Trust purchased Alex. Brown & Sons. The assets of the five largest investment banks—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns—quadrupled, from  trillion in  to  tril- lion in .  CHRG-109shrg24852--120 RESPONSE TO A WRITTEN QUESTION OF SENATOR CORZINE FROM ALAN GREENSPANQ.1. This morning, the Senate Agriculture Committee is marking up legislation reauthorizing the Commodities Futures Trading Commission. The proposed legislation would modify the Commodity Futures Modernization Act (CFMA) of 2000, which, as you know, this Committee and Agriculture jointly worked on to develop. That effort was based on recommendations from the President's Working Group (the Federal Reserve, Treasury, SEC, and CFTC) on Financial Markets. Yesterday, you expressed concerns to Agriculture Committee Chairman Chambliss about the legislation in response to a letter from Senator Crapo. Those concerns seem to revolve around the fact that the President's Working Group has not had the opportunity to review or deliberate key proposals contained in the draft reauthorization legislation. SEC Acting Chairman Glassman has expressed a similar concern, and Chairman Shelby and Ranking Member Sarbanes have done so as well. As you know, of major concern with the draft legislation are the provisions that would modify portions of the CFMA that were painstakingly crafted to balance the differing interests of all Federal financial regulators. I wonder if you could discuss more in depth the nature of the concerns you expressed in your letter and what specific harm could come from Congressional action that, done in haste, could disrupt the balance and legal certainty the CFMA struck which has aided the development of important financial markets and reaped significant benefits for the broader economy?A.1. The Federal Reserve Board believes the CFMA has unquestionably been a successful piece of legislation. It enacted provisions that excluded transactions between institutions and other eligible counterparties in over-the-counter financial derivatives and foreign currency from regulation under the Commodity Exchange Act (CEA). This exclusion resolved long-standing concerns that a court might find that the CEA applied to these transactions, thereby making them legally unenforceable. Another important part of the CFMA addressed problems associated with ``bucket shops'' that were marketing foreign currency futures to retail customers (that is, an individual or business that does not meet the definition of eligible counterparty). The legislation marked up by the Senate Agriculture Committee in July 2005 would apply the CEA as a whole to certain retail foreign currency contracts, regardless of whether they are futures contracts. We seriously question whether it is necessary to apply all the provisions of the CEA to these transactions in order to enable the CFTC to address fraud, and believe that a broad application of the Act could have unintended consequences." fcic_final_report_full--102 SUBPRIME LOANS:  “BUYERS WILL PAY A HIGH PREMIUM ” The subprime market roared back from its shakeout in the late s. The value of subprime loans originated almost doubled from  through , to  billion. In ,  of these were securitized; in , .  Low interest rates spurred this boom, which would have long-term repercussions, but so did increasingly wide- spread computerized credit scores, the growing statistical history on subprime bor- rowers, and the scale of the firms entering the market. Subprime was dominated by a narrowing field of ever-larger firms; the marginal players from the past decade had merged or vanished. By , the top  subprime lenders made  of all subprime loans, up from  in .  There were now three main kinds of companies in the subprime origination and securitization business: commercial banks and thrifts, Wall Street investment banks, and independent mortgage lenders. Some of the biggest banks and thrifts—Citi- group, National City Bank, HSBC, and Washington Mutual—spent billions on boost- ing subprime lending by creating new units, acquiring firms, or offering financing to other mortgage originators. Almost always, these operations were sequestered in nonbank subsidiaries, leaving them in a regulatory no-man’s-land. When it came to subprime lending, now it was Wall Street investment banks that worried about competition posed by the largest commercial banks and thrifts. For- mer Lehman president Bart McDade told the FCIC that the banks had gained their own securitization skills and didn’t need the investment banks to structure and dis- tribute.  So the investment banks moved into mortgage origination to guarantee a supply of loans they could securitize and sell to the growing legions of investors. For example, Lehman Brothers, the fourth-largest investment bank, purchased six differ- ent domestic lenders between  and , including BNC and Aurora.  Bear Stearns, the fifth-largest, ramped up its subprime lending arm and eventually ac- quired three subprime originators in the United States, including Encore. In , Merrill Lynch acquired First Franklin, and Morgan Stanley bought Saxon Capital; in , Goldman Sachs upped its stake in Senderra Funding, a small subprime lender. Meanwhile, several independent mortgage companies took steps to boost growth. CHRG-111hhrg63105--98 Mr. Luetkemeyer," I see as my time runs out here I just want to make one comment. And, Mr. Chilton, you made this earlier, that the intent is to protect the markets for their original purpose. And I sincerely hope that you continue to use that as your guiding thought in all of your deliberations. Because, to me, that is why we are here today, is to protect these markets for the original intent of the farmers and original commodity folks to be able to use these things, to use them to enhance their businesses and their ability to do business. It is not a speculative forum that we are worried about here. It is the original folks who use these things to manage their businesses. So that would be my only comment and my only concern and my wish to you. Thank you. And, Mr. Chairman, I yield back. " fcic_final_report_full--180 Clayton Holdings, a Connecticut-based firm, was a major provider of third-party due diligence services.  As Clayton Vice President Vicki Beal explained to the FCIC, firms like hers were “not retained by [their] clients to provide an opinion as to whether a loan is a good loan or a bad loan.” Rather, they were hired to identify, among other things, whether the loans met the originator’s stated underwriting guidelines and, in some measure, to enable clients to negotiate better prices on pools of loans.  The review fell into three general areas: credit, compliance, and valuation. Did the loans meet the underwriting guidelines (generally the originator’s standards, some- times with overlays or additional guidelines provided by the financial institutions purchasing the loans)? Did the loans comply with federal and state laws, notably predatory-lending laws and truth-in-lending requirements? Were the reported prop- erty values accurate?  And, critically: to the degree that a loan was deficient, did it have any “compensating factors” that offset these deficiencies? For example, if a loan had a higher loan-to-value ratio than guidelines called for, did another characteristic such as the borrower’s higher income mitigate that weakness? The due diligence firm would then grade the loan sample and forward the data to its client. Report in hand, the securitizer would negotiate a price for the pool and could “kick out” loans that did not meet the stated guidelines. Because of the volume of loans examined by Clayton during the housing boom, the firm had a unique inside view of the underwriting standards that originators were actually applying—and that securitizers were willing to accept. Loans were classified into three groups: loans that met guidelines (a Grade  Event), those that failed to meet guidelines but were approved because of compensating factors (a Grade  Event), and those that failed to meet guidelines and were not approved (a Grade  Event). Overall, for the  months that ended June , , Clayton rated  of the , loans it analyzed as Grade , and another  as Grade —for a total of  that met the guidelines outright or with compensating factors. The remaining  of the loans were Grade .  In theory, the banks could have refused to buy a loan pool, or, indeed, they could have used the findings of the due diligence firm to probe the loans’ quality more deeply. Over the -month period,  of the loans that Clayton found to be deficient—Grade —were “waived in” by the banks. Thus  of the loans sampled by Clayton were accepted even though the company had found a basis for rejecting them (see figure .). Referring to the data, Keith Johnson, the president of Clayton from May  to May , told the Commission, “That  to me says there [was] a quality control issue in the factory” for mortgage-backed securities.  Johnson concluded that his clients often waived in loans to preserve their business relationship with the loan originator—a high number of rejections might lead the originator to sell the loans to a competitor. Simply put, it was a sellers’ market. “Probably the seller had more power than the Wall Street issuer,” Johnson told the FCIC.  The high rate of waivers following rejections may not itself be evidence of some- thing wrong in the process, Beal testified. She said that as originators’ lending guide- lines were declining, she saw the securitizing firms introduce additional credit fcic_final_report_full--228 With over  metro areas representing nearly one-half of the na- tion’s housing stock experiencing or about to experience price declines, national house prices are also set to decline. Indeed, odds are high that national house prices will decline in .  For , the National Association of Realtors announced that the number of sales of existing homes had experienced the sharpest fall in  years. That year, home prices declined . In , they would drop a stunning . Overall, by the end of , prices would drop  from their peak in .  Some cities saw a particularly large drop: in Las Vegas, as of August , home prices were down  from their peak. And areas that never saw huge price gains have experienced losses as well: home prices in Denver have fallen  since their peak. In some areas, home prices started to fall as early as late . For example, in Ocean City, New Jersey, where many properties are vacation homes, home prices had risen  since ; they topped out in December  and fell  in the first half of . By mid-, they would be  below their peak. Prices topped out in Sacramento in October  and are today down nearly . In most places, prices rose for a bit longer. For instance, in Tucson, Arizona, prices kept increasing for much of , climbing  from  to their high point in August , and then fell only  by the end of the year.  One of the first signs of the housing crash was an upswing in early payment de- faults—usually defined as borrowers’ being  or more days delinquent within the first year. Figures provided to the FCIC show that by the summer of , . of loans less than a year old were in default. The figure would peak in late  at ., well above the . peak in the  recession. Even more stunning, first payment de- faults—that is, mortgages taken out by borrowers who never made a single payment— went above . of loans in early .  Responding to questions about that data, CoreLogic Chief Economist Mark Fleming told the FCIC that the early payment de- fault rate “certainly correlates with the increase in the Alt-A and subprime shares and the turn of the housing market and the sensitivity of those loan products.”  Mortgages in serious delinquency, defined as those  or more days past due or in foreclosure, had hovered around  during the early part of the decade, jumped in , and kept climbing. By the end of , . of mortgage loans were seriously delinquent. By comparison, serious delinquencies peaked at . in  following the previous recession.  Serious delinquency was highest in areas of the country that had experienced the biggest housing booms. In the “sand states”—California, Arizona, Nevada, and Florida—serious delinquency rose to  in mid- and  by late , double the rate in other areas of the country (see figure .).  CHRG-111hhrg53021Oth--120 Mr. Neugebauer," Thank you, Mr. Chairman. Thank you, Mr. Secretary, for coming. We had a little bit of a dialogue, the other night, about capital and equity, and I want to go back to that. Because when we look at the standardized and the customized transactions, the question I have is--I hear you talking about margin requirements, capital equity. In traditional commodities, the clearinghouses set the margins for clearing those transactions. The regulator then determines whether the clearing agency has adequate capital for the activities they are involved in. As we move to the trading of these derivatives, do you see that same structure? Because, sometimes, I hear you saying that the regulator would start setting the margin requirements for these transactions. And I wanted to be clear about my understanding of where you are on that issue. " CHRG-111hhrg53021--120 Mr. Neugebauer," Thank you, Mr. Chairman. Thank you, Mr. Secretary, for coming. We had a little bit of a dialogue, the other night, about capital and equity, and I want to go back to that. Because when we look at the standardized and the customized transactions, the question I have is--I hear you talking about margin requirements, capital equity. In traditional commodities, the clearinghouses set the margins for clearing those transactions. The regulator then determines whether the clearing agency has adequate capital for the activities they are involved in. As we move to the trading of these derivatives, do you see that same structure? Because, sometimes, I hear you saying that the regulator would start setting the margin requirements for these transactions. And I wanted to be clear about my understanding of where you are on that issue. " CHRG-111shrg54789--189 RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD FROM TRAVIS B. PLUNKETTQ.1. Both Mr. Yingling and Mr. Wallison testified repeatedly that the Administration's plan would result in credit being rationed to consumers, particularly consumers who need the credit the most. They also argued that the requirement that additional disclosures or warnings accompany products that are not ``plain-vanilla'' products would result in only those standard products being offered. Specifically, Mr. Wallison testified that `` . . . when a provider is confronted with the choice of whether to offer only the plain-vanilla product or the more complex product, he has to decide whether this particular consumer is going to be able to understand the product.'' Because lenders will be reluctant to make such judgments, they will, by default, offer the plain-vanilla product only, thereby constraining consumer choices. How do you respond to these arguments?A.1. Poor regulation of abusive credit products by Federal regulators over many years has led to exactly the result that Mr. Yingling and Mr. Wallison are concerned about: credit rationing. Deceptive and unsustainable lending practices by credit card companies and mortgage lenders led to record defaults and foreclosures by consumers, record losses by lenders, a crisis in the housing markets and the recession. These developments, in turn, have led to a ``credit crunch'' where credit card lenders, for example, have significantly reduced credit lines and sharply increase interest rates, even for borrowers with stellar credit scores. Had a Consumer Financial Protection Agency existed to prevent the excesses that occurred in the lending markets, there is a very good chance that this country could have avoided the worst aspects of the housing and economic crisis, and of the somewhat indiscriminate reduction in credit availability that has occurred. In other words, proper regulation will create the kind of stability in the credit markets that encourages lenders to offer credit to consumers, especially those who do not have perfect credit ratings. Similarly, the ``plain-vanilla'' requirement is designed to create choices in the credit marketplace that don't exist now, and certainly did not exist during the credit boom. ``Choices,'' such as prepayment penalties that lock consumers into unaffordable loans and ``exploding ARM'' loans that lenders knew many of their borrowers could not afford, crowded out less abusive options from the marketplace and ultimately harmed consumers and the economy. Lenders are quite capable of designing simple, understandable financial products that are profitable for them and useful for consumers, if they chose to do so." FOMC20080130meeting--269 267,CHAIRMAN BERNANKE.," I don't think so. I would just point out that with the 1990-91 episode, inflation after the recession--after the whole episode was over--was significantly lower than in the period before it. So if there are headwinds that are bringing the economy below potential and are causing high unemployment, for example, there has to be a mechanism. Expectations have to be tied to something, and there has to be some way in which excessively low interest rates are stimulating inflation, through either commodity prices or wage pressures or some other mechanism. If those pressures aren't there because of headwinds or some other factor, then unusually low interest rates will not by themselves create inflation. Vice Chairman, did you have anything else you wanted to add? " FOMC20080430meeting--112 110,MR. KOHN.," Thank you, Mr. Chairman. My forecasts of output and inflation for this and the next two years are in the central tendencies of the Committee forecasts. My Okun's law machine went haywire under the pressure of Debbie's deadline, [laughter] so my unemployment forecasts need to be revised. But I hit the 5:00 deadline, I think. I have stronger growth in 2008 than the Greenbook because I was hesitant to adopt the staff's assumption about persistent, serially correlated downside misses relative to fundamentals in consumption and investment implied by entering a recessionary period when we haven't seen those misses yet. But I didn't discount this possibility entirely, reasoning that the extraordinarily depressed business and household sentiment was significant. I came out between the Greenbook baseline and the ""nearterm upside risk"" alternative scenario. Despite slightly stronger growth than in the Greenbook, I have roughly the same headline and core inflation paths that are declining gradually through the next few years. I took some slight encouragement from recent better readings on core. I reasoned that flat commodity prices would reverse any recent tendency for inflation expectations to rise, and I anticipate that vacant housing units will continue to put downward pressure on rent increases. I have a couple of observations on the outlook. First, I think the expectation of improving financial conditions is critical to the favorable medium-term outcome for the economy that President Geithner was just talking about. We don't really know what the current state of overall financial conditions is and how spending is likely to respond to them. Directionally, I think we can say that the severe deterioration that was much in evidence around the time of the last meeting has stopped, as concerns about an even more generalized set of failures--the seizing up of markets and lending--have abated with our actions and with successful capital-raising by intermediaries. We have seen improvements in many segments of the markets, but continued deterioration in term funding suggests to me that there are continued worries about and pressures on credit availability, and credit availability and the cost of credit will be under some pressure as credit is re-intermediated through the banks. Even with some of the recent gains, markets are still fragile and impaired. Spreads have retraced only a small portion of the run-up since last summer. I noticed in Bill's charts that most of those spreads are back down to, say, those in January; and in January, we thought the markets were pretty impaired. So they are still very, very high by historical standards. Mortgage securitization markets away from GSEs remain broken. There are problems in some other securitization markets, including CMBS. A number of intermediate- and longer-term interest rates are still higher than they were before the crisis hit in August. Baa corporate bonds, which is about the median borrower rating for a corporation, long-term muni bonds, and prime jumbo mortgages are all higher than before we did any easing. Nonprice terms and standards are being tightened considerably, judging in part from the Senior Loan Officer Opinion Survey, and I think that process is likely to continue for a while. To be sure, short-term interest rates are a lot lower than they were in August. But I suspect that a continuation of current conditions would not be consistent with much of a pickup in growth and an eventual return toward full employment. This is a circumstance in which relationships between the federal funds rate and other measures of financial conditions have changed very, very substantially, and characterizing the stance of policy and financial conditions by looking at some measure of the real federal funds rate can be quite misleading in these circumstances. I think we need to be careful about how we characterize and think about the stance of policy. The sense that it is neutral right now, much less accommodative, depends very much on our expectations of substantial increases in risk-taking in financial markets. Now, I do think that the most likely path is improving financial market conditions, lower spreads, reopened securitization markets, and stabilization and maybe partial reversal of some of the tighter terms that have evolved. But this process is going to be slow. Until the housing market shows more signs of stabilizing, it is more likely to be subject to backsliding than to sudden unexpected improvements. A corollary to this line of thinking is that there isn't a lot of ease in the pipeline in the conventional sense. Our reductions in the fed funds rate have not eased financial conditions. They have kept them from tightening even more than they would have done otherwise. The lagged effects of policy easing come from improvements in financial markets. That is, as we look forward, the lagged effects of policy easing come from the improvements in financial markets that allow the reductions in the actual and expected paths of short-term rates to show through to the cost of capital more broadly defined. This is a longer and more nuanced process than the usual rules of thumb about seeing the effects of ease on output after X quarters and inflation after Y quarters. My second point about the outlook is that the risks around my forecast for growth are still to the downside. Uncertainty is huge. We are sailing in a fog in uncharted waters, and the depth finder is on the fritz. So much for sailing analogies. [Laughter] Too bad Bill Poole is not here, though I am glad Jim is here. Let me note that for the record. [Laughter] Downside risks from financial market meltdown have been reduced, though not eliminated. But I think an important source of downside risk now is the economy itself--the threat of recessionary tendencies taking hold. I am told we have never had three months of substantial employment declines and business and household sentiment as depressed as they are right now without sliding into a recession. Businesses and households have been unusually cautious in how they invest their savings, moving into government-only money funds and bank deposits, boosting M2, and demanding much larger compensation for taking risks. They are facing much tighter terms for their credit and uncertainty about its availability. It seems to me there is a reasonable possibility that this extraordinary caution in managing their financial portfolios and uncertainty about credit availability will carry over into their spending decisions. That is not my projection or apparently the central tendency of the Committee, but it must be a significant downside risk. In contrast, the risk to total inflation seems skewed to the upside by the potential behavior of commodity prices. I don't understand why these prices have risen so much over the last six months or so. To be sure, over the last several years the rise in prices must have reflected increasing demand in emerging-market economies, but over the past half-year the prospects for global growth have weakened. In those circumstances, I would expect the effects of lower interest rates--say, in the United States--to be offset by weaker demand. Still, prices have risen. The possibility that those types of surprises will continue poses an upside risk to headline inflation and, along with that, a risk to inflation expectations. Nonetheless, I saw the risk around a gradual downtrend in core inflation as about balanced, with the possibility of greater slack offsetting the possibility of higher commodity prices. I take some comfort in my projection for core inflation and implicitly for the more persistent aspects of overall inflation from the continued moderate increases in labor compensation. Those increases have been moderate for some time despite very high headline inflation for several years along with still-elevated markups for nonfinancial businesses. Outside of commodities, cost pressures appear to be muted, and businesses are able to absorb increases. Still, I agree that commodity price increases, like any supply shock, have complicated our choices. We are facing a sluggish economy with downside risks as well as uncomfortably high total inflation that is feeding through to some limited extent into core inflation and, by some measures, into inflation expectations, especially near-term expectations. I do think, however, that we need to keep in mind that the higher inflation is largely a function of these commodity prices rather than a broad acceleration in overall prices. Core inflation has come in less than we anticipated it would. I also take some comfort, relative to some of the tone I have heard around the table, in what has happened in markets over the intermeeting period. Markets have built in another � point decline in the fed funds rate but then an increase further out. So somehow they are taking this promise of an increase seriously. At the same time they did that, the dollar rose--it didn't fall--and the long-term inflation compensation built into markets came down. So I don't see the evidence in financial markets that we are on the cusp of the broad decline in our credibility that I have sensed that some others see around the table. Thank you, Mr. Chairman. " FOMC20070131meeting--39 37,MR. DUDLEY.," As you know, this topic is undergoing a lot of further research. The academic literature that I’ve surveyed has yet to uncover a strong causal relationship between a climb in speculative open interest and the effect on price. One reason that is hard to imagine happening to a powerful degree in the end is that the speculators really don’t want to take actual delivery of the physical commodity, and so the price really should clear in the spot market on what’s happening to underlying supply and demand. But this topic certainly remains under investigation by a number of researchers. I don’t think we have the definitive answer to the question at this point." CHRG-111hhrg74855--224 Mr. Markey," Thank the gentleman very much. I would just like to ask one final question and then we will move to the next panel. Ask this of Chairman Gensler, if the CFTC is doing an antifraud or anti-manipulation investigation of oil futures trading on the New York Mercantile Exchange and you believe that part of the fraudulent scheme may have involved wrongdoing in the cash market, you have the power under the Commodities Exchange Act to extend your investigation to cover that part of the fraud and you wouldn't want the Congress to deny the CFTC the power to look at transactions in both the NYMEX futures market and the cash market in your own investigation, is that correct? " CHRG-109shrg24852--118 RESPONSE TO A WRITTEN QUESTION OF SENATOR REED FROM ALAN GREENSPANQ.1. I mentioned in my opening remarks the study by the Boston Federal Reserve with respect to labor participation, which suggests there is a significant and growing lack of participation in the labor force which distorts our ability to see how well we are doing with respect to recoveries. In fact, one thing that I found interesting was the ratio of employment to population, 62.7 percent, is below the level at the start of the economic recovery in November 2001. And this is the first time the ratio has failed to surpass its trial level so far into a recovery. Can you comment?A.1. At my July 21 testimony before the Senate Banking Committee, you asked if I could provide additional detail concerning the Board staff's assessment of recent developments in labor force participation and their implications for the interpretation of the unemployment rate as a measure of slack in the labor market. As I noted in my response at the hearing, while cyclical factors likely have contributed to the weak recovery in labor force participation, our staff estimates that part of that weak performance in recent years can also be traced to a downtrend in the underlying rate of participation. The change in the overall trend has occurred both because the trend in the participation of adult women appears to have flattened out and because the large baby boom cohorts are moving into the age range in which their labor force participation will likely drop off sharply as many workers in these cohorts retire. More specifically, we estimate that the underlying trend in the participation rate has fallen from a little more than 66\1/2\ percent of the civilian working-age population in 2001 to about 66\1/4\ percent this year. Because the participation rate in recent months has averaged just over 66 percent, we estimate that the implied cyclical shortfall in participation equates to a few tenths of a percentage point on the unemployment rate. Our estimates are broadly similar to those of the Congressional Budget Office. Differences between our estimates and those reported in the Boston Fed study that we discussed at my hearing primarily reflect different views about the evolution of trends in participation for various demographic groups and different ways to measure the size of the current participation shortfall. In particular, the Boston Fed study examines a range of alternative trajectories for participation rates for women and older workers and calibrates the size of the estimated current shortfall as a percentage of the labor force. Of course, all such estimates are subject to considerable uncertainty, and our understanding of the relationship between labor force participation and labor market slack will undoubtedly benefit from additional research on this topic. CHRG-111hhrg63105--236 The Chairman," Thank you very much. And we do appreciate your coming. Our purpose today was to try to shed a little daylight on what is going on at this moment, the importance it is to our economy and all that goes on in the different markets. I think it has been a good day. We have learned and got the insight of the Chairman and all the Commissioners and some of the needs that you have. And we want to invite you to continue to be in contact with us, and I am sure you will. So with that, I thank you again. I wish you a great holiday and we look forward to seeing you, if not before, at least next year. Thank you so much. Under the rules of the Committee, the record of today's hearing will remain open for 10 calendar days to receive additional materials and supplementary written response from a witness to any questions posed by a Member. The hearing of the Subcommittee on General Farm Commodities and Risk Management is adjourned. [Whereupon, at 12:20 p.m., the Subcommittee was adjourned.] " CHRG-109shrg30354--92 Chairman Bernanke," I think certainly an important part of what has happened has been the increases in energy and commodity prices. That has directly added to total inflation, and now we are seeing it passing through, to some extent, to core inflation. I think if energy prices were $40, I think things would be much better. I would say that. Whether policy has been optimal or not, I really cannot judge. Certainly, along with fiscal stimulus and other measures we did succeed in getting the economy back on a strong growth track in the middle of 2003. And we have seen 3 years of strong growth. It took a while for jobs to come back but eventually the labor market also began to improve. Senator Sununu. When you say I cannot judge, is that because you are not technically suited to do that evaluation? Or because you do not think it would be productive in your current occupation? " CHRG-110shrg50416--96 Mr. Montgomery," Well, that is one of ten things that wake us all up in the middle of the night. The reason why FHA didn't take part in the boom, there are a lot of them. One is we did not lower our underwriting criteria. We had this crazy notion that people should verify their income. They should produce tax returns. They needed to have atleast 2 years with their current employer. And we have not lowered those standards. And our ratios, our front-end ratios, our back-end ratios exist for a reason. I think because of that, I think you will see FHA continue to perform admirably over here on the long term. If I could just interject one thing here real quick, sir, on the servicing, FHA, and I referenced this number before, the last 3 years, we have saved 300,000 FHA borrowers from foreclosure, 300,000. That is a number you have not read anywhere. You don't see that, and it is because our loss mitigation program, which Congress put into place 10 years ago, is working, and the main reason it works is because we require it. Lenders and servicers know this. The borrowers know this. The investors know this. They are required to do loss mitigation. If they don't do that, they face treble damages from FHA and I think that is one of the keys to why this has been successful. You have not read about those borrowers going to foreclosure because they have not been. Senator Corker. Thank you, and if I could just--we have all traveled a long ways to be here and we thank you for having this hearing. Mr. Kashkari, I have to tell you that the concern about the--first of all, thank you for what you are doing and I appreciate the conversations that we have had. I do think the concern about the loans is somewhat unfounded. I mean, at the end of the day, people are paying 5 percent for this money. I know it raises at some point to 9 percent. At some point, the banks have to make a profit. I mean, they can't just hoard cash. I mean, it is pretty self-evident, is it not, that the way that money is going to be made is lending that money, and while there may be an initial hoarding, at some point, this money has to go out. Otherwise, these enterprises are not making money. I mean, that is just sort of self-evident. I wonder if you could just take maybe 10 seconds to address that issue. It concerns me. Obviously, I supported this measure and was involved in it. One of the things in the back of my mind was, once the camel nose goes under the tent and you get a bunch of Senators and a bunch of House members involved in the business of banking, all of a sudden, we are telling the banks what to do, which, let us face it, part of our problem with Fannie and Freddie, and I don't want to go into that now, we will deal with it after the election, but was that very thing, OK. And so I am very concerned about us making prescriptive arrangements with these banks. I don't think you are going to get many participants in that regard, but we are going to destroy our banking system if we do that. I appreciate the balance you are trying to create, but is it not self-evident that with paying for these through dividends--it is basically a loan, let us face it, that they can show as equity--they have got to make loans to make money and be in business. Is that a yes or no answer? " CHRG-109hhrg31539--125 Mr. Bernanke," Well, Congressman, as you point out, there is uncertainty. We have a baseline forecast which assumes that energy prices don't do another big increase, that expectations remain contained, as they appear to be currently. We have talked about the cost side of labor costs, which seem not at this point to be a problem from a cost perspective. So from all that perspective, again, we have the baseline forecast that the inflation will gradually decline over the next couple of years. At the same time, we talk about risks, and we think there are some risks. The risk that I talk about in my testimony is that, given the tightening of markets, product markets in particular, that some firms may be better able to pass through those energy and commodity prices that you mention, and that that might become possibly embedded in the expectations of the public. So we do see some upside risks, and we have to take that into account as we make policy. " CHRG-111hhrg52397--54 Mr. Pickel," I would also reference back to this whole discussion about legal certainty. The Act passed by Congress, the Commodity Futures Modernization Act in 2000, provided that legal certainty and Secretary Geithner's letter makes it very clear, and you have heard from the panelists today, that we should not tinker with that legal certainty. In that situation, if the wrong decision had been made, the business would have almost by necessity had to move elsewhere. Here we are talking about aspects of regulation, it may on the margin increase the cost, it may in some cases decrease the costs. That will be a calculation in the decision as to where a transaction might be traded or booked, but we are not talking about undermining the fundamental enforceability. " FOMC20080430meeting--75 73,MR. STOCKTON.," Your intuition on that last point is correct. Obviously, in that simulation we have inflation expectations deteriorate a little more from where we think they have deteriorated already over the past year or so. Again, this is really hard to pin down, but we think there has probably been an increase of maybe � percentage point in longer-term inflation expectations over the last couple of years in the context of this step-up in headline inflation and the higher commodity prices that are associated with that increase. So in the simulation, we're basically assuming that the process continues: If you have another year or two of high headline inflation, you may get additional deterioration of inflation expectations on the order of � percentage point. You're right that, if expectations truly became unhinged and people began to view the entire inflation process as generating some greater upward momentum, it would have implications both for inflation and-- " FinancialCrisisReport--305 Moody’s staff, however, had raised concerns about personnel shortages impacting their work quality as early as 2002. A 2002 survey of the Structured Finance Group staff reported, for example: “[T]here is some concern about workload and its impact on operating effectiveness. … Most acknowledge that Moody’s intends to run lean, but there is some question of whether effectiveness is compromised by the current deployment of staff.” 1182 Similar concerns were expressed three years later in a 2005 employee survey: “We are over worked. Too many demands are placed on us for admin[istrative] tasks ... and are detracting from primary workflow .... We need better technology to meet the demand of running increasingly sophisticated models.” 1183 In 2006, Moody’s analyst Richard Michalek worried that investment bankers were taking advantage of the fact that analysts did not have the time to understand complex deals. He wrote: “I am worried that we are not able to give these complicated deals the attention they really deserve, and that they (CS) [Credit Suisse] are taking advantage of the ‘light’ review and the growing sense of ‘precedent’.” 1184 Moody’s managers and analysts interviewed by the Subcommittee stated that staff shortages impacted how much time could be spent analyzing a transaction. One analyst responsible for rating CDOs told the Subcommittee that, during the height of the boom, Moody’s analysts didn’t have time to understand the complex deals being rated and had to set priorities on what issues would be examined: “When I joined the [CDO] Group in 1999 there were seven lawyers and the Group rated something on the order of 40 – 60 transactions annually. In 2006, the Group rated over 600 transactions, using the resources of approximately 12 lawyers. The hyper-growth years from the second half of 2004 through 2006 represented a steady and constant adjustment to the amount of time that could be allotted to any particular deal’s analysis, and with that adjustment, a constant re-ordering of the priority assigned to the issues to be raised at rating Committees.” 1185 1181 Id. at 97. 1182 5/2/2002 “Moody’s SFG 2002 Associate Survey: Highlights of Focus Groups and Interviews,” Hearing Exhibit 4/23-92a at 6. 1183 4/7/2006 “Moody’s Investor Service, BES-2005: Presentation to Derivatives Team,” Hearing Exhibit 4/23-92b. 1184 5/1/2006 email from Richard Michalek to Yuri Yoshizawa, Hearing Exhibit 4/23-19. 1185 Prepared statement of Richard Michalek at 20, April 23, 2010 Subcommittee hearing. FOMC20080130meeting--278 276,MR. PLOSSER.," Thank you, Mr. Chairman. Since September, this Committee has lowered the federal funds rate 175 basis points. My estimate is that the real funds rate before any action today is 1 percent or slightly below that, and that is very low by historical standards. The slowdown in growth suggests that the equilibrium real rate really has fallen, and the Committee has appropriately allowed the nominal funds rate to fall as well. Do nominal rates need to go lower and, if so, about how much? Part of this depends on what you think the equilibrium real rate of the economy is now. The Bluebook indicates that estimates of r* vary considerably by the model and the process they use to calculate them. The 70 percent confidence interval around them is 3 percentage points. Moreover, the estimates of r*, as we talked a bit about yesterday, can be quite volatile. It troubles me that the estimate of r* consistent with the Greenbook has changed by 140 basis points from December to today. I am uncomfortable using an estimate that is so variable and so sensitive to stock markets as a guide to setting policy. I also want to note that the Bluebook indicates that the appropriate funds rate, based on a range of Taylor rule specifications, is anywhere from 40 to 120 basis points above where we currently are today. That includes forecast-based versions of the rule that rely on the weak forecast found in the Greenbook. While I don't want to suggest that such guidelines are definitive, they do suggest that the current level of the fed funds rate is clearly accommodative and that we have taken out insurance against downside risk. When do we stop taking out more insurance? If we do cut 50 basis points today, which is the amount the market is expecting, it would bring, to my mind, the real funds rate down to below � percent. That is based on expectations of about 2� percent inflation, which in fact may be conservative. To my way of thinking, that is a very accommodative policy by any standard. Moreover, I don't believe that enough time has elapsed for us to realize the full effect of the cuts that we have already put in place. I share President Hoenig's concern that only the market can solve many of the problems that we see out there, and we must give the market time and patience to do so. The last time real rates were this low was in 2003-04, when the real rate was in fact apparently negative. But that was different. Inflation was running around 1 percent or less, and our concern was possible deflation. Today, we are not worried about deflation in the near term. We are worried about inflation; inflation has been moving up. Lowering rates too aggressively in today's situation would seem to me a risky strategy, fueling inflation; possibly setting up the next boom-bust cycle, which I worry about; and delaying the recognition of losses on bank's balance sheets but not eliminating them. The main effect of the rate cut will be after the first half of the year, if the economy begins to recover. I think we need to be very cautious not to get carried away in our insurance strategies with lowering rates too much. In my view, we are on the verge of overshooting, and I worry about the broad range of consequences for our credibility and the expectations of our future actions such behavior may have. That is closely related to President Lacker's comments about what people interpret that behavior to mean about what we may do in future episodes. But two things are even more important, in my mind, about what we may do and what we do today. First, we need to be very careful about our communications and not to excessively reinforce the market's expectation that further rate cuts are coming. In particular, I would feel much more comfortable with supporting a moderate 25 or 50 basis point cut if the statement language today were more agnostic about the balance of risks, as I suggested in my memo before the meeting. The market interprets our saying that there are downside risks to growth as that we are planning to cut rates again. I do not think we should encourage those beliefs. I worry that the balance of risks portion of our statements has come to be a code for predicting the path of our federal funds rate. I think that is not a good position for us to be in, nor should we condone it. Given the Greenbook forecast, I don't believe that negative real rates are called for, and signaling further cuts clearly sends the message that negative real rates are on the way, if not already here. When our forecasts are released, the public will get our assessments of the risks in our outlook. We don't need to say anything more about it in the statement. That, of course, does not preclude us from cutting rates again if our forecast deteriorates further. But until it does, I am reluctant to encourage the perception that more rate cuts are forthcoming. Second, as I said in the last go-round, we need to be able to better understand how we are going to unwind these cuts that we have implemented as insurance against the macroeconomic effects and financial disruptions. Of course, this was the theme of the discussion we had before the go-round. Unwinding those cuts too slowly not only risks our credibility on inflation but also risks setting up the next boom�bust cycle. Hindsight, of course, is always 20/20, but as we discussed in Monday's videoconference, the Fed's being slow to raise rates back up after the deflationary scare was over in 2003 may indeed have contributed to the conditions we are facing today. Thus, it is crucially important, to my mind, that we do have a plan for unwinding the significant cuts we have implemented as insurance against the financial turmoil. If the market turmoil subsides, I believe this Committee needs to have clear signals as to what we are going to look at and what has to happen before we start to remove the accommodation. I believe that the Committee must undo the accommodation as aggressively as we put it in play. We need to determine what indicators we will be looking at to determine when that process should begin. When we know ourselves, we want to help the markets and public understand what our process will be as well. I strongly believe that we must be both credible and committed policymakers, and our communications must signal not a particular funds rate path but articulate and focus on the contingent nature of that path and help the public understand and appreciate the systematic part of our policies and our policy decisions. Thank you, Mr. Chairman. " CHRG-111hhrg51698--305 Mr. Taylor," Thank you. Thank you, Chairman Peterson, Ranking Member Lucas, and Members of the Committee. I am Gary Taylor, CEO of Cargill Cotton in Memphis, Tennessee; and I appear today here representing the members of the National Cotton Council, the American Cotton Shippers and AMCOT, which is a trade association of marketing cooperatives. In the past year, the cotton industry has undergone severe financial strain due to the unpredictable risk caused by a dysfunctional futures market. The March 2008, debacle and the ICE No. 2 Cotton Contract forced a number of first handlers into bankruptcy, while others have announced orderly closures. Traditional merchandising relationships have ceased, because price risks are too great for hedging purposes. Growers continue to be concerned about the financial viability of marketing entities with whom they have previously contracted. To ensure the survival of our marketing structure, the cotton futures market must be returned to its historical function of price discovery and risk management relative to real market conditions. As the cotton industry informed this Committee in 2008, investment funds and over-the-counter operatives flooded our futures markets with record amounts of cash. In our opinion, their presence distorted both the futures and physical markets. We believe the legislation before the Committee, the Derivatives Markets Transparency and Accountability Act of 2009, addresses these concerns raised by our industry and the agriculture sector and restores confidence of the commercial trade and lending institutions. It will facilitate market fundamentals, not speculative activity, resulting in accurate price discovery. The cotton industry acknowledges the importance of market liquidity and the essential function speculative interests perform in our commodity markets. In our view, by requiring full transparency and accountability of speculative trades, the proposed legislation would not discourage speculative participation in the commodity contracts. Market liquidity is essential, but it must be tempered and monitored, and it should not dictate the direction of the market. In the current regulatory structure, Congress's CFTC has imposed speculative position limits in our futures contracts to reduce the potential for market disruption or manipulation. Such limits are no longer effective for three reasons: first, hedge exemptions granted to investment funds allowed them to exceed the limit; second, large traders using swaps exemptions operate outside the regulatory framework altogether; and third, nontraditional trader's speculative limits are only imposed as these contracts go into convergence. The other significant area of concern is the exempt status afforded swaps transactions that are executed off-exchange with each party mutually agreeing to satisfy each other's credit standards, and to remit margins to one another as the underlying market fluctuates. Such transactions pose problems when one of the parties has a hedge exemption that exempts his or her on-exchange futures trading from position size limits. These arrangements, along with billions of dollars invested in index funds, has brought so much cash into our markets that the traditional speculators could not take a short position to match the institutional longs. This left it up to the commercials to offset these positions. But, lacking the necessary capital to meet the huge margin requirements, they could not do so. The result is a market with no economic purpose for the commercial traders. Simply put, the investment funds have negated the real purpose of our futures markets. In order to restore the integrity of the markets, and to ensure they fulfill the basic roles of price discovery risk management and hedging, the cotton industry has developed a number of recommendations that are incorporated into the legislation before the Committee. First, establish trading limits to prevent excessive speculation; second, subject all contract and over-the-counter market participants to speculative position limits; third, subject speculative entities to the same weekly reporting requirements as the trade; and finally, limit hedge exemptions and limit eligibility for hedge margin levels to those actually involved in the physical handling of our commodities. The cotton industry also believes that the lack of transparency and disparate reporting requirements by market participants is appropriately addressed by legislation requiring the CFTC to disaggregate index funds, and publish the number of positions and total value of the index funds and other passive, long-only, short-only investors and data on speculative positions relative to their bona fide physical hedges. And also to establish reporting requirements for index traders and swap traders in designated market contracts, derivative transaction execution facilities and all other trading areas. In addition to these necessary changes, the cotton industry feels strongly that the CFTC should require the IntercontinentalExchange and its clearinghouse members to adhere to the practice of margining futures to futures settlements and options to options settlements. Also, the cotton industry has an important caveat for both the Committee and the CFTC. We submit that no action should be taken to discourage over-the-counter transactions with legitimate commercial purposes, transactions that are transparent and have proven to be beneficial risk management tools. It is essential that we encourage commercial innovation for those producing, merchandising or using physical commodities traded in the futures market. In closing, I would like to stress restoring confidence in the futures markets is of the utmost importance, and we thank you for considering our views. [The prepared statement of Mr. Taylor follows:] Prepared Statement of Gary W. Taylor, CEO, Cargill Cotton Company, Cordova, TN; on Behalf of National Cotton Council; American Cotton Shippers Association; and AMCOT Chairman Peterson, Ranking Member Lucas, and Members of the Committee, I am Gary Taylor, CEO of Cargill Cotton Company in Cordova, Tennessee. Cargill Cotton is a division of Cargill, Incorporated, an international provider of food, agricultural and risk management products and services. We service growers, ginners, buyers and textile mills worldwide through our network of buying, selling and shipping offices and our cotton gins and warehouses. I appear today representing the members of the National Cotton Council, the American Cotton Shippers Association, and AMCOT, a trade association of marketing cooperatives. We appreciate your scheduling this week's hearing and the outstanding leadership you have provided this past year on this subject critical to farmers, marketers, processors and consumers of agricultural and energy products. The involvement of the Committee this past year exemplifies its interest and its willingness to effectively oversee the commodity futures markets and to address issues vitally important to the functioning of the U.S. economy.Impact of Futures Markets on Cotton Industry The sound and effective regulation of a transparent futures market would provide significant benefits to the cotton industry, which is concentrated in 17 cotton-producing states, stretching from Virginia to California with the downstream manufacturers of cotton apparel and home furnishings located in virtually every state. The industry and its suppliers, together with the cotton product manufacturers, account for more than 230,000 jobs in the U.S. The annual economic activity generated by cotton and its products in the U.S. is estimated to be in excess of $100 billion. In the past year, the cotton industry has undergone severe financial strain due to the uncertainty and unpredictable risk caused by a dysfunctional futures market. Coming to light is the damage of the March 2008 debacle in the ICE No. 2 Upland Cotton Contract as a number of first handlers have been forced into bankruptcy, several have announced orderly closures, and most have seen their assets dwindle to a critical level. Traditional merchandising relationships between growers and buyers have ceased because price risks are too great for short hedging purposes. Growers continue to be concerned about the financial viability of marketing entities with whom they have previously contracted crop sales. The inability of merchandisers to hedge their risks translates into a weaker basis and lower prices offered to the cotton producer. Each penny reduction in the price of cotton means that U.S. cotton farmers lose $85 million in revenue. Therefore, to insure the survival of our marketing structure, the cotton futures market must be returned to its historical function of price discovery and risk management relative to real market conditions.The Lesson Learned As the cotton industry and the agricultural complex informed this Committee in 2008, investment funds and over-the-counter (OTC) operatives flooded the futures markets with record amounts of cash, throwing the trading fundamentals out of balance, resulting in a widened basis, and thereby making these markets illiquid for those for whom Congress created these markets. The presence of large speculative funds and index funds in the energy and agricultural futures contracts distorted the futures and the physical or cash markets of these commodities. The abundance of unregulated cash allowed these funds to overwhelm these markets negating their primary purposes. Long before others in the Congress or the regulatory agencies recognized the problem or began to take action, the House Agriculture Committee had hearings underway and appropriate legislation before the Congress. Now, the leaders of the developed and developing world are calling for the U.S. to effectively regulate the commodity markets. We commend the Committee for that bipartisan foresight and believe that the legislation before the Committee, The Derivatives Markets Transparency and Accountability Act of 2009, would address the concerns raised by the cotton industry and the agricultural sector and restore the confidence of the commercial trade and the lending institutions. Above all, it will facilitate market fundamentals, not speculative activity, resulting in accurate price discovery in the futures markets.The Importance of Market Liquidity The cotton industry acknowledges the importance of market liquidity and the essential function the speculative interests perform in the commodity markets. We welcome that participation and do not wish to discourage it. In our view, the legislation before the Committee by requiring full transparency and accountability of speculative trades would not discourage speculative participation in the commodity contracts. Market liquidity is essential, but it must be tempered and monitored--it should not dictate the direction of the market.Speculative Position Limits and the Swaps Exemption In the current regulatory structure of the futures markets, Congress, through the CFTC, has imposed speculative positions limits in the futures contracts to reduce the potential for market disruption or manipulation. But such limits are no longer effective for three reasons: 1. The CFTC has granted Hedge Exemptions to the investment funds allowing them to exceed the limits; 2. Large traders were permitted by Congress, through the Swaps Exemption, to operate outside the regulatory framework altogether; and 3. Non-traditional traders speculative limits are only imposed as contracts go into convergence. The other significant area of concern is the exempt status afforded Swaps transactions that are executed off-exchange with each party mutually agreeing to satisfy each other's credit standards and to remit margins to one another as the underlying market fluctuates. Such transactions, however, pose problems when one of the parties to the Swap has a ``Hedge Exemption'' that exempts his or her on-exchange futures trading from position-size limits.\1\--------------------------------------------------------------------------- \1\ In such situations, the Swaps dealer would take an equal and opposite position in the futures market to the Swaps trade. For example, should a pension fund desire to purchase $20 million in long exposure in a commodity, it can purchase this exposure from a Swaps dealer. The dealer, now short the price of that commodity via the Swap, enters the futures market to hedge his position by buying futures in that commodity. Given that he is a ``hedger,'' the CFTC allows him to trade futures in excess of the normal speculative position-size limits. This has created a situation where such large investors can trade in any contract in any size they desire without regard to position limits. They are not limited by the CFTC. Only a Swaps dealer can limit such trades, and it is unlikely that a Swaps dealer would turn a deaf ear to a financial entity awash in cash.--------------------------------------------------------------------------- These arrangements, along with the billions of dollars invested in index funds, brought so much cash into the market that the traditional speculators could not take a short position to match the institutional longs. This left it up to the commercials to offset these positions. But lacking the necessary capital to meet the huge margin requirements, they could not do so. That has been the situation this past year as the funds continued to purchase futures. Unwilling to assume such margin risks in such a volatile futures market, the commercial traders were forced to remain passive not only in the futures, but in the physical markets as well. The result: markets with no economic purpose for the commercials. Therefore, no business was done. Producers, lacking a price, could not properly plan and processors had to buy hand to mouth. Simply put, the investment funds have negated the real purpose of the futures markets, causing severe disruptions in the marketing process.Cotton Industry Recommendations In order to restore the integrity of the futures and derivatives markets and to ensure that such markets function properly by providing price discovery and hedging thereby allowing producers and manufacturers to lock in prices and merchants and cooperatives to offer forward prices to producers and manufacturers, the U.S. cotton industry has developed a number of recommendations that are incorporated in The Derivatives Markets Transparency and Accountability Act of 2009. Congress should: Establish trading limits to prevent excessive speculation, Subject all contract and over-the-counter market participants to speculative position limits, Subject speculative entities to the same weekly reporting requirements as the trade, and Limit hedge exemptions and limit eligibility for hedge margin levels to those actually involved in the physical handling of the agricultural commodity. The cotton industry also believes that the lack of transparency and disparate reporting requirements by market participants is appropriately addressed by the legislation by requiring the CFTC to: Disaggregate index funds and publish the number of positions and total value of the index funds and other passive, long-only and short-only investors, and data on speculative positions relative to their bona fide physical hedges, and Establish reporting requirements for index traders and swap dealers in designated contract markets (exchanges), derivative transaction execution facilities and all other trading areas. In addition to these necessary changes, the cotton industry feels strongly that the CFTC should require the IntercontinentalExchange and its clearing house members to adhere to the practice of margining futures to futures settlements and options to options settlements. Also, the cotton industry has an important caveat for both the Committee and the CFTC. We submit that no action should be taken to discourage over-the-counter transactions with legitimate commercial purposes--transactions that are transparent and have proven to be beneficial risk management tools utilized by producers, merchants, and manufacturers. It is essential that we encourage commercial innovation for those producing, merchandising, manufacturing, or using the physical commodity traded in the futures markets. In closing, I would like to stress that restoring confidence in the futures market is of the utmost importance to our industry. Thank you for considering our views and recommendations during the development and consideration of this vitally important legislation. " FOMC20080805meeting--132 130,MR. KOHN.," Thank you, Mr. Chairman. Like others around the table, I made only small revisions to the central tendency of my forecast going forward as a result of the developments of the intermeeting period, maybe a slight reduction in the path of output and a quicker decline in headline inflation owing to the oil prices. But I think more important than any shift in central tendencies is the sense that the information tends to reinforce--to reduce the uncertainties around--the basic contours of a projection in which the economy operates with a wider output gap and a lower inflation rate on balance over the next 18 months or so than it has over recent quarters. About the output gap, the incoming information strongly suggests that we are on a trajectory that at least for some time will have the economy growing appreciably below the growth rate of its potential. The most obvious evidence is the persistence of a soft labor market--continuing declines in employment and no sign of near-term strengthening in the initial claims data. I agree that the declines in employment, as several of you have pointed out, are not consistent with a recession, but they're certainly not consistent with the economy growing close to its potential. You need another 150,000 or 200,000 jobs rather than minus 60,000, which is where we are now. So I think the economy is likely to grow below potential for some time. Even on the spending side, the decline in consumption in June, when rebate checks were continuing to hit bank accounts, and a further sharp drop in auto sales in July might be early signs that households are beginning to pull back under pressure from higher energy prices, job worries, declining house values, and reduced credit availability. To be sure, one month's consumption data along with auto sales, which are subject to all kinds of idiosyncratic influences, are not enough to justify a major change in outlook. But as President Lacker noted, household spending has for some time been a source of downside risk to the forecast. At some point, household spending could begin to reflect attitudes, and this information at a minimum seems to underline those risks as well as to point to sluggish growth of spending in the third quarter. Soggy economic news has extended to our trading partners, where actual activity and expected activity also have been marked down. The tone of news from abroad has been decidedly downbeat, as those economies feel the effect of weaker purchases from the United States, continuing financial strain, softening housing markets, and higher energy prices. Much as in the United States, attitudes abroad seem weaker than the data; but the euro area did report a record decline in retail sales in June this morning, and my sense is that our trading partners are facing larger downside risks to growth as well as a markdown of central tendencies. The dollar hasn't changed much on balance for four or five months now. With a stable dollar and weaker demand abroad, production in the United States will be getting a lot less cushion from net exports over the next few quarters than it did in the first half of the year. Finally, despite the downward movement in Treasury interest rates and in the expected federal funds rate path, financial conditions for households and businesses have tightened since the last FOMC meeting. Savers and intermediaries have become even more cautious amid concerns about deepening losses spreading beyond subprime mortgages, about the safety of uninsured deposits at regional banks, high volatility in markets, and the possible weakening of the underlying macro situation. Lenders are hunkering down to endure a long period of rising credit problems and great uncertainty. I don't think we need to rely on anecdotes here. Mortgage interest rates have actually risen on balance, as have corporate bond yields across many risk categories; and in many of these cases, the nominal interest rates are at least as high as or in some cases much higher than they were last August when the federal funds rate was at 5�. Banks continue to tighten terms and standards for nearly all categories of loans. Equity prices have fallen, adding to the downward pressure on wealth from declining house prices, and I think these developments underscore the very slow recovery likely in financial markets and the possible downside risks relative to even that very gradual improvement that many of us were expecting. The tightening of conditions is damping credit growth broadly defined and will constrain, at least to some extent, spending going forward, delaying the return to trend or above-trend growth. Thus although uncertainties remain quite elevated, I think we can be a little more confident that the economy will be subject to further quarters of below-trend growth and declining resource utilization. Furthermore, with housing prices still falling fast, inventories of homes still high, and financial markets quite skittish, the downside risks even to a slightly lower central tendency forecast remain high. Greater confidence that output will grow below potential for a time contributes to a little more optimism on my part that inflation will, indeed, come down substantially over the coming quarters. An environment of rising unemployment and declining capacity utilization is not one in which businesses or labor will find it easy to restore real incomes or raise profit margins after the increase in energy prices. With regard to that increase in energy and other commodity prices and how it affects headline inflation, I like to differentiate pass-through from spillover. I think we can expect passthrough. Pass-through to consumer prices of the higher energy and commodity prices is part of the adjustment process by which demand gets damped and by which consumers realize, unfortunately, the lower real income that they get from the adverse terms of trade. So the fact that businesses are able to pass through higher commodity prices and higher petroleum prices I don't find all that worrisome, provided that they're passing through a one-time increase in prices rather than a continuing rise. I think we have some further evidence that at least to date--things could change, I admit--what we are seeing is a pass-through of a one-time rise rather than some continuing increases. For one thing, commodity prices, as shown in Bill's chart, have flattened out or actually declined in the past few months. So presumably that pass-through is a one-time jump, if that's what they're doing, passing through those prices. Second, I think we saw in the GDP chain-type price indexes that the price of domestic value added increased at an annual rate of only 1.1 percent in the second quarter--which suggests to me that, at least through the second quarter, there was very little spillover from these higher commodity and energy prices to the stuff we produce here at home. Also, labor compensation growth, which could be a lagging indicator, at least to date hasn't increased. If anything, it has slowed a little further, which along with relatively robust productivity growth is holding down unit labor costs. Headline inflation--the goods and services that people purchase--has been high. Energy prices are being passed through, but I think to date there's no evidence or very little evidence that it's spilling over into other prices in the economy. So this is about the adjustment to relative prices. Obviously the decline in oil prices, if it holds, will be helpful on the inflation front, both in its direct effect on headline inflation and its indirect effect on inflation expectations. We finally have evidence of two-way risk in oil prices, and that should make us more comfortable with an assumption of stable prices as a reasonable basis for forecasting. Other recent contributors to higher price levels have also become less averse. As I mentioned, other industrial commodity prices have leveled out or declined, and the dollar has been relatively stable in recent months. Although I feel a little more confident about the expectation of lower inflation going forward, I agree that upside risks still prevail. Core inflation has ticked up. Headline inflation will be high for some time and could threaten to spill over through increases in inflation expectations. Oil and commodity price declines are largely an endogenous response to perceptions of weak growth, and if those perceptions turn around, so will those prices. Longer-term inflation expectations remain elevated by some measures and are probably less well anchored than they were a couple of years ago, before oil and commodity prices rose so much. In sum, I see upside risks to both the inflation gaps and the output gaps as having diminished over the intermeeting period, and we'll get to the implications of that for policy in the next part of the meeting. " CHRG-111hhrg63105--52 Mr. Chilton," There shouldn't be any exemptions from commercial. People that have an underlying interest in the physical commodity, whether or not it is a Swift or Cargill or just a normal farmer or independent petroleum producer, they should have exemptions. Other than that, there shouldn't be exemptions. Whether or not there should be different levels, you might be right, sir. It may be more appropriate to have a little more granular view of it, because--and we can address this if you look at what their net position is. It is one thing if people have a large position, but the added benefit of what we are going to be doing in the future is we are going to be looking at this swaps data to find out where they really are. So we can't just base things on whether or not they have a percentage on ICE or a percentage on CME, you have to look at where they are net, and we will be able to do that with this new rule, I think. " CHRG-111hhrg53246--55 Mr. Gensler," I would agree with that. I think that we are in agreement. And the products, the interest rate, currency, and commodity products, the CFTC would take the lead on. On the narrow-based, the SEC would take the lead. This is broad-based product area. Currently, there are over 150 broad-based futures contracts. There are five or six that trade actively that are regulated by the CFTC. There are about 60 options on those futures, again, regulated by us. So broad-based implicate those. But there is a second category that I should mention. I do think we can go in and harmonize for the trading platforms. And working with Congress and working together we can do that, but we haven't yet, between our agencies, been able to get to that level of detail. But I think that would be important. " CHRG-111shrg54675--59 Mr. Hopkins," We have adequate dollars available for ag-operating loans, and for the most part, most of our ag producers have done quite well. We are in a heavy crop area and the corn and soybean prices have been quite good. The problem we are seeing with some of our operators is the input costs over the last 12 to 24 months have increased dramatically. We feel at some point the commodity prices will come down more. We are seeing some real pressure on our livestock producers. Those are the people that I think we are seeing some real pressure on right now and I think it will be more so going forward over the next 12 to 24 months. Senator Tester. Do you have much dairy in your region? " CHRG-111hhrg48868--284 Chairman Kanjorski," The gentlelady from California for 2 minutes. Ms. Speier. Thank you, Mr. Chairman. I think that it is very important for us today to realize that Congress has a lot of finger pointing to do at itself. When the Commodities and Futures Trading Commission Chairman said, ``Credit default swaps should be regulated,'' came up here, testified to that fact, she lost her job, and subsequently, credit default swaps were unregulated specifically by legislation that passed the Congress. We had the Glass-Steagall Act that was on the books for over 60 years, it worked, and then the financial services industry wanted the Gramm-Leach-Bliley Act, which allowed for this financial supermarket to happen, and what did Congress do? It passed it. So I believe that part of the responsibility falls with us. One last question to Mr. Clark. You rated AIG at an A or A minus through most of 2008, is that not correct? " fcic_final_report_full--432 Commission focused thousands of staff hours on investigation, and not nearly enough on analyzing these critical economic questions. The investigations were in many cases productive and informative, but there should have been more balance be- tween investigation and analysis. Conclusions: • The credit bubble was an essential cause of the financial crisis. • Global capital flows lowered the price of capital in the United States and much of Europe. • Over time, investors lowered the return they required for risky investments. Their preferences may have changed, they may have adopted an irrational bub- ble mentality, or they may have mistakenly assumed that the world had become safer. This inflated prices for risky assets. • U.S. monetary policy may have contributed to the credit bubble but did not cause it. THE HOUSING BUBBLE The housing bubble had two components: the actual homes and the mortgages that financed them. We look briefly at each component and its possible causes. There was a housing bubble in the United States—the price of U.S. housing in- creased by more than could be explained by market developments. This included both a national housing bubble and more concentrated regional bubbles in four “Sand States”: California, Nevada, Arizona, and Florida. Conventional wisdom is that a bubble is hard to spot while you’re in one, and painfully obvious after it has burst. Even after the U.S. housing bubble burst, there is no consensus on what caused it. While we still don’t know the relative importance of the possible causes of the housing bubble, we can at least identify some of the most important hypotheses: • Population growth. Arizona, Florida, Nevada, and parts of California all expe- rienced population growth that far exceeded the national average. More people fueled more demand for houses. • Land use restrictions. In some areas, local zoning rules and other land use re- strictions, as well as natural barriers to building, made it hard to build new houses to meet increased demand resulting from population growth. When supply is constrained and demand increases, prices go up. • Over-optimism. Even absent market fundamentals driving up prices, shared expectations of future price increases can generate booms. This is the classic explanation of a bubble. • Easy financing. Nontraditional (and higher risk) mortgages made it easier for potential homebuyers to borrow enough to buy more expensive homes. This doesn’t mean they could afford those homes or future mortgage payments in the long run, but only that someone was willing to provide the initial loan. Mortgage originators often had insufficient incentive to encourage borrowers to get sustainable mortgages. CHRG-111shrg51395--274 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM DAMON A. SILVERSQ.1. Do you all agree with Federal Reserve Board Chairman Bernanke's remarks today about the four key elements that should guide regulatory reform? First, we must address the problem of financial institutions that are deemed too big--or perhaps too interconnected--to fail. Second, we must strengthen what I will call the financial infrastructure--the systems, rules, and conventions that govern trading, payment, clearing, and settlement in financial markets--to ensure that it will perform well under stress. Third, we should review regulatory policies and accounting rules to ensure that they do not induce excessive procyclicality--that is, do not overly magnify the ups and downs in the financial system and the economy. Finally, we should consider whether the creation of an authority specifically charged with monitoring and addressing systemic risks would help protect the system from financial crises like the one we are currently experiencing.A.1. I would cover some of the same ground that Chairman Bernanke did in a different way. I think regulatory reform must: 1. LProtect the public by creating an independent consumer protection agency for financial services, which would, among other duties, ensure mortgage markets are properly regulated 2. LReregulate the shadow markets-in particular, derivatives, hedge funds, private equity funds, and off-balance sheet vehicles, so that it is no longer possible for market actors to choose to conduct activities like bond insurance or money management either in a regulated or an unregulated manner. As President Obama said in 2008 at Cooper Union, financial activity should be regulated for its content, not its form. 3. LProvide for systemic risk regulation by a fully public entity, including the creation of a resolution mechanism applicable to any financial firm that would be the potential subject of government support. The Federal Reserve System under its current governance structure, which includes significant bank involvement at the Reserve Banks, is too self-regulatory to be a proper systemic risk regulator. Either the Federal Reserve System needs to be fully public, or the systemic risk regulatory function needs to reside elsewhere, perhaps in a committee that would include the Fed Chairman in its leadership. The issue of procyclicality is complex. I think anticyclicality in capital requirements may be a good idea. I have become very skeptical of the changes that have been made to GAAP that have had the effect, in my opinion, of making financial institutions' balance sheets and income statements less transparent and reliable. See the August, 2009, report of the Congressional Oversight Panel. Most importantly, moves that appear to be anticyclical may be procyclical, by allowing banks not to write down assets that are in fact impaired, these measures may be a disincentive, for example, for banks to restructure mortgages in ways that allow homeowners to stay in their homes.Q.2. Would a merger or rationalization of the roles of the SEC and CFTC be a valuable reform, and how should that be accomplished?A.2. A merger of the SEC and the CFTC would be a valuable reform. Alternatively, jurisdiction over financial futures and derivatives could be transferred from the CFTC to the SEC so that there is no possibility of regulatory arbitrage between securities on the one hand and financial futures and derivatives on the other. Recent efforts by both agencies to harmonize their approaches to financial regulation, while productive, have highlighted the degree to which they are regulating the same market, and the extent of the continuing threat of regulatory arbitrage created by having separate agencies. If there were to be a merger, it must be based on adopting the SEC's greater anti-fraud and market oversight powers. The worst idea that has surfaced in the entire regulatory reform debate, going back to 2006, was the proposal in the Paulson Treasury blueprint to use an SEC-CFTC merger to gut the investor protection and enforcement powers of the SEC. For more details on these issues, the Committee should review the transcript of the second day of the joint SEC-CFTC roundtable on coordination issues held on September 3, 2009. I have attached my written statement to that roundtable. [See, Joint Hearing Testimony, below.]Q.3. How is it that AIG was able to take such large positions that it became a threat to the entire financial system? Was it a failure of regulation, a failure of a product, a failure of risk management, or some combination?A.3. AIG took advantage of three regulatory loopholes that should be closed. Their London-based derivatives office was part of a thrift bank, regulated by the OTS, an agency which during the period in question advertised itself to potential ``customers'' as a compliant regulator. This ability to play regulators off against each other needs to end. Second, the Basel II capital standards for banks allowed banks with AAA ratings not to have to set capital aside to back up derivatives commitments. Third, thanks to the Commodities Futures Modernization Act, there was no ability of any agency to regulate derivatives as products, or to require capital to be set aside to back derivative positions. Within AIG, the large positions taken by the London affiliate represent a colossal managerial and governance failure. It is a managerial failure in that monitoring capital at risk and leverage is a central managerial function in a financial institution. It is a governance failure in that the scale of the London operation, and its apparent contribution to AIG's profits in the runup to the collapse, was such that the oversight of the operation should have been of some importance to the board. The question now is, what sort of accountability has there really been for these failures?Q.4. How should we update our rules and guidelines to address the potential failure of a systematically critical firm?A.4. We need to make the following changes to our financial regulatory system to address the need to protect the financial system against systemic risk: 1. LWe need to give the FDIC and a systemic risk regulator the power to resolve any financial institution, much as that power is now given to the FDIC to resolve insured depositary institutions, if that financial institution represents a systemic threat. 2. LCapital requirements and deposit insurance premiums need to increase as a percentage of assets as the size of the firm increases. The Obama Administration has proposed a two tier approach to this idea. More of a continuous curve would be better for a number of reasons--in particular it would not tie the hands of policy makers when a firm fails in the way a two tier system would. If we have a two tier system, the names of the firm in the top tier must be made public. These measures both operate as a deterrent to bigness, and compensate the government for the increased likelihood that we will have to rescue larger institutions. 3. LBank supervisory regulators need to pay much closer attention to executive compensation structures in financial institutions to ensure they are built around the proper time horizons and the proper orientation around risk. This is not just true for the CEO and other top executives--it is particularly relevant for key middle management employees in areas like trading desks and internal audit. Fire alarms should go off if internal audit is getting incentive pay based on stock price. 4. LWe need to close regulatory loopholes in the shadow markets so that all financial activity has adequate capital behind it and so regulators have adequate line of site into the entire market landscape. This means regulating derivatives, hedge funds, private equity and off-balance sheet vehicles based on the economic content of what they are doing, not based on what they are called. 5. LWe need to end regulatory arbitrage, among bank regulators; between the SEC and the CFTC, and to the extent possible, internationally by creating a global financial regulatory floor. 6. LWe need to adopt the recommendation of the Group of Thirty, chaired by Paul Volcker, to once again separate proprietary securities and derivatives trading from the management of insured deposits. AMERICAN FEDERATION OF LABOR AND CONGRESS OF INDUSTRIAL ORGANIZATIONS Joint Hearing of the CFTC and the SEC--Harmonization of Regulation September 3, 2009 Good morning Chairman Schapiro and Chairman Gensler. My name is Damon Silvers, I am an Associate General Counsel of the AFL-CIO, and I am the Deputy Chair of the Congressional Oversight Panel created under the Emergency Economic Stabilization Act of 2008 to oversee the TARP. My testimony reflects my views and the views of the AFL-CIO unless otherwise noted, and is not on behalf of the Panel, its staff or its chair, Elizabeth Warren. I should however note that a number of the points I am making in this testimony were also made in the Congressional Oversight Panel's Report on Financial Regulatory Reform's section on reregulating the shadow capital markets, and I commend that report to you. \1\--------------------------------------------------------------------------- \1\ Congressional Oversight Panel, Special Report on Regulatory Reform, at 22-24 (Jan. 29, 2009), available at http://cop.senate.gov/documents/cop-012909-report-regulatoryreform.pdf--------------------------------------------------------------------------- Thank you for the opportunity to share my views with you today on how to best harmonize regulation by the SEC and the CFTC. Before I begin, I would like to thank you both for bringing new life to securities and commodities regulation in this country. Your dedication to and enforcement of the laws that ensure fair dealing in the financial and commodities markets has never been more important than it is today. Derivatives are a classic shadow market. To say a financial instrument is a derivative says nothing about its economic content. Derivative contracts can be used to synthesize any sort of insurance contract, including most prominently credit insurance. Derivatives can synthesize debt or equity securities, indexes, futures and options. Thus the exclusion of derivatives from regulation by any federal agency in the Commodity Futures Modernization Act ensured that derivatives could be used to sidestep thoughtful necessary regulations in place throughout our financial system. \2\ The deregulation of derivatives was a key step in creating the Swiss cheese regulatory system we have today, a system that has proven to be vulnerable to shocks and threatening to the underpinnings of the real economy. The result--incalculable harm throughout the world, and harm in particular to working people and their benefit funds who were not invited to the party and in too many cases have turned out to be paying for the cleanup.--------------------------------------------------------------------------- \2\ Commodity Futures Modernization Act of 2000, Pub. L. No. 106-554, 114 Stat. 2763 (2000).--------------------------------------------------------------------------- There are three basic principles that the AFL-CIO believes are essential to the successful harmonization of SEC and CFTC regulation and enforcement, and to the restoration of effective regulation across our financial system: 1. Regulators must have broad, flexible jurisdiction over the derivatives markets that prevents regulatory arbitrage or the creation of new shadow markets under the guise of innovation. 2. So long as the SEC and the CFTC remain separate agencies, the SEC should have authority to regulate all financial markets activities, including derivatives that reference financial products. The CFTC should have authority to regulate physical commodities markets and all derivatives that reference such commodities. 3. Anti-fraud and market conduct rules for derivatives must be no less robust than the rules for the underlying assets the derivatives reference. The Administration's recently proposed Over-the-Counter Derivatives Markets Act of 2009 (``Proposed OTC Act'') will help to close many, but not all, of the loopholes that make it difficult for the SEC and the CFTC to police the derivatives markets. It will also make it even more important that the SEC and the CFTC work together to ensure that regulation is comprehensive and effective.Regulators Must Have Broad, Flexible Jurisdiction Over the Entire Derivatives Market Derivatives as a general matter should be traded on fully regulated, publicly transparent exchanges. The relevant regulatory agencies should ensure that the exchanges impose tough capital adequacy and margin requirements that reflect the risks inherent in contracts. Any entity that markets derivatives products must be required to register with the relevant federal regulators and be subject to business conduct rules, comprehensive recordkeeping requirements, and strict capital adequacy standards. The Proposed OTC Act addresses many of the AFL-CIO's concerns about the current lack of regulation in the derivatives markets. If enacted, the Proposed OTC Act would ensure that all derivatives and all dealers face increased transparency, capital adequacy, and business conduct requirements. \3\ It would also require heightened regulation and collateral and margin requirements for OTC derivatives.--------------------------------------------------------------------------- \3\ Available at http://www.financialstability.gov/docs/regulatoryreform/titleVII.pdf--------------------------------------------------------------------------- The Proposed OTC Act would also require the SEC and CFTC to develop joint rules to define the distinction between ``standardized'' and ``customized'' derivatives. \4\ This would make SEC/CFTC harmonization necessary to the establishment of effective derivatives regulation.--------------------------------------------------------------------------- \4\ Proposed OTC Act 713(a)(2) (proposing revisions to the Commodity Exchange Act, 7 U.S.C. 2(j)(3)(A)).--------------------------------------------------------------------------- The AFL-CIO believes that the definition of a customized contract should be very narrowly tailored. Derivatives should not be permitted to trade over-the-counter simply because the counterparties have made minor tweaks to a standard contract. If counter-parties are genuinely on opposite sides of some unique risk event that exchange-trading could not accommodate, then they should be required to show that that is the case through a unique contract. The presence or absence of significant arms-length bargaining will be indicative of whether such uniqueness is genuine, or artificial. In a recent letter to Senators Harkin and Chambliss, Chairman Gensler flagged several areas of the Proposed OTC Act that he believes should be improved. \5\ The AFL-CIO strongly supports Chairman Gensler's recommendation that Congress revise the Proposed OTC Act to eliminate exemptions for foreign exchange swaps and forwards. We also strongly agree with Chairman Gensler that mandatory clearing and exchange trading of standardized swaps must be universally applicable and there should not be an exemption for counterparties that are not swap dealers or ``major swap participants.''--------------------------------------------------------------------------- \5\ Letter from Gary Gensler, Chairman of the Commodity Futures Trading Commission, to The Honorable Tom Harkin and The Honorable Saxby Chambliss, August 17, 2009, page 4, available at http://tradeobservatory.org/library.cfm?refid=106665---------------------------------------------------------------------------The SEC Should Regulate Financial Markets and the CFTC Should Regulate Commodities Markets The SEC was created in 1934, due to Congress' realization that ``national emergencies . . . are precipitated, intensified, and prolonged by manipulation and sudden and unreasonable fluctuations of security prices and by excessive speculation on such exchanges and markets, and to meet such emergencies the Federal Government is put to such great expense as to burden the national credit.'' \6\ As a result of the impact instability in the financial markets had on the broader economy during the Great Depression, Congress gave the SEC broad authority to regulate financial markets activities and individuals that participate in the financial markets in a meaningful way. \7\--------------------------------------------------------------------------- \6\ 15 U.S.C. 78b. \7\ See generally The Securities Act of 1933 (15 USC 77a et seq.); The Securities Exchange Act of 1934 (15 USC 78a et seq.); The Investment Company Act of 1940 (15 USC 80a-1 et seq.); The Investment Advisers Act of 1940 (15 USC 80b-1 et seq.).--------------------------------------------------------------------------- As presently constituted, the CFTC has oversight not only for commodities such as agricultural products, metals, energy products, but also has come to regulate--through court and agency interpretation of the CEA--financial instruments, such as currency, futures on U.S. government debt, and security indexes. \8\--------------------------------------------------------------------------- \8\ 7 U.S.C. 1a(4) provides the CFTC with jurisdiction over agricultural products, metals, energy products, etc. See Commodity Futures Trading Com'n v. International Foreign Currency, Inc., 334 F.Supp.2d 305 (E.D.N.Y. 2004), Commodity Futures Trading Com'n v. American Bd. of Trade, Inc., 803 F.2d 1242 (2d Cir 1986) discussing the CFTC's authorities with regard to currency derivatives. Since 1975, the CFTC has determined that all futures based on short-term and long-term U.S. government debt qualifies as a commodity under the CEA. See CFTC History, available at http://www.cftc.gov/aboutthecftc/historyofthecftc/history--1970s.html. Other financial products regulated by the CFTC include security indexes, Mallen v. Merrill Lynch., 605 F.Supp. 1105 (N.D.Ga.1985).--------------------------------------------------------------------------- So long as two agencies continue to regulate the same or similar financial instruments, there will be opportunities for market participants to engage in regulatory arbitrage. As we have seen on the banking regulatory side and with respect to credit default swaps, such arbitrage can have devastating results. As long as the SEC and the CFTC are separate, the SEC should regulate all financial instruments including stocks, bonds, mutual funds, hedge funds, securities, securities-based swaps, securities indexes, and swaps that reference currencies, U.S. government debt, interest rates, etc. The CFTC should have authority to regulate all physical commodities and commodities-based derivatives. We recognize that the proposed Act does not in all cases follow the principles laid out above. To the extent financial derivatives remain under the jurisdiction of the CFTC, it is critical that the CFTC and the SEC seek the necessary statutory changes to bring the CFTC's power to police fraud and market manipulation in line with the SEC's powers. In this respect, we are heartened by the efforts by the CFTC under Chairman Gensler's leadership to address possible gaps in the Administration's proposed statutory language. A vigorous and coordinated approach to enforcement by both agencies can in some respects correct for flaws in jurisdictional design. They cannot correct for lack of jurisdiction or weak substantive standards of market conduct. In his letter to Senators Harkin and Chambliss, Chairman Gensler raised concerns about the Administration's proposal for the regulation of ``mixed swaps,'' or swaps whose value is based on a combination of assets including securities and commodities. Because the underlying asset will include those regulated by both the SEC and the CFTC, the Administration proposes that both agencies separately regulate these swaps in a form of ``dual regulation.'' Chairman Gensler expresses concern that such dual regulation will be unnecessarily confusing, and suggests instead that each mixed swap be assigned to one agency or the other, but not both. In that proposed system, the mixed swap would be ``primarily'' deriving its economic identity from either a security or a commodity. \9\ Under the Chairman's view, only one agency would regulate any given mixed swap, depending on whether the swap was ``primarily'' a security- or a commodity-based swap.--------------------------------------------------------------------------- \9\ Id.--------------------------------------------------------------------------- Chairman Gensler's proposal certainly has a great deal of appeal--it's simpler, and eliminates the concern that duplicative regulation becomes either unnecessarily burdensome, or worse, completely ineffective. One could imagine a situation where each agency defers to the other, leaving mixed swaps dealers with free reign to develop their market as they see fit. But a proposal that focuses on the boundary between an SEC mixed swap and a CFTC mixed swap will run into a clear problem. There are swaps that are not primarily either security- or commodity-based: in fact, by design, they are swaps that, at the time of contract, are exactly 50/50, where the economic value of the SEC-type asset is equivalent to the economic value of the CFTC based asset. 50/50 swaps aren't that unusual, and Chairman Gensler's approach does not address what to do in those instances. These kinds of boundary issues become inevitable when we decide not to merge the two agencies. In order to prevent these problems from becoming loopholes, a solution must either eliminate the boundary--e.g., the Administration's dual regulation proposal--or it must adequately police that boundary. One potential alternative would be to form a staff-level joint task force between the CFTC and the SEC to ensure that these 50/50 swaps--those that are neither obviously SEC-swaps nor CFTC-swaps--would be regulated comprehensively, and consistently, across the system.Anti-Fraud and Market Conduct Rules In considering enforcement issues for derivatives, it is critical to consider the appropriate level of regulation of the underlying assets from which these derivatives flow. Some of the strongest tools in the agencies' toolboxes are anti-fraud and market conduct enforcement. Derivatives must be held at a minimum to the same standards as the underlying assets. The Administration's Proposed OTC Derivatives Act makes important steps in this direction. However, there will be a continuing problem if the rules governing the underlying assets are too weak. Here the CFTC's current statutory framework is substantially weaker in terms of both investor protection and market oversight than the SEC. The Commodities Exchange Act (CEA) does not recognize insider trading as a violation of the law. This is a serious weakness in the context of mixed derivatives and both financial futures and derivatives based on financial futures. It also appears to be an obstacle to meaningful oversight of the commodities markets themselves in the light of allegations of market manipulation in the context of the recent oil price bubble. Similarly, the CEA has an intentionality standard for market manipulation, while the SEC operates under a statutory framework where the standard in general is recklessness. Intentionality as a standard for financial misconduct tends to require that the agency be able to read minds to enforce the law. Recklessness is the proper common standard.Rules Versus Principles The Treasury Department's White Paper on Financial Regulatory Reform suggests there should be a harmonization between the SEC's more rules-based approach to market regulation and the CFTC's more principles-based approach. \10\ Any effective system of financial regulation requires both rules and principles. A system of principles alone gives no real guidance to market actors and provides too much leeway that can be exploited by the politically well connected. A system of rules alone is always gameable.--------------------------------------------------------------------------- \10\ Financial Regulatory Reform: A New Foundation. Department of the Treasury (June 17, 2009). See also http://www.financialstability.gov/docs/regs/FinalReport_web.pdf--------------------------------------------------------------------------- Unfortunately, in the years prior to the financial crisis that began in 2007 the term ``principles based regulation'' became a code word for weak regulation. Perhaps the most dangerous manifestation of this effort was the Paulson Treasury Department's call in its financial reform blueprint for the weakening of the SEC's enforcement regime in the name of principles based regulation by requiring a merged SEC and CFTC to adopt the CEA's approach across the entire securities market. \11\--------------------------------------------------------------------------- \11\ http://www.treas.gov/press/releases/reports/Blueprint.pdf--------------------------------------------------------------------------- The SEC and the CFTC should build a strong uniform set of regulations for derivatives markets that blend principles and rules. These rules should not be built with the goal of facilitating speedy marketing of innovative financial products regardless of the risks to market participants or the system as a whole. In particular, the provisions of the Commodities Exchange Act that place the burden on the CFTC to show an exchange or clearing facilities operations are not in compliance with the Act's principles under a ``substantial evidence'' test are unacceptably weak, and if adopted in the area of derivatives would make effective policing of derivatives' exchanges and/or clearinghouses extremely difficult. It remains a mystery to us why ``innovation'' in finance is uncritically accepted as a good thing when so much of the innovation of the last decade turned out to be so destructive, and when so many commentators have pointed out that the ``innovations'' in question, like naked credit default swaps with no capital behind them, were well known to financial practitioners down through the ages and had been banned in our markets for good reason, in some cases during the New Deal and in some cases earlier. This approach is not a call for splitting the difference between strong and weak regulation. It is a call for building strong, consistent regulation that recognizes that the promotion of weak regulation under the guise of ``principles based regulation'' was a major contributor to the general failure of the financial regulatory system.Conclusion The last 2 years have shown us the destructive consequences of the present system--destructive not only to our overall economy, but also to the lives and livelihoods of the men, women, and families least positioned to weather these storms. We have seen firsthand how regulatory arbitrage in the financial markets create tremendous systemic risks that can threaten the stability of the global economy. Derivatives are a primary example of how jurisdictional battles among regulators can result in unregulated and unstable financial markets. We urge you to work together to create a system that will ensure that nothing falls through the cracks when the SEC and the CFTC are no longer under your collective leadership. CHRG-111hhrg53021Oth--135 Secretary Geithner," I share that skepticism and concern, and I think you are right in seeing it that way. I think what the CFTC Chairman proposed the other day, and what is an appropriate approach to think about policy in this area, is to look for ways to limit volatility. And it is very hard to not look at the last 2 years of pattern in the global energy markets, even though there has been such enormous shifts in confidence about the strength and weakness of the global economy, and not to believe we have seen a level of volatility that has been damaging, fundamentally, to the capacity of businesses to manage risk and damaging to confidence. And so it is worth trying to see whether you can, through better disclosure, limit that risk. Hard to do. Lots of people have tried it unsuccessfully. But, you are also right that, if you are going to do that effectively, you have to try and do it in a common approach where oil and other commodities are traded globally. " CHRG-111hhrg53021--135 Secretary Geithner," I share that skepticism and concern, and I think you are right in seeing it that way. I think what the CFTC Chairman proposed the other day, and what is an appropriate approach to think about policy in this area, is to look for ways to limit volatility. And it is very hard to not look at the last 2 years of pattern in the global energy markets, even though there has been such enormous shifts in confidence about the strength and weakness of the global economy, and not to believe we have seen a level of volatility that has been damaging, fundamentally, to the capacity of businesses to manage risk and damaging to confidence. And so it is worth trying to see whether you can, through better disclosure, limit that risk. Hard to do. Lots of people have tried it unsuccessfully. But, you are also right that, if you are going to do that effectively, you have to try and do it in a common approach where oil and other commodities are traded globally. " fcic_final_report_full--155 AIG also bestowed the imprimatur of its pristine credit rating on commercial pa- per programs by providing liquidity puts, similar to the ones that Citigroup’s bank wrote for many of its own deals, guaranteeing it would buy commercial paper if no one else wanted it. It entered this business in ; by , it had written more than  billion of liquidity puts on commercial paper issued by CDOs. AIG also wrote more than  billion in CDS to protect Société Générale against the risks on liquidity puts that the French bank itself wrote on commercial paper issued by CDOs.  “What we would always try to do is to structure a transaction where the transaction was vir- tually riskless, and get paid a small premium,” Gene Park, who was a managing direc- tor at AIG Financial Products, told the FCIC. “And we’re one of the few guys who can do that. Because if you think about it, no one wants to buy disaster protection from someone who is not going to be around. . . . That was AIGFP’s sales pitch to the Street or to banks.”  AIG’s business of offering credit protection on assets of many sorts, including mortgage-backed securities and CDOs, grew from  billion in  to  billion in  and  billion in .  This business was a small part of the AIG Finan- cial Services business unit, which included AIG Financial Products; AIG Financial Services generated operating income of . billion in , or  of AIG’s total. AIG did not post any collateral when it wrote these contracts; but unlike mono- line insurers, AIG Financial Products agreed to post collateral if the value of the un- derlying securities dropped, or if the rating agencies downgraded AIG’s long-term debt ratings. Its competitors, the monoline financial guarantors—insurance compa- nies such as MBIA and Ambac that focused on guaranteeing financial contracts— were forbidden under insurance regulations from paying out until actual losses occurred. The collateral posting terms in AIG’s credit default swap contracts would have an enormous impact on the crisis about to unfold. But during the boom, these terms didn’t matter. The investors got their triple-A- rated protection, AIG got its fees for providing that insurance—about . of the notional amount of the swap per year  —and the managers got their bonuses. In the case of the London subsidiary that ran the operation, the bonus pool was  of new earnings.  Financial Products CEO Joseph J. Cassano made the allocations at the end of the year.  Between  and , the least amount Cassano paid himself in a year was  million. In the later years, his compensation was sometimes double that of the parent company’s CEO.  In the spring of , disaster struck: AIG lost its triple-A rating when auditors discovered that it had manipulated earnings. By November , the company had reduced its reported earnings over the five-year period by . billion.  The board forced out Maurice “Hank” Greenberg, who had been CEO for  years. New York Attorney General Eliot Spitzer prepared to bring fraud charges against him. Greenberg told the FCIC, “When the AAA credit rating disappeared in spring , it would have been logical for AIG to have exited or reduced its business of writing credit default swaps.”  But that didn’t happen. Instead, AIG Financial Prod- ucts wrote another  billion in credit default swaps on super-senior tranches of CHRG-111hhrg63105--64 Mr. Chilton," The Chairman probably wants to comment further, and I know you only have a little bit of time. While everybody says we to need to get all this data that Mr. Marshall and people talked about, ``Let's get it all, let's not make a haphazard decision,'' I agree. The spot month we could do right now even in the swaps area. This is the currently unregulated area. This is the one that you have given us the authority to look at. And the reason we can set that limit now is because you base the limit on the deliverable supply of whatever the commodity is. So you don't need to see all-months. You don't need to see the aggregate. We could do the spot month right now, which would in part get us to where Congress instructed us to go. The Chairman wanted to add? " FOMC20080916meeting--120 118,MS. YELLEN.," Thank you, Mr. Chairman. During the past several weeks, my head office and Branch directors have become decidedly more pessimistic about the economic outlook. My own assessment of incoming data coincides with theirs. My contacts also report that their businesses are still raising prices in response to past increases in commodity and import prices that boosted their costs. I expect as a consequence that core inflation will remain uncomfortably high for a while longer, but the marked decline in commodity prices since June reinforces my conviction that there is light at the end of this inflation tunnel. With respect to growth, our forecast is similar to the Greenbook's, with a little more weakness in the second half of this year and a little more strength in 2009. I think the risks to this forecast are decidedly skewed to the downside. I agree with the Greenbook's assessment that the strength we saw in the upwardly revised real GDP growth in the second quarter will not hold up. Despite the tax rebates, real personal consumption expenditures declined in both June and July, and retail sales were down in August. My contacts report that cutbacks in spending are widespread, especially for discretionary items. For example, East Bay plastic surgeons and dentists note that patients are deferring elective procedures. [Laughter] Reservations are no longer necessary at many high-end restaurants. And the Silicon Valley Country Club, with a $250,000 entrance fee and seven-to-eight-year waiting list, has seen the number of would-be new members shrink to a mere thirteen. [Laughter] Exports were a huge source of strength in the second quarter, but I am concerned that we cannot count on very large contributions to growth from exports going forward, now that the dollar has begun to rise and economic growth abroad has slowed, even turning negative in some important trade partners. Indeed, the growing weakness of the global outlook appears to be an important explanation for the reversion in commodity prices, and this adds a dimension of gloom to what would otherwise be a decided plus for both inflation and demand. Recent data also suggest that labor markets are weakening across the board--a development that will cast a pall on household income and spending. The interaction of higher unemployment with the housing and financial markets raises the potential for even worse news--namely, an intensification of the adverse feedback loop we have long worried about and are now experiencing. Indeed, delinquencies have risen substantially across the spectrum of consumer loans, and credit availability continues to decline. One ray of hope is that the changes at Fannie and Freddie have caused a notable drop in mortgage rates. Another is that the decline in home prices has become somewhat less steep, and we have seen an outright improvement in home inventories relative to sales. But my contacts are very pessimistic about the prospects for nonresidential construction. They note that construction is continuing on projects in the pipeline with committed funding, but new projects are all but impossible to finance. Turning to inflation, I have long anticipated and still expect that inflation will fall to more-reasonable levels in 2009. However, developments since our August meeting diminish the upside risks to this projection. The drop in oil and other commodity prices, along with the appreciation of the dollar, should work to moderate the current inflation bulge and diminish the potential for a wage�price spiral to develop. Import inflation has already begun to ease. Furthermore, we have seen a remarkable decline in inflation compensation for the next five years in the TIPS market. I would not rely heavily on this decline to support my view, but I do have to say that the decline is a lot more reassuring than the alternative. I was also encouraged by the 30 basis point drop in long-term inflation expectations in the most recent Michigan survey. I anticipate that the recent jump in the unemployment rate will place some additional downward pressure on growth in labor compensation, which has been quite low, and in core inflation. Although the jump in the unemployment rate probably partly reflects the extension of unemployment insurance coverage, a back-of-the-envelope calculation suggests that the upper bound on this effect is just a few tenths of a percent. I would agree with the Greenbook estimates. We have also examined the possibility that the increase in unemployment reflects a rise in the NAIRU due to sectoral employment shifts out of construction and finance and into other industries. Ned Phelps has argued that the sectoral shift story implies a sizable dispersion of employment growth across industries and states. But we looked at these data and found no significant increase, so I don't find this Phelps argument particularly convincing. Considering all of these factors, I expect both headline and core PCE price inflation to fall to about 2 percent for 2009 as a whole, and I see the risks to this projection as roughly balanced. With respect to policy, I would be inclined to keep the funds rate target at 2 percent today. For now, it seems to me that the additional liquidity measures that have been put in place are an appropriate response to the turmoil. I am fine with the wording of alternative B and would support President Lockhart's suggestion for change. That would seem fine to me, too. In view of the intensified financial stress and the potential for more turmoil, obviously I think we will need to be flexible in setting policy going forward, and I am very concerned about downside risks to the real economy and think that inflation risk is diminished. " CHRG-111shrg54589--30 Mr. Gensler," I believe, sir, that that should be reported to all the regulators and certainly aggregated in the aggregate positions by underlying commodity. In that way, jet fuel derivatives should be reported to the public. I think working together, we have to think through whether that should also be part of this consolidated tape or whether there are some that would be so unique that the commercial attributes of, as you said, Delta Airlines might be put at risk. But they, I believe, should be---- Senator Bunning. I think---- " Mr. Gensler," ----aggregated in part, seen clearly by the regulators, and possibly be part of the consolidated tape. Senator Bunning. I can't see how Delta Airlines would be put at risk if they are smart enough to hedge against the market's advance in future oils or future jet fuel or whatever it might be---- " CHRG-110shrg50369--125 Chairman Dodd," Let me, if I can, Mr. Chairman, I want to raise a couple of questions, if I can for you, and some of them have been touched on. I do not want to take a long time here with you, but I am just intrigued by the correlation of some of these issues. Sometimes we cite a bunch of statistics and wonder what the correlations are between them. There are two factors that I want your thoughts on, if I can, that contribute to this huge run-up in commodity prices that we heard Senator Tester talk about and others. Oil is the first thing I think about, but obviously, if you are a farmer or a baker in Rhode Island, it can be the cost of wheat and others. The first is the increase in the demand for these goods. That is obviously one set of issues. The second is that these goods are priced in dollar terms. Sometimes we pass over that idea, but we talked about the price of oil a barrel, it is in dollar terms. And to what extent is the decline in the value of the dollar driving this? And beyond that concern, is that decline in the dollar--does that decline represent a decrease in confidence in the U.S. financial system? As the Fed report indicates--and I mentioned this at the outset--there was a net sale of U.S. securities by private foreign investors in the third quarter of 2007, the first quarterly net sale in more than 15 years. And I wonder how is that loss of confidence in the U.S. by foreign investors leading into a decline in the dollar, which leads to the rising commodity prices. I am trying to connect these questions, if at all. I was talking to a friend of mine in Europe this morning who is involved in the financial services sector--a totally different matter--and I told him I was going to be having the hearing this morning with you. And he was saying that one of the problems we have got is the fact that Europe is not cutting its interest rates at all, and so you are getting that comparison as well, which probably exacerbates this problem to some extent, at least in that market. And I was curious, because we have had a lot of questions of you--and I will come back to this in a minute--on the sovereign wealth funds, and I was trying to get some sense of proportionality about private investment versus sovereign wealth funds. And I do not minimize the importance of the sovereign wealth funds issues, but I asked staff to give me some sense of the proportionality of numbers. And out of the estimated $150 trillion in global capital stock, $2.2 trillion is held by sovereign wealth funds. And while sovereign wealth funds are about double the size of hedge fund assets, they represent less than 5 percent of global assets. And while China's sovereign wealth fund hold is about $200 billion in assets, the size of China's foreign exchange reserves is about $1.3 trillion. And so you have got--putting aside that for a second, the private investment sector here is an important one, and maybe I--am I making too much of this bar graph I saw in the Monetary Report Fund where you see for the first time that looks like a selling off here? And I noticed in your response to one of the--I forget who it was raised the question earlier. At least I thought I heard you say this was not as--that foreign investment is still coming in and that is a source of some confidence here. Anyway, could you try and connect those things for me? Is it a false connection? But I am curious how that relates to the decline in the dollar, the rise in commodity prices, and whether or not there is some connection here. " FOMC20080430meeting--67 65,MR. STOCKTON.," I think that is a fair characterization. You know, one thing that we're struggling with--and I assume you are as well in giving your own views about the uncertainty and the skewness around your forecast--is whether things have changed. Is the skew large enough for us to argue that, in fact, the risks look unbalanced? We thought about that and about the potential upside and downside risks. Clearly, as I indicated, upside risks would be associated with ongoing increases in underlying prices for oil and other commodities that would probably feed through indirectly into core inflation over time. On the downside, we have been struck with how little upward pressure there has been on labor compensation and labor costs. Now, if you pinned me down and said draw a fine line on this, I'd probably say that, given the pattern of the past few years, it would look to me as though there's probably a little more upside risk than downside risk, but I don't see that skewness as being material in the forecast. " fcic_final_report_full--564 Washington, D.C., May 14, 1998, p. 8. 19. Federal Housing Finance Agency, Report to Congress, 2008 (2009), tables 3, 4, 12, and 13. 20. Lawrence Lindsey, interview by FCIC, September 20, 2010. 21. Jim Callahan, interview by FCIC, October 18, 2010. 22. Securities Industry and Financial Markets Association (SIFMA), US ABS Outstanding. 23. Scott Patterson, interview by FCIC, August 12, 2010. 24. Gillian Tett, Fool’s Gold: How the Bold Dream of a Small Tribe at J. P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe (New York: Free Press, 2009), pp. 32–33, 49, 70, 115. 25. Emmanuel Derman, interview by FCIC, May 12, 2010. 26. Volcker, interview. 27. Vincent Reinhart, interview by FCIC, September 10, 2010. 28. Lindsey, interview. 29. A futures contract is a bilateral contract in which one party, the long position, is compensated if the price or index or rate underlying the contract rises while the other party, the short position, is com- pensated if it goes down. An options contract grants the right but not the obligation to purchase or sell a commodity or financial instrument at a particular price in the future; the option holder derives a benefit if the price moves in his or her favor. In a swaps contract, the two parties exchange streams of payments based on different benchmarks. 30. Securities options are regulated by the SEC. 31. Commodity Futures Trading Commission, Exemption for Certain Swap Agreements, Final Rule, Federal Registrar 58 (January 22, 1993): 5587. 32. Brooksley Born, chairperson, Commodity Futures Trading Commission, “Concerning the Over- the-Counter Derivatives Market,” prepared testimony before the House Committee on Banking and Fi- nancial Services, 105th Cong., 2nd sess., July 24, 1998. 33. GAO, “Financial Derivatives: Actions Needed to Protect the Financial System,” GGD-94-133 (Re- port to Congressional Requesters), May 18, 1994. 34. Commodity Futures Trading Commission, “Division of Enforcement” (www.cftc.gov/anr/an- renf98.htm). 35. “Joint Statement by Treasury Secretary Robert E. Rubin, Federal Reserve Board Chairman Alan Greenspan, and Securities and Exchange Commission Chairman Arthur Levitt,” Treasury Department press release, May 7, 1998. 36. Fed Chairman Alan Greenspan, “The Regulation of OTC Derivatives,” prepared testimony before the House Committee on Banking and Financial Services, 105th Cong., 2nd sess., July 24, 1998. 37. GAO, “Long-Term Capital Management: Regulators Need to Focus Greater Attention on Systemic Risk,” GAO/GGD-00-3 (Report to Congressional Requesters), October 1999, pp. 7, 18, 39–40. The no- tional amount of OTC derivatives contracts is a standard measure used in reporting the outstanding vol- ume of such contracts. Its calculation is based on the value of the underlying instrument, commodity, index, or rate that the swap is based on. It therefore may be of limited use in measuring the potential ex- posure of the parties to the contracts. For example, an interest rate swap based on changes in interest rate on a $100 million loan would likely involve only a small percentage of the $100 million notional amount. On the other hand, price changes on an oil swap based on $100 million worth of oil could be even more than the notional amount, depending on the volatility in oil prices. For credit default swaps, which are discussed in more detail later in this volume, the notional amount is usually a close measure of the poten- tial financial exposure of the issuer or seller of the swap. 561 38. Fed Chairman Alan Greenspan, “Private-sector Refinancing of the Large Hedge Fund, Long-Term Capital Management,” prepared testimony before the House Committee on Banking and Financial Serv- ices, 105th Cong., 2nd sess., October 1, 1998. 39. Fed Chairman Alan Greenspan, “Financial Derivatives,” remarks before the Futures Industry As- sociation, Boca Raton, Florida, March 19, 1999. 40. “Over-the-Counter Derivatives Markets and the Commodity Exchange Act,” report of the Presi- dent’s Working Group on Financial Markets, November 1999. 41. Gross market value is the current price at which the outstanding swaps contract can be sold or re- placed on the market. As such, that amount reflects the current amount owing on a contract but does not reflect the possible future exposure on these generally long-term instruments. 42. Bank for International Settlements, data on semiannual OTC derivatives statistics. 43. Alan Greenspan, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Entities (GSEs), day 1, session 1: The Federal Reserve, April 1, 2010, tran- script, pp. 88–89. 44. Robert Rubin, testimony before the FCIC, FCIC Hearing on Subprime Lending and Securitization and Government-Sponsored Entities (GSEs), day 2, session 1: Citigroup Senior Management, April 8, 2010, transcript, pp. 108–10, 123–24. 45. Lawrence Summers, interview by FCIC, May 28, 2010. 46. Daniel K. Tarullo, Banking on Basel: The Future of International Financial Regulation (Washington, CHRG-111hhrg74855--355 Mr. Shelk," So under the version that you have suggested essentially the tier one bank wouldn't post the collateral, we would have to post the collateral as the counterparty to the tier one institution and as I indicated earlier, the problem with that is it would tie-up, and the examples we have come up with about an average a quarter of the capital of the end user so we fully agree with your comments that the electric utilities and other generators didn't cause the problem. We think the way to get to your transparency goal which we share because we are in the market too, is to have a data repository so that information on these trades would be available to the CFTC and others, and the problem with electricity is it is very customized. These products are traded over hundreds of different nodes around the country so it doesn't really lend itself, the CFTC doesn't lend itself to the corn example, and the T-bill example and kinds of commodities that the chairman indicated. " CHRG-111hhrg49968--24 Mr. Bernanke," Mr. Plosser does, as well. He is simply saying we shouldn't put too much weight because it is very difficult to measure them. But what I am saying is that, currently, there is not much doubt that there is an output gap, and that, therefore, there would be a downward effect on inflation. That being said, there are other factors as well, including the currency, including commodity prices and so on, and we watch those very carefully. I think I would note that, if you look around for evidence of inflation, inflation expectations, you are not going to find very much. If you look, for example, at surveys of consumers, if you look at the forecast of professional forecasters, if you look at the spreads between indexed and nonindexed bonds, all of those things are quite consistent with inflation remaining stable and well within the bounds that the Federal Reserve believes is consistent with price stability. " FinancialCrisisInquiry--196 CHAIRMAN ANGELIDES : You refer to “animal spirits,” in the context of your remarks today. To what extent do the animal spirits extend beyond the housing market? In other words, as we look at causes, perhaps—I don’t want to characterize it—it was certainly a large fire burning, but what were the other fires burning—what were the other areas of excess within the economy in the last few years, in your judgment? If any? ZANDI: I think the... CHAIRMAN ANGELIDES: And by proportion? (LAUGHTER) ZANDI: I think the hubris in the financial system was widespread. I think it was clearest and most evident in the residential mortgage market, thus the focus on that. But I think it extends well beyond that, and, as we can see to this day, into commercial real estate lending, which many small banks are now struggling with, to corporate lending, all various kinds of—of corporate lending. It was evident more broadly in financial markets, in the derivatives market, stock prices, obviously in commodity markets at certain points in time. So I think the hubris among investors, global investors, was extraordinarily widespread and cut across lots of different markets, a whole range of markets. In fact, it would be more difficult to identify the markets that weren’t affected at the height of this by that hubris. CHAIRMAN ANGELIDES: Is there any way of measuring proportionality? FinancialCrisisInquiry--610 ZANDI: I think the hubris in the financial system was widespread. I think it was clearest and most evident in the residential mortgage market, thus the focus on that. But I think it extends well beyond that, and, as we can see to this day, into commercial real estate lending, which many small banks are now struggling with, to corporate lending, all various kinds of—of corporate lending. It was evident more broadly in financial markets, in the derivatives market, stock prices, obviously in commodity markets at certain points in time. So I think the hubris among investors, global investors, was extraordinarily widespread and cut across lots of different markets, a whole range of markets. In fact, it would be more difficult to identify the markets that weren’t affected at the height of this by that hubris. FOMC20060808meeting--41 39,MS. JOHNSON.," I would say in a kind of notional sense that most especially China, for example, has not slowed to the degree that we and everybody else had been expecting. There was a significant positive surprise in the Q2 numbers for China. At the time we saw what we called the “volatility” of May-June, when it looked as though some commodity prices were coming off and the stories that they had been held up by speculators and so forth seemed true, and it looked as though those prices might actually adjust downward and stay down. Well, that perception was very short lived: The fundamental demand for some of these products seems to have reasserted itself, and many of those prices are back up where they once were. So based on those kinds of indirect signals, I would say that the strength of the global economy is at least what it was three months ago and perhaps a tiny bit stronger." CHRG-111hhrg52397--103 Mrs. Biggert," Okay. No one else? Well, then if it has been a concern that some of the OTC derivative products are not safe for retail investors, should we simply restrict participation in these markets? We heard long ago that these were not for the people who were in pensions or whatever but for those who had the ability to take a loss on a large amount of money and somehow it seemed to have slipped from that. Is there any concern that we would go back to that? Mr. Don Thompson. Well, I think it is fair to say the over-the-counter derivatives market is already an institutional market. The eligible contract participant requirement in the Commodity Exchange Act restricts it from retail investors. Now, I guess one can quibble about whether that has been set high enough, low enough or whatever, but it is not, and has never been, a retail market, unlike the exchange traded markets. " CHRG-111hhrg51698--332 Mr. Pickel," We focus on the trading limits and the hedge exemption provisions. Keep in mind that we represent the bilateral, privately negotiated derivatives business. In that role, parties, whether we are talking about interest rates or other types of commodities, would typically be entering into bilateral contracts that are tailored to the particular needs of the counterparties. The dealer in that situation hedges its risk in various ways. If it can find an offsetting position with another bilateral trade it will do that, but often it looks to manage that risk via the futures markets. That is the root of the hedging exemption that is provided for, is to recognize that ability for the dealer to hedge its position that it takes on the bilateral trade it may wish to access the futures market and, therefore, that is the appropriate role for that exemption. " CHRG-111hhrg63105--84 Mr. Marshall," Thank you, Mr. Kissell. Just sort of following up where I was when I stopped, you clearly have the statutory authority not to move forward unless it is appropriate to do so. That is why that language was stuck in there. And that if you move forward without understanding precisely what the problem is, then it seems to me that you are not moving forward appropriately. And if your staff hasn't identified what the problem is, then how do you actually come up with a regulation to solve that problem. You don't even know what it is. It is sort of too broad a brush. But back to this classes of traders. We intentionally stuck that language in there to give you the discretion to distinguish among the speculators and, if you chose to do so, I don't know whether there is a massive passive problem here. I just don't have the expertise. And there are, as Mr. Kissell points out, people on both sides of that. So I leave it to you and your staff and your economists and whatnot to figure it out. But if it is massive passive that is the problem, then the solution should focus specifically on that, and one-size-fits-all position limits don't do that. And you just use ratios. Assume you have 20 traders in the market, five of them are passive. You put a position limit in that is designed to maintain their percentage at no more than 25 percent. And then let us say a whole bunch of additional passives show up. Let us say 20 additional passives show up. Now I have 40 traders in the market and 60 percent of it is passive money. So you really do need to at least consider distinguishing among the classes of traders if you conclude that that is a problem. I associate myself with the questioning of Mr. Conaway in many different respects, and he has observed there is a fiduciary duty here. And I guess a final question. Let us assume that you impose position limits and that there is a large market demand out there that is now sort of stymied. It doesn't have an opportunity to just come into these markets because you are aggregate. You are across all of the markets. Where does that money go? How do people who want to take a position in commodities to do whatever, hedge or because they want that in their portfolio or whatnot and they can't do it in these vehicles, where do they go? Do they go to Europe? Do they start hoarding commodities? I mean, what do they do? " fcic_final_report_full--32 Maker told the board that she feared an “enormous economic impact” could re- sult from a confluence of financial events: flat or declining incomes, a housing bub- ble, and fraudulent loans with overstated values.  In an interview with the FCIC, Maker said that Fed officials seemed impervious to what the consumer advocates were saying. The Fed governors politely listened and said little, she recalled. “They had their economic models, and their economic mod- els did not see this coming,” she said. “We kept getting back, ‘This is all anecdotal.’”  Soon nontraditional mortgages were crowding other kinds of products out of the market in many parts of the country. More mortgage borrowers nationwide took out interest-only loans, and the trend was far more pronounced on the West and East Coasts.  Because of their easy credit terms, nontraditional loans enabled borrowers to buy more expensive homes and ratchet up the prices in bidding wars. The loans were also riskier, however, and a pattern of higher foreclosure rates frequently ap- peared soon after. As home prices shot up in much of the country, many observers began to wonder if the country was witnessing a housing bubble. On June , , the Economist magazine’s cover story posited that the day of reckoning was at hand, with the head- line “House Prices: After the Fall.” The illustration depicted a brick plummeting out of the sky. “It is not going to be pretty,” the article declared. “How the current housing boom ends could decide the course of the entire world economy over the next few years.”  That same month, Fed Chairman Greenspan acknowledged the issue, telling the Joint Economic Committee of the U.S. Congress that “the apparent froth in housing markets may have spilled over into the mortgage markets.”  For years, he had warned that Fannie Mae and Freddie Mac, bolstered by investors’ belief that these in- stitutions had the backing of the U.S. government, were growing so large, with so lit- tle oversight, that they were creating systemic risks for the financial system. Still, he reassured legislators that the U.S. economy was on a “reasonably firm footing” and that the financial system would be resilient if the housing market turned sour. “The dramatic increase in the prevalence of interest-only loans, as well as the in- troduction of other relatively exotic forms of adjustable rate mortgages, are develop- ments of particular concern,” he testified in June. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is be- ginning to add to the pressures in the marketplace. . . . Although we certainly cannot rule out home price declines, espe- cially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications. Nationwide banking and widespread securitization of mortgages makes it less likely that financial intermediation would be impaired than was the case in prior episodes of regional house price corrections.  CHRG-111hhrg51698--5 Mr. Lucas," Thank you, Chairman Peterson, for calling today's hearing. We appreciate the opportunity to examine your draft legislation that addresses concerns with the derivatives industry and its impact on the U.S. economy. During the past several months, the Committee has spent a great deal of time monitoring the issue of trading activity in the futures market, as well as exploring the role credit default swaps have played in our current financial crisis. The draft legislation we are considering would impact a wide array of financial instruments, and what the ultimate effect will be in the marketplace is unknown. My main concern is how the legislation will impact risk management for agricultural producers. How far will this legislation go beyond credit default swaps and derivatives in general? I support greater transparency and accountability in respect to the over-the-counter transactions. However, I also believe any legislation to regulate financial markets has to strike a delicate balance between protecting the economic workings of this country and creating opportunities for economic growth, business expansion, risk management for our agricultural producers. To that end, I believe this Committee must work to ensure that the Commodity Futures Trading Commission, the CFTC, plays a leading role in appropriately regulating the derivative and commodity markets once the Committee decides what level of additional regulations are needed. We should also work to ensure that the CFTC has the tools it needs, human resources, technical resources, economic resources to effectively carry out its statutory mandate. It must be noted that the CFTC has a proven track record in clearing futures contracts, and to date has not lost a single dollar of a single customer's money due to failure of a clearinghouse. Finally, I would like to thank the participants of our two panels today. We appreciate your time and your commitment to the public policy process, and we look forward to your testimony and answers to our questions. Thank you, Mr. Chairman. " FOMC20080805meeting--143 141,CHAIRMAN BERNANKE.," You want it before 2:15, though. All right. Well, I spent a lot of time through the meeting and during the break working up a crystalline summary of the discussion. [Laughter] But I am a bit concerned about getting to lunch and avoiding the 2:15 hard deadline; so if you would excuse me, this time I will just go directly to a few comments of my own, and then we can go to the policy round. We saw growth of about 2 percent in the second quarter, which suggests a campaign slogan for the Republicans, ""The Economy: It Could Be Worse."" [Laughter] The question, though, is whether this higher-than-expected growth rate in the second quarter implies that we are actually looking forward to a better-than-expected remainder of the year or whether this was in some sense a last hurrah of borrowing from the future. I feel that I am very strongly in the latter camp, unfortunately. I do think that, for reasons people have talked about, the remainder of the year and into next year are likely to be quite weak. I don't know how weak, but if you look at each component of spending or component of production, you see mostly very negative indicators. We have talked about consumption. We know about all the fundamental issues that are affecting consumers, and we have seen recently, I think both anecdotally and in terms of the data, some softness, particularly in the auto area. In the labor market, several people have noted that the loss of payroll jobs has not been as rapid as, for example, in 2001. The unemployment rate, though, has risen as quickly as in previous episodes, and any look at the unemployment rate would suggest that this is something close to a normal recession dynamic. Housing, of course, remains very uncertain. We don't really know when the bottom will be, although I would add, a point that I think Bill Dudley made, that there seems to be a growing confidence that when we have reached the bottom in housing, whenever that may be, we will see a very quick improvement, both in the financial markets and then, presumably, in the economy as well. In other areas, such as nonresidential construction, architectural billings and other factors suggest slowing there. We see slowing in the other industrial countries, although some strength is still in the emerging markets. So just looking at the traditional indicators of growth and production, I think the best guess is for a slow second half, a slow beginning of 2009, and an unemployment rate that continues to rise from here. I do believe that the financial stress and its implications for credit availability are important in this whole dynamic. I guess President Lacker and I keep talking past each other, but I don't think that the federal funds rate is an adequate description of the stance of monetary policy. To give another example, in the past we have used money growth as an indicator of monetary policy. If we used that indicator, it would look quite different. I think the appropriate indicators are the rates and terms that are being faced by the people making decisions to spend in the economy. You can go through the entire list, and in every case, as Governor Kohn suggested, the actual rates being faced in the data by borrowers are as high as or higher than they were last summer. Mortgages, which are a particularly sensitive area, are of course critical here. Despite the decline in the federal funds rate, the spread between mortgage-backed securities and duration-matched Treasuries is now about 260 basis points compared with 120 basis points last summer. In addition, for the spread between jumbo loans and conforming loans, which in the past has normally been between 25 and 50 basis points, the offer rate is about 120 basis points. So there seems little doubt--and we can check with Governor Duke about this--that, despite the lower rate on overnight bank lending, the rates that matter for economic activity are largely higher than they were a year ago. Therefore, I don't think it is evident at all that we are in a financial situation that is conducive to rapid, excessive growth and inflationary increases a priori. Now, going forward, of course, a lot of what happens in the economy is going to depend on bank balance sheets. I won't spend much time. In April, I talked about the staff's estimates of losses going forward. That has been updated. Nellie Liang is working with people in New York. The numbers are not too encouraging under the baseline scenario, forgetting about the more severe scenarios. The staff now projects about $228 billion in losses for U.S. banks and thrifts in '08 and '09. That excludes investment banks. That excludes write-downs. If that occurs, it would be about a 2 percent loss rate over the next two years, which would be above the peak of 1991 and 1992. Of course, if the economy does worse, it would be even higher. Relative to that $228 billion in losses, there are so far loan-loss provisions of about $68 billion. So it looks as though we still have a long way to go in terms of bank losses and write-downs. In addition, some of the biggest banks will take very significant hits. This is very preliminary, and I don't want to make too much of it, but the preliminary analysis shows that for five of the very biggest banks, under a baseline scenario and looking at the composition of their asset holdings, their current tier 1 capital ratios will be reduced between 30 percent and 50 percent over the next two years. So there is a real concern about the availability of credit and about the cost of credit. I could go on and talk about a variety of other areas, including the Senior Loan Officer Opinion Survey, which suggests that credit will be a concern going forward. President Lacker and I have, I hope, respect--I respect him, and I hope he respects me. But we disagree also about President Bullard on systemic risk. I take his criticism to be that it works in practice, but can it work in theory? Systemic risk is an old phenomenon. There are literally dozens and dozens of historical episodes that are suggestive of that phenomenon. There is also an enormous theoretical literature. Maybe it is not entirely satisfactory, but certainly many people have thought about that issue. I, myself, have obviously worked in this area. Clearly, it is not something that we can tightly explain in all aspects, but I do think it is a concern. We need to remain concerned about it. Although it is true, as President Bullard points out, that there is an accommodation and a basis for anticipating crises as we go forward, it is also the case, as I think Governor Mishkin noted, that after a year we are also facing a situation of greater fragility, of much lower capital, and fewer shock absorbers. Those things will make any crisis that much more severe, should it occur. So overall I think there is still significant downside risk to growth. I think the baseline of slow growth is right. I am hopeful that we will see growth restored early next year, but I think it is very uncertain at this point. On inflation, I do have concerns, as everyone else does. I think that the commodity price movements we have seen are good news. They have been quite significant. Besides oil prices down about 10 percent and natural gas prices down about 32 percent, since the last meeting corn is off 27 percent; soybeans, 17 percent; and wheat, 16 percent. Those are not small changes. Now, obviously, the level of prices is still very high. It has risen considerably over the past year. We will continue to see that high level of prices being passed through into the core, as Governor Kohn noted, but I would argue that if--and this is a very big ""if""--commodity prices do begin to stabilize within the general range of what we see now, I think that the inflation concerns will moderate over time because they will have lost essentially their driving force. We don't really have the conditions to turn the commodity price increases into persistent inflation, absent continued pressure on that front and absent changes in inflation expectations, of which there is only limited evidence at this point. So I want to be very clear: I think that containing inflation is enormously important, and I think it is our first responsibility. We need to watch this very carefully. I think there will be continued pressures even if commodity prices don't rise, but I do think there is also a chance that we will see a moderation of this problem going forward. What else? I guess there has been a lot of discussion about the appropriate withdrawal of stimulus. Again, I don't think I accept the idea that we are currently in an extremely stimulative situation. However, if financial markets were to normalize, for example, that would lead to a more stimulative situation. I would like to say just a word about that. That is to say that the speed at which we remove the accommodation--and I think it is clear we do have to do that relatively soon--should depend to some extent on how inflation evolves. Under the more benign scenario that I have just described--if inflation does decline significantly because of commodity prices--I think that we obviously have more time. I would just note for comparison past episodes. In 1994, for example, the pause lasted 17 months, and the first increase in rates came two years after payrolls began growing again. In 2001, again, it was more than a year after unemployment rates started coming down, and payrolls began growing before the rates started going up. Now, I think there is a view, which is a reasonable one, that maybe in at least the second of those two episodes we waited too long to begin to normalize. That is entirely possible. But, again, it would be extraordinary if we were to begin raising rates without an immediate inflation problem with the economy still in a declining or extremely weakened situation. If inflation does in fact become the problem that many around the table think it is, particularly if commodity prices begin to go up again or if the dollar begins to weaken, then I will be the first here to support responding to that. I do think it is incredibly important to keep inflation expectations well anchored, particularly to the extent that movements of commodity prices and the dollar seem to be derived from monetary policy as opposed to things like geopolitical risk. Then, I think we can't treat them as truly exogenous. We would have to respond to those things. So I welcome the ongoing discussion we should have about the pace of withdrawal of accommodation. I do think it depends very much on how things evolve, and I do think that our strategy should be to watch carefully and to make the right decisions as we see the data come in. Let me stop there and turn to the last round and ask Brian, please, to introduce the policy discussion. " CHRG-111hhrg48867--114 Mr. Silvers," Well, you certainly mentioned one which is Gramm-Leach-Bliley. The second was the Commodities Act--and I can't recall the formal title--which deprived the CFDC of the ability to regulate financial futures--financial derivatives and other derivatives. A third was not Congress, at least Congress didn't act formally. It was the court decision that took away from the SEC the ability to regulate hedge funds. Congress then failed to act in response to that. Fourth was--here is an instance where Congress acted responsibly but the regulators didn't act, where Congress gave the Fed the ability to regulate mortgages comprehensively, and the Fed didn't use it. The fifth is somewhat older, which is--and I think goes to the-- " CHRG-111hhrg51698--289 The Chairman," All right. I thank the panel. I thank the Committee Members. The Committee stands adjourned subject to the call of the chair. [Whereupon, at 4:10 p.m., the Committee was adjourned.] [Material submitted for inclusion in the record follows:] Submitted Statement by American Public Gas Association Chairman Peterson, Ranking Member Lucas and Members of the Committee, the American Public Gas Association (APGA) appreciates this opportunity to submit testimony to you today. We also commend the Committee for calling this hearing on the important subject of derivative trading. APGA would also like to commend Chairman Peterson and the House Agriculture Committee for its ongoing focus on market transparency and oversight. APGA is the national association for publicly-owned natural gas distribution systems. There are approximately 1,000 public gas systems in 36 states and over 700 of these systems are APGA members. Publicly-owned gas systems are not-for-profit, retail distribution entities owned by, and accountable to, the citizens they serve. They include municipal gas distribution systems, public utility districts, county districts, and other public agencies that have natural gas distribution facilities. APGA's number one priority is the safe and reliable delivery of affordable natural gas. To bring natural gas prices back to a long-term affordable level, we ultimately need to increase the supply of natural gas. However, equally critical is to restore public confidence in the pricing of natural gas. This requires a level of transparency in natural gas markets which assures consumers that market prices are a result of fundamental supply and demand forces and not the result of manipulation, excessive speculation or other abusive market conduct. We, along with other consumer groups, have watched with alarm over the last several years certain pricing anomalies in the markets for natural gas. More recently, we have noted much greater volatility in the price of energy and other physical commodities. APGA has strongly supported an increase in the level of transparency with respect to trading activity in these markets from that which currently exists. We believe that additional steps are needed in order to restore our current lack of confidence in the natural gas marketplace and to provide sufficient transparency to enable the CFTC, and market users, to form a reasoned response to the critically important questions that have been raised before this Committee during the course of these hearings. APGA believes that the increased regulatory, reporting and self-regulatory provisions relating to the unregulated energy trading platforms contained in legislation that reauthorizes the Commodity Futures Trading Commission (``CFTC'') is a critically important first step in addressing our concerns. Those provisions are contained in Title XIII of the farm bill which has become law. We commend this Committee for its work on this important legislation. The market transparency language that was included in the farm bill will help shed light on whether market prices in significant price discovery energy contracts are responding to legitimate forces of supply and demand or to other, non-bona fide market forces. However, APGA believes that more can, and should, be done to further increase transparency of trading in the energy markets. Many of these steps would likely also be useful in better understanding the current pricing trends in the markets for other physical commodities as well. Although the additional authorities which have been provided to the CFTC under Title XIII of the 2008 Farm Bill will provide the CFTC with significant additional tools to respond to the issues raised by this hearing (at least with respect to the energy markets), we nevertheless believe that it may be necessary for Congress to provide the CFTC with additional statutory authorities. We are doubtful that the initial steps taken by the reauthorization legislation are, or will be, sufficient to fully respond to the concerns that we have raised regarding the need for increased transparency. In this regard, we believe that additional transparency measures with respect to transactions in the Over-the-Counter markets are needed to enable CFTC to assemble a more complete picture of a trader's position and thereby understand a large trader's potential impact on the market. We further believe, that in light of the critical importance of this issue to consumers, that this Committee should maintain active and vigilant oversight of the CFTC's market surveillance and enforcement efforts, that Congress should be prepared to take additional legislative action to further improve transparency with respect to trading in energy contracts and, should the case be made, to make additional amendments to the Commodity Exchange Act, 7 U.S.C. 1 et seq. (``Act''), that allows for reasonable speculative position limits in order to ensure the integrity of the energy markets.Speculators' Effect on the Natural Gas Market As hedgers that use both the regulated futures markets and the OTC energy markets, we value the role of speculators in the markets. We also value the different needs served by the regulated futures markets and the more tailored OTC markets. As hedgers, we depend upon liquid and deep markets in which to lay off our risk. Speculators are the grease that provides liquidity and depth to the markets. However, speculative trading strategies may not always have a benign effect on the markets. For example, the 2006 blow-up of Amaranth Advisors LLC and the impact it had upon prices exemplifies the impact that speculative trading interests can have on natural gas supply contracts for local distribution companies (``LDCs''). Amaranth Advisors LLC was a hedge fund based in Greenwich, Connecticut, with over $9.2 billion under management. Although Amaranth classified itself as a diversified multi-strategy fund, the majority of its market exposure and risk was held by a single Amaranth trader in the OTC derivatives market for natural gas. Amaranth reportedly accumulated excessively large long positions and complex spread strategies far into the future. Amaranth's speculative trading wagered that the relative relationship in the price of natural gas between summer and winter months would change as a result of shortages which might develop in the future and a limited amount of storage capacity. Because natural gas cannot be readily transported about the globe to offset local shortages, the way for example oil can be, the market for natural gas is particularly susceptible to localized supply and demand imbalances. Amaranth's strategy was reportedly based upon a presumption that hurricanes during the summer of 2006 would make natural gas more expensive in 2007, similar to the impact that Hurricanes Katrina and Rita had had on prices the previous year. As reported in the press, Amaranth held open positions to buy or sell tens of billions of dollars of natural gas. As the hurricane season proceeded with very little activity, the price of natural gas declined, and Amaranth lost approximately $6 billion, most of it during a single week in September 2006. The unwinding of these excessively large positions and that of another previously failed $430 million hedge fund--MotherRock--further contributed to the extreme volatility in the price of natural gas. The Report by the Senate Permanent Subcommittee on Investigations affirmed that ``Amaranth's massive trading distorted natural gas prices and increased price volatility.'' \1\--------------------------------------------------------------------------- \1\ See ``Excessive Speculation in the Natural Gas Market,'' Report of the U.S. Senate Permanent Subcommittee on Investigations (June 25, 2007) (``PSI Report'') at p. 119.--------------------------------------------------------------------------- Many natural gas distributors locked-in prices prior to the period Amaranth collapsed at prices that were elevated due to the accumulation of Amaranth's positions. They did so because of their hedging procedures which require that they hedge part of their winter natural gas in the spring and summer. Accordingly, even though natural gas prices were high at that time, it would have been irresponsible (and contrary to their hedging policies) to not hedge a portion of their winter gas in the hope that prices would eventually drop. Thus, the elevated prices which were a result of the excess speculation in the market by Amaranth and others had a significant impact on the price these APGA members, and ultimately their customers, paid for natural gas. The lack of transparency with respect to this trading activity, much of which took place in the OTC markets, and the extreme price swings surrounding the collapse of Amaranth have caused bona fide hedgers to become reluctant to participate in the markets for fear of locking-in prices that may be artificial. Recently, additional concerns have been raised with respect to the size of positions related to, and the role of, passively managed long-only index funds. In this instance, the concern is not whether the positions are being taken in order to intentionally drive the price higher, but rather whether the unintended effect of the cumulative size of these positions has been to push market prices higher than the fundamental supply and demand situation would justify. The additional concern has been raised that recent increased amounts of speculative investment in the futures markets generally have resulted in excessively large speculative positions being taken that due merely to their size, and not based on any intent of the traders, are putting upward pressure on prices. The argument made is that these additional inflows of speculative capital are creating greater demand then the market can absorb, thereby increasing buy-side pressure which results in advancing prices. Some have responded to these concerns by reasoning that new futures contracts are capable of being created without the limitation of having to have the commodity physically available for delivery. This explains why, although the open-interest of futures markets can exceed the size of the deliverable supply of the physical commodity underlying the contract, the price of the contract could nevertheless reflect the forces of supply and demand. As we noted above, as hedgers we rely on speculative traders to provide liquidity and depth to the markets. Thus, we do not wish to see steps taken that would discourage speculators from participating in these markets using bona fide trading strategies. But more importantly, APGA's members rely upon the prices generated by the futures to accurately reflect the true value of natural gas. Accordingly, APGA would support additional regulatory controls, such as stronger speculative position limits, if a reasoned judgment can be made based on currently available, or additional forthcoming market data and facts, that such controls are necessary to address the unintended consequences arising from certain speculative trading strategies or to reign in excessively large speculative positions. To the extent that speculative investment may be increasing the price of natural gas or causing pricing aberrations, we strongly encourage Congress to take quick action to expand market transparency in order to be able to responsibly address this issue and protect consumers from additional cost burdens. Consumers should not be forced to pay a ``speculative premium.''The Markets in Natural Gas Contracts The market for natural gas financial contracts is composed of a number of segments. Contracts for the future delivery of natural gas are traded on NYMEX, a designated contract market regulated by the CFTC. Contracts for natural gas are also traded in the OTC markets. OTC contracts may be traded on multi-lateral electronic trading facilities which are exempt from regulation as exchanges, such as the IntercontinentalExchange (``ICE''). ICE also operates an electronic trading platform for trading non-cleared (bilateral) OTC contracts. They may also be traded in direct, bilateral transactions between counterparties, through voice brokers or on electronic platforms. OTC contracts may be settled financially or through physical delivery. Financially-settled OTC contracts often are settled based upon NYMEX settlement prices and physically delivered OTC contracts may draw upon the same deliverable supplies as NYMEX contracts, thus linking the various financial natural gas market segments economically. Increasingly, the price of natural gas in many supply contracts between suppliers and local distribution companies, including APGA members, is determined based upon monthly price indexes closely tied to the monthly settlement of the NYMEX futures contract. Accordingly, the futures market serves as the centralized price discovery mechanism used in pricing these natural gas supply contracts. Generally, futures markets are recognized as providing an efficient and transparent means for discovering commodity prices.\2\ However, any failure of the futures price to reflect fundamental supply and demand conditions results in prices for natural gas that are distorted and do not reflect its true value.\3\ This has a direct affect on consumers all over the U.S., who as a result of such price distortions, will not pay a price for the natural gas that reflects bona fide demand and supply conditions. If the futures price is manipulated or distorted, then the price consumers pay for the fuel needed to heat their homes and cook their meals will be similarly manipulated or distorted.--------------------------------------------------------------------------- \2\ See the Congressional findings in section 3 of the Commodity Exchange Act, 7 U.S.C. 1 et seq. (``Act''). Section 3 of the Act provides that, ``The transactions that are subject to this Act are entered into regularly in interstate and international commerce and are affected with a national public interest by providing a means for . . . discovering prices, or disseminating pricing information through trading in liquid, fair and financially secure trading facilities.'' A further question with respect to whether other speculative strategies, or excessively large speculative positions is also distorting market prices by pushing prices higher than they otherwise would be. \3\ The effect of Amarath's trading resulted in such price distortions. See generally PSI Report. The PSI Report on page 3 concluded that ``Traders use the natural gas contract on NYMEX, called a futures contract, in the same way they use the natural gas contract on ICE, called a swap. . . . The data show that prices on one exchange affect the prices on the other.''--------------------------------------------------------------------------- Today, the CFTC provides generally effective oversight of futures exchanges and the CFTC and the exchanges provide a significant level of transparency. And under the provisions of the Title XIII of the farm bill, the CFTC has been given additional regulatory authority with respect to significant price discovery contracts traded on exempt commercial markets, such as ICE. This is indeed a major step toward greater market transparency. However, even with this additional level of transparency, a large part of the market remains opaque to regulatory scrutiny. The OTC markets lack such price transparency. This lack of transparency in a very large and rapidly growing segment of the natural gas market leaves open the potential for a participant to engage in manipulative or other abusive trading strategies with little risk of early detection; and for problems of potential market congestion to go undetected by the CFTC until after the damage has been done to the market. Equally significant, even where the trading is not intended to be abusive, the lack of transparency for the over-all energy markets leaves regulators unable to answer questions regarding speculators' possible impacts on the market. For example, do we know who the largest traders are in the over-all market, looking at regulated futures contracts, significant price discovery contracts and bilateral OTC transactions? Without being able to see a large trader's entire position, it is possible that the effect of a large OTC trader on the regulated markets is masked, particularly when that trader is counterparty to a number of swaps dealers that in turn take positions in the futures market to hedge these OTC exposures as their own.Regulatory Oversight NYMEX, as a designated contract market, is subject to oversight by the CFTC. The primary tool used by the CFTC to detect and deter possible manipulative activity in the regulated futures markets is its large trader reporting system. Using that regulatory framework, the CFTC collects information regarding the positions of large traders who buy, sell or clear natural gas contracts on NYMEX. The CFTC in turn makes available to the public aggregate information concerning the size of the market, the number of reportable positions, the composition of traders (commercial/noncommercial) and their concentration in the market, including the percentage of the total positions held by each category of trader (commercial/noncommercial). The CFTC also relies on the information from its large trader reporting system in its surveillance of the NYMEX market. In conducting surveillance of the NYMEX natural gas market, the CFTC considers whether the size of positions held by the largest contract purchasers are greater than deliverable supplies not already owned by the trader, the likelihood of long traders demanding delivery, the extent to which contract sellers are able to make delivery, whether the futures price is reflective of the cash market value of the commodity and whether the relationship between the expiring future and the next delivery month is reflective of the underlying supply and demand conditions in the cash market.\4\--------------------------------------------------------------------------- \4\ See letter to the Honorable Jeff Bingaman from the Honorable Reuben Jeffery III, dated February 22, 2007.--------------------------------------------------------------------------- Title XIII of the 2008 Farm Bill, empowered the CFTC to collect large trader information with respect to ``significant price discovery contracts'' traded on the ICE trading platform. However, there remain significant gaps in transparency with respect to trading of OTC energy contracts, including many forms of contracts traded on ICE. Despite the links between prices for the NYMEX futures contract and the OTC markets in natural gas contracts, this lack of transparency in a very large and rapidly growing segment of the natural gas market leaves open the potential for participants to engage in manipulative or other abusive trading strategies with little risk of early detection and for problems of potential market congestion to go undetected by the CFTC until after the damage has been done to the market, ultimately costing the consumers or producers of natural gas. More profoundly, it leaves the regulator unable to assemble a true picture of the over-all size of a speculator's position in a particular commodity.Greater Transparency Needed Our members, and the customers served by them, believe that although Title XIII of the 2008 Farm Bill goes a long way to addressing the issue, there is not yet an adequate level of market transparency under the current system. This lack of transparency has led to a growing lack of confidence in the natural gas marketplace. Although the CFTC operates a large trader reporting system to enable it to conduct surveillance of the futures markets, it cannot effectively monitor trading if it receives information concerning positions taken in only one, or two, segments of the total market. Without comprehensive large trader position reporting, the government will remain handicapped in its ability to detect and deter market misconduct or to understand the ramifications for the market arising from unintended consequences associated with excessive large positions or with certain speculative strategies. If a large trader acting alone, or in concert with others, amasses a position in excess of deliverable supplies and demands delivery on its position and/or is in a position to control a high percentage of the deliverable supplies, the potential for market congestion and price manipulation exists. Similarly, we simply do not have the information to analyze the over-all effect on the markets from the current practices of speculative traders. Over the last several years, APGA has pushed for a level of market transparency in financial contracts in natural gas that would routinely, and prospectively, permit the CFTC to assemble a complete picture of the overall size and potential impact of a trader's position irrespective of whether the positions are entered into on NYMEX, on an OTC multi-lateral electronic trading facility which is exempt from regulation or through bilateral OTC transactions, which can be conducted over the telephone, through voice-brokers or via electronic platforms. APGA is optimistic that the enhanced authorities provided to the CFTC in the provisions of the CFTC reauthorization bill will help address the concerns that we have raised, but recognizes that more needs to be done to address this issue comprehensively.Additional Potential Enhancements in Transparency In supporting the CFTC reauthorization bill, we previously noted that only a comprehensive large trader reporting system would enable the CFTC, while a scheme is unfolding, to determine whether a trader, such as Amaranth, is using the OTC natural gas markets to corner deliverable supplies and manipulate the price in the futures market.\5\ A comprehensive large trader reporting system would also enable the CFTC to better detect and deter other types of market abuses, including for example, a company making misleading statements to the public or providing false price reporting information designed to advantage its natural gas trading positions, or a company engaging in wash trading by taking large offsetting positions with the intent to send misleading signals of supply or demand to the market. Such activities are more likely to be detected or deterred when the government is receiving information with respect to a large trader's overall positions, and not just those taken in the regulated futures market. It would also enable the CFTC to better understand the overall size of speculative positions in the market as well as the impact of certain speculative investor practices or strategies on the future's markets ability to accurately reflect fundamental supply and demand conditions.--------------------------------------------------------------------------- \5\ See e.g. U.S. Commodity Futures Trading Commission v. BP Products North America, Inc., Civil Action No. 06C 3503 (N.D. Ill.) filed June 28, 2006.--------------------------------------------------------------------------- Accordingly, APGA supports proposals to further increase and enhance transparency in the energy markets, generally, and in the markets for natural gas, specifically. APGA supports greater transparency with respect to positions in natural gas financial contracts acquired through bilateral transactions. Because bilateral trading can in fact be conducted on an all-electronic venue, and can impact prices on the exchanges even if conducted in a non-electronic environment, it is APGA's position that transparency in the bilateral markets is critical to ensure an appropriate level of consumer protection.Electronic Bilateral trading One example of the conduct of bilateral trading on an all-electronic trading platform was ``Enron On-line.'' Enron, using its popular electronic trading platform, offered to buy or sell contracts as the universal counterparty to all other traders using this electronic trading system. This one-to-many model constitutes a dealer's market and is a form of bilateral trading. This stands in contrast to a many-to-many model which is recognized as a multi-lateral trading venue. This understanding is reflected in section 1a(33) of the Commodity Exchange Act, which defines ``Trading Facility'' as a ``group of persons that . . . provides a physical or electronic facility or system in which multiple participants have the ability to execute or trade agreements, contracts or transactions by accepting bids and offers made by other participants that are open to multiple participants in the facility or system.'' On the Enron On-line trading platform, only one participant--Enron--had the ability to accept bids and offers of the multiple participants--its customers--on the trading platform. Section 1a(3) continues by providing that, ``the term 'trading facility' does not include (i) a person or group of persons solely because the person or group of persons constitutes, maintains, or provides an electronic facility or system that enables participants to negotiate the terms of and enter into bilateral transactions as a result of communications exchanged by the parties and not from interaction of multiple bids and multiple offers within a predetermined, nondiscretionary automated trade matching and execution algorithm . . . .'' This means that it is also possible to design an electronic platform for bilateral trading whereby multiple parties display their bids and offers which are open to acceptance by multiple parties, so long as the consummation of the transaction is not made automatically by a matching engine. Both of these examples of bilateral electronic trading platforms might very well qualify for exemption under the current language of sections 2(g) and 2(h)(1) of the Commodity Exchange Act. To the extent that these examples of electronic bilateral trading platforms were considered by traders to be a superior means of conducting bilateral trading over voice brokerage or the telephonic call-around markets, or will not fall within the significant price discovery contract requirements, their use as a substitute for a more-regulated exempt commercial market under section 2(h)(3) of the Act should not be readily discounted.Non-Electronic Bilateral Trading Moreover, even if bilateral transactions are not effected on an electronic trading platform, it is nonetheless possible for such direct or voice-brokered trading to affect prices in the natural gas markets. For example, a large hedge fund may trade bilaterally with a number of counterparty/dealers using standard ISDA documentation. By using multiple counterparties over an extended period of time, it would be possible for the hedge fund to establish very large positions with each of the dealer/counterparties. Each dealer in turn would enter into transactions on NYMEX to offset the risk arising from the bilateral transactions into which it has entered with the hedge fund. In this way, the hedge fund's total position would come to be reflected in the futures market. Thus, a prolonged wave of buying by a hedge fund, even through bilateral direct or voice-brokered OTC transactions, can be translated into upward price pressure on the futures exchange. As NYMEX settlement approaches, the hedge fund's bilateral purchases with multiple dealer/counterparties would maintain or increase upward pressure on prices. By spreading its trading through multiple counterparties, the hedge fund's purchases would attract little attention and escape detection by either NYMEX or the CFTC. In the absence of routine large-trader reporting of bilateral transactions, the CFTC will only see the various dealers' exchange positions and have no way of tying them back to purchases by a single hedge fund. Given that the various segments of the financial markets that price natural gas are linked economically, it is critical to achieving market transparency that traders holding large positions entered into through bilateral transactions be included in any large-trader reporting requirement. As explained above, by trading through multiple dealers, a large hedge fund would be able to exert pressure on exchange prices similar to the pressure that it could exert by holding those positions directly. Only a comprehensive large-trader reporting system that includes positions entered into in the OTC bilateral markets would enable the CFTC to see the entire picture and trace such positions back to a single source. If large trader reporting requirements apply only to positions acquired on multi-lateral electronic trading platforms, traders in order to avoid those reporting requirements may very well move more transactions to electronic bilateral markets or increase their direct bilateral trading. This would certainly run counter to efforts by Congress to increase transparency. APGA remains convinced that all segments of the natural gas marketplace should be treated equally in terms of reporting requirements. To do otherwise leaves open the possibility that dark markets on which potential market abuses could go undetected would persist and that our current lack of sufficient information to fully understand the impact of large speculative traders and certain trading strategies on the markets will continue, thereby continuing to place consumers at risk.Derivatives Markets Transparency and Accountability Act of 2009 As stated previously, APGA supports proposals to further increase and enhance transparency in the energy markets, generally, and in the markets for natural gas, specifically. APGA commends Chairman Peterson for drafting the Derivatives Markets Transparency and Accountability Act of 2009. This legislation would significantly enhance market transparency and would provide the CFTC with additional needed resources to help ensure that the ``cop on the beat'' has the tools needed to do its job. Specifically, this legislation would provide greater transparency with respect to the activities of the Index Funds by requiring them to be separately accounted for in the CFTC's Commitment of Traders Reports. APGA strongly supports provisions in the legislation that would provide greater transparency to the CFTC with respect to bilateral swap contracts. Another provision in the bill that APGA strongly supports is the requirement that the CFTC appoint at least 100 new full time employees. The CFTC plays a critical role in protecting consumers, and the market as a whole, from fraud, manipulation and market abuses that create distortion. It is essential that the CFTC have the necessary resources, both in terms of employees but also in terms of information technology, to monitor markets and protect consumers from attempts to manipulate the market. This is critical given the additional oversight responsibilities the CFTC will have through the market transparency language included in the 2008 Farm Bill and the additional transparency requirements that APGA is proposing to the Committee. Over the last several years, trading volumes have doubled while CFTC staffing levels have decreased. In fact, while we are experiencing record trading volumes, employee levels at the CFTC are at their lowest since the agency was created. Further, more complex and comprehensive monitoring practices from the CFTC will require the latest technology. It is critical that CFTC have the necessary tools to catch abuses before they occur. APGA is concerned that if funding for the CFTC is inadequate, so may be the level of protection.Conclusion Experience tells us that there is never a shortage of individuals or interests who believe they can, and will attempt to, affect the market or manipulate price movements to favor their market position. The fact that the CFTC has assessed over $300 million in penalties, and has assessed over $2 billion overall in government settlements relating to abuse of these markets affirms this. These efforts to punish those that manipulate or abuse markets or to address those that might innocently distort markets are important. But it must be borne in mind that catching and punishing those that manipulate markets after a manipulation has occurred is not an indication that the system is working. To the contrary, by the time these cases are discovered using the tools currently available to government regulators, our members, and their customers, have already suffered the consequences of those abuses in terms of higher natural gas prices. Greater transparency with respect to traders' large positions, whether entered into on a regulated exchange or in the OTC markets in natural gas will provide the CFTC with the tools to answer that question and to detect and deter potential manipulative or market distorting activity before our members and their customers suffer harm. The Committee's ongoing focus on energy markets has raised issues that are vital to APGA's members and their customers. We do not yet have the tools in place to say with confidence the extent to which the pricing mechanisms in the natural gas market today are reflecting market fundamentals or the possible market effects of various speculative trading strategies. However, we know that the confidence that our members once had in the pricing integrity of the markets has been badly shaken. In order to protect consumers the CFTC must be able to (1) detect a problem before harm has been done to the public through market manipulation or price distortions; (2) protect the public interest; and (3) ensure the price integrity of the markets. Accordingly, APGA and its over 700 public gas system members applaud your continued oversight of the CFTC's surveillance of the natural gas markets. We look forward to working with the Committee towards the passage of legislation that would provide further enhancements to help restore consumer confidence in the integrity of the price discovery mechanism. ______ Statment Submitted by Steve Suppan, Senior Policy Analyst, Institute for Agriculture and Trade Policy The Institute for Agriculture and Trade Policy (IATP) is a 501(c)(3) organization headquartered in Minneapolis, MN with an office in Geneva, Switzerland. IATP, founded over 20 years ago, works locally and globally to ensure fair and sustainable food, farm and trade systems. IATP is grateful for the opportunity to comment on a bill that is crucial for ensuring that commodities exchange activities contribute to the orderly functioning of markets that enable food and energy security. In November, IATP published ``Commodity Market Speculation: Risk to Food Security and Agriculture'' (http://www.iatp.org/iatp/publications.cfm?accountID=451&refID=104414). The study found that commodity index fund speculation in U.S. commodity exchanges distorted prices and induced extreme price volatility that made the futures and options market unusable for commercial traders. For example, one market consultant estimated that index fund trading accounted for about 30 percent of the nearly $8 a bushel price of corn on the Chicago Board of Trade at the height of the commodities bubble in late June. Until the bubble burst, many country elevators, unable to assess their risk in such volatile markets, had stopped forward contracting, endangering the cash flows and operations of many U.S. farms. The spike in developing country food import bills and increasing food insecurity, both in the United States and around the world, is partly due to the financial damage of deregulated speculation. While researching this study, I monitored the Committee hearings that contributed to H.R. 6604, ``Commodity Exchange Transparency and Accountability Act of 2008.'' IATP congratulates the Committee for the intense and expedited schedule of hearings and legislative drafting that resulted in the passage of H.R. 6604 and revisions to it in the draft ``Derivatives Markets Transparency and Accountability Act of 2009'' (hereafter ``the Act''). Due to the complexity of the legislation, our comments will only concern a small portion of the Act's provisions.Section 3. Speculative limits and transparency of off-shore trading and Section 6. Trading limits to prevent excessive speculation U.S. commodity exchanges have a dominant international influence over both cash and futures prices for many commodities. Because of the affects of that influence on food security and agriculture around the world, it is crucial that U.S. regulation and oversight of commodity exchanges be exemplary for the regulation of other markets. However, incidents of off-shore noncommercial traders benefiting from U.S. commodity exchanges while claiming to be beyond the jurisdiction of the Commodity Exchange Act (CEA) have resulted in the need for the prudent measures of section 3. The Committee and its staff are to be congratulated for the work undertaken since the passage of H.R. 6604 on September 18 to improve the bill. Particularly noteworthy are the visits of Chairman Peterson and Committee staff to regulatory authorities in London and Brussels both to explain H.R. 6604 and to learn how it might be improved. Section 3 would do by statute what the Commodities Futures Trading Commission's (hereafter ``the Commission'') memoranda of understanding with other regulatory authorities have failed to do: to ensure that foreign traders of futures, options and other derivatives cannot trade on U.S. exchanges unless they submit completely to the authorities of the CEA. Section 6 is so drafted as to avoid the possibility of a trade dispute ruling against the United States for ``discrimination'' against foreign firms in the peculiar trade and investment policy sense of that term. However, the World Trade Organization negotiations seek to further liberalize and deregulate financial services, particularly through the Working Party on Domestic Regulation of the General Agreement on Trade in Services (GATS).\1\ The members of the Financial Leaders Group that has lobbied effectively for GATS and U.S. deregulation (and particular regulatory exemptions for their firms) are major recipients of taxpayer bailouts through the Troubled Asset Relief Program.--------------------------------------------------------------------------- \1\ Ellen Gould. ``Financial Instability and the GATS Negotiations.'' Canadian Centre for Policy Alternatives. July 2008. http://www.tradeobservatory.org/library.cfm?refID=103596. --------------------------------------------------------------------------- The Committee should invite testimony from the Office of the U.S. Trade Representative (USTR) concerning U.S. GATS commitments, to ensure that those commitments and/or USTR positions advocated at the GATS negotiations not conflict with sections 3 and 6 or leave them vulnerable to WTO challenge. Furnished with that testimony and documents relevant to it, legislative drafting may be tightened to avoid the possibility of a WTO challenge. As the Committee is well-aware, the number of contracts held by noncommercial speculators far outweighs those of bona fide physical hedgers. The overwhelming dominance of purely financial speculation has induced price volatility that can be neither explained nor justified in terms of physical supply and demand, bona fide hedging by commercial traders and/or the amount of purely financial speculation required to clear trades. For example, in May, The Brock Report stated, ``no [commercial] speculator today can have a combined contract position in corn that exceeds 11 million bushels. Yet, the two biggest index funds [Standard and Poors/Goldman Sachs and Dow Jones/American Insurance Group] control a combined 1.5 billion bushels!'' \2\--------------------------------------------------------------------------- \2\ ``A Big Move Lies Ahead.'' The Brock Report. May 23, 2008.--------------------------------------------------------------------------- Section 3 of the Act seeks to close the regulatory exemption granted to Wall Street banks that enabled this massive imbalance between bona fide hedging on physical commodities and contracts held purely for financial speculation. However, closing that loophole will not suffice to begin to repair the damage wrought by the speculative position exemption. In 2004, the Security Exchange Commission granted for just a half dozen investment banks an exemption to prudential reserve requirements to cover losses, thus freeing up billions of dollars of speculative capital and handing the chosen banks a huge competitive advantage.\3\ These two regulatory exemptions enabled the asset price bubbles that began to burst in July, with dire consequences for the entire financial system and the global economy. The Act should authorize the Commission to work with the SEC to close all exemptions to prudential capital reserve requirements.--------------------------------------------------------------------------- \3\ Stephen LaBaton. ``Agency's `04 Rule Let Banks Pile Up New Debt, and Risk.'' The New York Times. October 3, 2008.--------------------------------------------------------------------------- Despite the commodities price collapse, Goldman Sachs, whose then CEO Henry Paulson lead the successful campaign to exempt his firm and other paragons of risk management from prudential capital reserve requirements, is estimated to have made $3 billion in net revenue in 2008 from its commodities division alone. The average bonus for a commodities trading managing director is estimated to be $3-$4 million in 2008, down 25 percent from 2007.\4\ Hence, there is little trader disincentive to exceed whatever speculative position limits that are agreed as a result of the deliberations of the Position Limit Agricultural and Energy Advisory Groups (stipulated by section 6. 4a). The Act provides for no advisory group for base and precious metals, which suggests that those components of the index funds may continue without speculative limits. The Act can readily be amended to provide for a Position Limit Metals Advisory Group. Given the financial service industry incentives structure, there is much to be done in the Act to provide strong disincentives for firms and individual traders to exceed the agreed speculative position limits.--------------------------------------------------------------------------- \4\ Ann Davis. ``Top Traders Still Expect the Cash.'' The Wall Street Journal. November 19, 2008.--------------------------------------------------------------------------- One of the responsibilities of the advisory groups is to submit to the Commission a recommendation about whether the exchanges themselves or the Commission should administer the position limit requirements ``with enforcement by both the registered entity and the Commission'' (lines 10-12, p. 15). While IATP agrees that the exchanges may have a role to play in administering the position limits requirement, we fail to understand why enforcement is not exclusively the Commission's prerogative. We urge the Committee to modify this provision to remove any suggestion of exchange enforcement authority.Section 4. Detailed Reporting and Disaggregation of Market Data and Section 5. Transparency and Record Keeping Authorities The provisions in these sections will help regulators monitor the size, number and value of contracts during the reporting period ``to the extent such information is available'' (Sec. 4(g)(2)). It is this qualifying last clause that worries IATP, since the Commission's ability to carry out its statutory obligations depends on complete and timely reporting of index fund data that disaggregates the agricultural, energy, base metal and precious metal contract components of these funds. The duration of agricultural futures contracts are typically 90 days, while energy and metals futures are for 6 months to a year. Both sections should stipulate that disaggregation not only concern contract positions held by traders with a bona fide commercial interest in the commodity hedged versus contracts held by financial speculators. Disaggregated and detailed reporting requirements should also stipulate reporting data from all component commodities contracts of the index funds, taking into account the differences in typical contract duration. Furthermore, the Act should authorize the Commission to stipulate that the reporting period for the disaggregated and detailed data be consistent with the duration of the index funds' component contracts, rather than with the reporting period of the index fund itself. The Act should further stipulate that the privilege to trade may be revoked or otherwise qualified if that trader's reporting does not provide sufficient information for the Commission to determine whether the trader is complying with the CEA as amended. Section 5 anticipates that traders will exceed the speculative position limits set by the Commission and provides for the terms of a special call by the Commission for trading data to determine whether the violation of the position limit has lead to price manipulation or excessive speculation, as defined in the CEA. Although IATP finds these provisions necessary for prudential regulation, we believe that the Act should stipulate how the Commission should seek to obtain the documents requested in the special call, when the trading facilities are located outside the United States. The Act wisely provides a ``Notice and Comment'' provision concerning the implementation of the reporting requirements for deals that exceed the speculative position limits. We anticipate that this ``Notice and Comment'' period will be used and guide the Commission's implementation of section 5 reporting requirements.Section 7. CFTC Administration IATP believes that the increase in Commission staff, above that called for in H.R. 6604, is well warranted. The Committee should consider adding to this section a provision for a public ombudsman who could take under consideration evidence of misuse or abuse of the Act's authorities by Commission employees and evidence of damage to market integrity that may result from non-implementation or non-enforcement of the Act's provisions.Section 9. Review of Over-the-Counter Markets Because of the prevalence of over-the-counter trades in commodities markets, and the damage to market integrity caused by lack of regulation of OTC trades, the need for speculative position limits on those trades seems all but self-evident. However, the Committee is wise to mandate the Commission's study of the OTC market given the heterogeneity, as well as the sheer volume of OTC contracts. We would suggest, however, that the study not be limited to transactions involving agricultural and energy commodities, but should also include base and precious metals.Section 10. Study Relating to International Regulation of Energy Commodity Markets IATP is very disappointed that section 10 has dropped the study of agricultural commodity markets called for in H.R. 6604. The Commission will be better able to carry out its responsibilities if it understands how agricultural commodities are regulated or not on exchanges outside of the United States. While U.S. exchanges are dominant in determining futures and cash prices for many agricultural commodities, there are other influential exchanges for certain commodities. The Commission should study these exchanges to find out whether there are best practices from which U.S. exchanges could benefit. IATP urges the Committee to restore the provision for a study of the international regulation of agricultural commodity markets to section 10.Section 13. Certain Exclusions and Exemptions Available Only for Certain Transactions Settled and Cleared Through Registered Derivatives Clearing Organizations We confess to not understanding these amendments to the CEA and to skepticism about the need for the exclusions, exemptions and waivers, in light of the exclusions, exemptions, and waivers whose abuse has helped bankrupt both financial institutions and individual investors. IATP suggests that the Committee add a ``Notice and Comment'' provision to this section, so that the public has an opportunity to argue for or against individual provisions of this section.Section 14. Treatment of Emission Allowances and Off-Set Credits This addition to H.R. 6604 may be premature, as the efficacy of emissions trading for actual reduction of global greenhouse gas emissions is under debate in the negotiations for a new United Nations Framework Convention on Climate Change. IATP believes that the Committee should await the results of the Framework Convention negotiations in December in Copenhagen before deciding whether to add this amendment to the CEA. If the Committee decides to retain this section, it should consider whether the current amendment should be limited to carbon sequestration or whether it should cover other green house gas emissions. Again, I thank the Committee for the opportunity to submit testimony. I congratulate the Committee on moving forward on this important work. I'm available to answer any questions concerning this testimony. FOMC20080916meeting--158 156,CHAIRMAN BERNANKE.," Thank you very much, and thanks, everyone, for very helpful comments. Let me try to summarize, and I will just make some comments, and then we can turn to the statement and policy. The group indicated, of course, that economic growth has slowed and looks to be quite sluggish in the second half. I didn't hear a great deal of change in the general profile, with most people still viewing growth as being slow in the near term but perhaps recovering somewhat in 2009. But obviously there is a lot of uncertainty surrounding that judgment. The ongoing problems in housing and the financial system are, of course, the downside risks to growth. Another factor, which is becoming more relevant, is the slowing global economy, which together with the stronger dollar may mean that U.S. export growth will be somewhat less. Despite the tax rebate, consumer spending seems likely to be weak in the near term, reflecting a variety of factors that we noted before, including housing and equity wealth, credit conditions, and particularly perhaps the ongoing weakness in the labor market. The labor market is deteriorating, with unemployment up, although UI programs may play some role in the unemployment rate. It is somewhat difficult to predict the peak of the unemployment rate, given the upward momentum we are seeing. Declines in energy prices, however, will improve real incomes and help consumer sentiment--so that is a potentially positive factor. The housing sector continues to be the central concern in the economy, in both the real and the financial sides. There are no clear signs of stabilization, although obviously regional conditions vary considerably. The government action regarding the GSEs has lowered mortgage rates and may be of some assistance. Credit conditions have tightened, though, in other areas as well, including nonresidential construction. Firms are continuing to struggle with weaker demand, higher uncertainty, and high costs. Manufacturing has been relatively stable to weaker, but we had at least one report of a survey that in the medium term the outlook is looking a little better. Inventories appear to be relatively well managed. Credit conditions for business vary, but there are indications that some firms are finding it very difficult to attract capital. Financial markets received a lot of attention around the table. Conditions clearly have worsened recently, despite the rescue of the GSEs, the latest stressor being the bankruptcy of Lehman Brothers and other factors such as AIG. Almost all major financial institutions are facing significant stress, particularly difficulties in raising capital, and credit quality is problematic, particularly in residential-related areas. One member noted that it is not evident that markets are clearly differentiating between weaker and stronger firms at this point. Deleveraging is continuing, and securitization markets are moribund. Credit terms and conditions are quite tight and may be a significant drag on the economy. However, the mediumterm implications of the recent increases in financial stress for the economy are difficult to assess. We may have to wait for some time to get greater clarity on the implications of the last week or so. On the inflation front, recent core and headline numbers have been high, reflecting earlier increases in the prices of energy and raw materials. There are positive factors, including the significant intermeeting declines in the prices of oil and other commodities, which, if maintained, would bring headline inflation down rather notably by the end of the year or next year. The dollar has also strengthened. Generally speaking, inflation expectations, though noisy, have improved. We have seen a decline in TIPS breakevens and some decline in survey expectations as well. But it was noted that the five-by-five TIPS breakeven remains above a level consistent with long-term price stability. Nominal wage growth has remained subdued so far, slack is increasing, productivity has been strong, and therefore, unit labor costs are well controlled. Again, all of these factors are positive in terms of a better inflation picture going forward. On the other hand, recent declines notwithstanding, the cumulative increases in commodity prices over the past year or so do remain large, and there is some evidence that these cost increases are being passed through into core prices. Commodity prices are extremely volatile, which makes inflation very difficult to forecast and makes the inflation outlook, therefore, quite uncertain. Wages could also begin to rise more quickly as the economy strengthens. For all these reasons, inflation risks are still in play and remain a concern for the Committee. Some participants reiterated their concern that maintaining rates too low for too long risks compromising our credibility and stimulating inflation over the medium run. That is a very quick survey of the comments. Are there any comments or questions? If not, let me just make a few comments. Personally, I see the prospects for economic growth in the foreseeable future as quite weak, notwithstanding the second quarter's strength. I think what we saw in the recent labor reports removes any real doubt that we are in a period that will be designated as an official NBER recession. Unemployment rose 1.1 percentage points in four months, which is a relatively rapid rate of increase. The significance of that for our deliberations is, again, that there does seem to be some evidence that, in recession regimes, the dynamics are somewhat more powerful and we tend to see more negative and correlated innovations in spending equations. So I think that we are in for a period of quite slow growth. That is confirmed by what we are seeing in consumption, which probably would be quite negative if it weren't for the remainder of the fiscal stimulus package. Other components of demand are, likewise, quite weak. We are all familiar with the housing situation. Some other factors that were supportive in Q2 are weakening--a number of people have noted the export growth. Actually, it is net exports--which is important--not just exports, and we are seeing both slowing growth in exports and some forecast of increased growth in imports. A factor that we haven't talked about much is the fiscal side. That has been supportive and may be less supportive going forward. Generally speaking, though, I do think--and I have said this for a long time--that the credit effects will be important. They operate with a lag. It is very difficult to judge the lag. But my strong sense is that they are still some distance from their peak; that they will begin to be felt outside of housing, in nonresidential construction, for example, in consumer spending, and in investment; and that this is going to be independent of last week's financial developments. I think that is going to be a major drag, probably well into next year. There are a few positives, which give some hope of some improvement next year. We have talked about energy and commodity prices as they relate to inflation, but of course, the decline in energy and commodity prices is also a plus for consumers and raises real incomes and would be supportive of sentiment, as we have already seen. There are a few positive indications here and there on the housing market, a few glimmers of stability, particularly in some regions. I think that the GSE stabilization is going to be very important. It has already lowered mortgage rates. It suggests that there will be a market for securitized mortgages, and I think that is positive. So if I wanted to outline an optimistic scenario, it would involve stronger indications of stabilization in housing, which in turn would feed into more confidence in the financial sector and would lead over time to improvement in the broader economy. I do think that financial conditions are a major concern. The situation right now is very uncertain, and we are not by any means away from significant systemic risk. Even if we avoid a major systemic event, the increase in risk aversion, the pullback from all counterparties, the deleveraging, the sale of assets--all of these things are going to continue for some time and are going to make the financial sector very stressed, which obviously will have effects on the economy. I have been grappling with the question I raised for President Lacker, and I would be very interested in hearing other views either now or some other time. The ideal way to deal with moral hazard is to have in place before the crisis begins a well-developed structure that gives clear indications in what circumstances and on what terms the government will intervene with respect to a systemically important institution. We have found ourselves, though, in this episode in a situation in which events are happening quickly, and we don't have those things in place. We don't have a set of criteria, we don't have fiscal backstops, and we don't have clear congressional intent. So in each event, in each instance, even though there is this sort of unavoidable ad hoc character to it, we are trying to make a judgment about the costs--from a fiscal perspective, from a moral hazard perspective, and so on--of taking action versus the real possibility in some cases that you might have very severe consequences for the financial system and, therefore, for the economy of not taking action. Frankly, I am decidedly confused and very muddled about this. I think it is very difficult to make strong, bright lines given that we don't have a structure that has been well communicated and well established for how to deal with these conditions. I do think there is some chance--it is not yet large, but still some chance--that we will in fact see a much bigger intervention at the fiscal level. One is tempted to argue that by doing more earlier you can avoid even more later, but of course that is all contingent and uncertain. So we will collectively do our best to deal with these very stressful financial conditions, which I don't think will be calm for some time. With respect to inflation, I accept the many caveats around the table. I have to say that I think, on net, inflation pressures are less worrisome now. The last two meetings have been very positive in that respect. The declines in energy and commodity prices are quite substantial. Natural gas, for example, has reversed all of its gains of the year. Steel scrap is down 40 percent in two months. We are seeing many other indications that commodity prices really have come down quite a bit. The dollar's increase is also quite striking, and we have talked about wages, TIPS, and other factors. So I think overall I see at least the near-term inflation risk as considerably reduced. I do agree, though, with the points that were made that we may well see pressure on core inflation for a while longer, despite this morning's reasonably benign number. The increases in commodity costs, although they have been partially reversed, have not been entirely reversed. Certainly over the last year to year and a half there is still a net substantial increase, which will show up as firms begin to pass through those costs. It is also the case, of course, that we have seen a very, very sharp movement in commodity prices and the dollar. Therefore, there is no logical reason why that couldn't be reversed. Clearly, one problem we face is that the uncertainty about forecasting commodity prices is so large that it makes our forecasting exercises extraordinarily uncertain and means that we need to be somewhat more careful than we otherwise would be if we were back in the days of the Texas Railroad Commission, when we knew the price of oil six months in advance. We don't have that privilege anymore. So I think core inflation may be elevated for a while. It may take a while for inflation to moderate. Everything I say is contingent on the dollar and commodity trends not being strongly reversed. But if those things are not reversed, I think we will see some improvement in inflation in the near term. I also agree with those who say that, when the time comes, we do need to be prompt at removing accommodation. It is just as much a mistake to move too late and allow inflation, and perhaps even financial imbalances, to grow as it is to move too early and be premature in terms of assuming a recovery. I think that is a very difficult challenge for us going forward, and I acknowledge the importance of that, which a number of people have noted. So that is a quick summary of my views. Let me just turn briefly, then, to policy. Do we have the statement? Let me just preview. I talked with Governor Warsh, and he gave me now during the break some of those suggestions he made. As they fit closely with other things that people said around the table, we have made a version here that incorporates them. I'll discuss that in just a minute. 3 First, as a number of people have said, let me just say that I thought the memo that the staff prepared over the intermeeting period was extraordinarily helpful. We have been debating around the table for quite a while what the right indicator of monetary policy is. Is it the federal funds rate? Is it some measure of financial stress? Or what is it? I think the only answer is that the right measure is contingent on a model. As President Lacker and President Plosser pointed out, you have to have a model and a forecasting mechanism to think about where the interest rate is that best achieves your objectives. It was a very useful exercise to find out, at least to some 3 The statement referred to here is appended to this transcript (appendix 3). extent, how the decline in the funds rate that we have put into place is motivated. In particular, the financial conditions do appear to be important both directly and indirectly--directly via the spreads and other observables that were put into the model and indirectly in terms of negative residuals in spending equations and the like. The recession dynamics were also a big part of the story. I hope that what this memo does for us--again, I think it's extraordinarily helpful--is to focus our debate better. As President Plosser pointed out, we really shouldn't argue about the level of the funds rate or the level of the spreads. We should think about the forecast and whether our policy path is consistent with achieving our objectives over the forecast period. I am sympathetic to the general view taken by the staff, which argues that those recession dynamics and financial restraints are important, that we are looking at slow growth going forward, and that inflation is likely to moderate. Based on those assumptions, I think that our policy is looking actually pretty good. To my mind, our quick move early this year, which was obviously very controversial and uncertain, was appropriate. Their analysis also suggests that the amount of insurance that we have is perhaps limited, given that they take a risk-neutral kind of modeling approach. Having said that, I think they have also clearly set out the conditions and the framework in which we can debate going forward exactly where we should be going. To the extent that those around the table disagree with the model or with the projection, then that is the appropriate way, it seems to me, to address our policy situation. So, again, I do very much appreciate that. It helped me think about the policy situation. As I said, I think our aggressive approach earlier in the year is looking pretty good, particularly as inflation pressures have seemed to moderate. Overall I believe that our current funds rate setting is appropriate, and I don't really see any reason to change. On the one hand, I think it would be inappropriate to increase rates at this point. It is simply premature. We don't have enough information. There is not enough pressure on inflation at this juncture to do that. On the other hand, cutting rates would be a very big step that would send a very strong signal about our views on the economy and about our intentions going forward, and I think we should view that step as a very discrete thing rather than as a 25 basis point kind of thing. We should be very certain about that change before we undertake it because I would be concerned, for example, about the implications for the dollar, commodity prices, and the like. So it is a step we should take only if we are very confident that that is the direction in which we want to go. Therefore my recommendation to the Committee--and I will open it up for comment in a moment--is to keep the funds rate at its current level. I listened very carefully to the conversation around the table in terms of the statement. I think it was President Lockhart, President Stern, and Governor Warsh, among others, who talked about strengthening the language on financial markets. So the draft statement that you have in front of you is an attempt to make that change. It has two changes relative to existing alternative B. First, as Governor Warsh suggested, it reverses the first two sentences and so focuses in the first sentence on ""Strains in financial markets have increased significantly and labor markets have weakened further,"" and then the rest of it is basically the same as it was. The other change, which is in the last paragraph in the risk assessment, is pretty small, but it is probably worth considering. The word ""closely"" has been added to suggest, obviously, that we understand that the situation is changing rapidly and that we are carefully following conditions as they evolve. Kevin, we took your word ""market"" there--what was the rationale for it? " FOMC20060629meeting--19 17,MR. KAMIN.," In contrast to the mixed news on economic activity coming out of the United States and despite the international financial volatility that Dino described, readings on foreign economic activity have been generally positive. Importantly, some of the areas of the global economy that had been weak in previous years are showing signs of strength. As indicated by the blue line in the top left panel of exhibit 11, euro-area industrial production has been moving up on balance in recent months, buoyed by solid manufacturing orders. The consumer had been the laggard in the euro zone’s recovery; but retail sales have edged up, and the first-quarter data on German consumption (not shown) were quite encouraging. In Japan, the middle panel, the rapid expansion that kicked in last year appears to be continuing: As in the euro area, manufacturing orders and output have been quite strong. And after generally disappointing growth for the past several years, Mexico’s economy, shown on the right, has accelerated on the back of strong manufacturing production, destined in large part for the United States. These indications support our estimate that total foreign growth (line 1 in the middle panel) registered a healthy and broad-based 3½ percent in the current quarter. To be sure, this represents a step-down from the exceptionally strong performance in the first quarter. The deceleration was mainly in emerging market economies (line 7), particularly China and Mexico. The Chinese government has taken several additional measures in recent months to slow investment, including restricting investment in certain sectors, raising down payments for real estate purchases, and tightening lending guidelines; we anticipate that these measures will finally bring overall growth down to a more sustainable pace. Mexican GDP, having surged more than 6 percent in the first quarter, likely has cooled to a still-robust 3½ percent rate in the second. Second-quarter growth in the industrial economies (line 2) is estimated to have shown a more muted decline from its first-quarter pace. Canadian growth likely slowed along with the U.S. economy, but Japanese growth is estimated to have stayed strong while activity in the euro area and the United Kingdom accelerated. Beyond the current quarter, we see growth in the emerging market economies holding steady while that of industrial economies moderates a bit further. Lower U.S. economic growth will restrain demand. Additionally, foreign economic activity will be responding to previous and prospective increases in interest rates. As shown in the bottom left panel, which presents our projections for key foreign policy rates, although we believe the tightening cycle is winding down in Canada, it still has a way to go in the euro area, and it has yet to begin in Japan. Finally, the recent sharp declines in global stock markets (the black and purple lines on the right) as well as the increase in emerging market credit spreads (the red line) will likely weigh on spending in both industrial and emerging market economies. Were downdrafts in international financial markets to continue and to intensify, they could lead to sharp falloffs in activity. For now, however, financial markets appear to be stabilizing with equity prices having reversed only a small part of previous steep run-ups and EMBI spreads remaining at historically low levels. A few economies—especially Turkey, South Africa, and Hungary—remain under pressure, but this likely reflects their particular vulnerabilities rather than more generalized turmoil in emerging markets. Accordingly, returning to the top line of the middle panel, total foreign growth is projected to make a smooth landing to its estimated trend rate of roughly 3¼ percent. This “goldilocks” projection for the foreign economies hinges on our assessment that inflation will remain contained despite continued high commodity prices and diminishing slack. As shown on the top left panel of exhibit 12, average inflation in the industrial economies is projected to move up a bit further in the current quarter but to then ease as the pass-through of higher energy and other commodity prices into consumer prices is completed. In the emerging economies, government policies tend to slow the response of domestic energy prices to those set in world markets; accordingly, inflation for these economies is not projected to peak until later this year, after which it also moves down. As shown on the right, our projection, based on quotes from futures markets, is that prices of both West Texas intermediate crude oil and non-energy commodities will flatten out but stay elevated. Oil prices have increased considerably faster than our import-weighted aggregate of non-energy commodity prices; but some non- energy prices, especially those of metals such as copper, have indeed moved up sharply over a short period of time. The quarterly data plotted in the chart obscure the fact that, most recently, prices of metals and other commodities have moved back down, in part because of the same concerns about future monetary policies and growth that have weighed on financial markets. The middle left panel shows spot prices for copper and zinc; although these have declined sharply, they remain extremely elevated. Increases in demand have been an important driver of the overall rise in commodity prices in the past few years. Some observers have taken this rise to be a signal that the global economy is overheating. Indeed, as shown on the right, world GDP growth (the red dashed line) has been brisk in the past two years, and this growth does appear to be correlated with the rate of change of oil and other commodity prices. Yet rising commodity prices are probably not so much a symptom of generalized global overheating as a reflection of rapid industrial development in Asia, particularly China. As indicated in line 2 of the bottom left panel, China, by itself, has contributed 1½ percentage points to global economic growth in the past three years; moreover, of the total increase in world oil consumption (shown in line 3), increases in Chinese consumption (shown in line 4) accounted for more than one-quarter. China’s contributions to global output growth appear to have been supported by corresponding increases in capacity. CPI inflation excluding food, the solid line in the panel on the right, has remained quite low at around 1 percent recently. Data on overall industrial capacity are not available, but we do have data for specific sectors. The red cross-hatched bars in the panel indicate Chinese steel-making capacity, and the solid bars represent actual production. China’s steel production has soared to 31 percent of total global output, but by dint of extraordinary levels of investment, capacity has risen even more. Thus, rising commodity prices likely reflect sectoral bottlenecks in the midst of rapid Asian development rather than a more-generalized global overheating. The top left panel of exhibit 13 focuses on resource utilization in the foreign industrial economies. The solid black line represents the staff estimate of the output gap—that is, the excess of actual over potential GDP; it suggests that actual output in the industrial economies is now near but not significantly above potential. The message that the industrial economies are not overheating is also supported by measures of capacity utilization rates in manufacturing, expressed as deviations from their ten-year averages; aside from Japan, capacity utilization rates in the major foreign industrial economies are close to historical levels. It is not possible to construct reliable measures of potential output and of the output gap for the developing economies because the requisite data on stocks of labor and especially capital are not available. Moreover, as these economies are undergoing rapid structural change, conventional output gap calculations would be doubly tenuous. Measures of manufacturing capacity utilization are available for some developing economies, as shown on the right, and they point to declining levels of resource slack. Whether overall GDP in these economies has moved up beyond potential, however, is difficult to say. The middle panels present a mixed picture of recent inflation trends in three of our important trading partners. In the euro area, twelve-month headline inflation (the solid black line) has edged up in recent months; however, both core inflation (the dotted red line) and wage growth (the blue dashed line) have stayed subdued. In Canada, headline, core, and wage inflation have all been creeping up, although core inflation remains at only 2 percent. In Mexico, notwithstanding rising global energy prices and accelerating wages, both headline inflation and core inflation have been trending down. The bottom left panel shows unit labor costs. Recent cost growth has been coming down from high levels in Canada and the United Kingdom, has been reasonably contained in France, and remains negative in Germany. Finally, the right panel indicates that long-term inflation expectations in the foreign industrial economies excluding Japan—whether measured by bond market breakeven rates (the black line) or semiannual surveys (the red line) have remained around 2½ percent or below. To sum up this lengthy discussion, although there is some risk of more-severe upward pressures on foreign inflation, the data in hand appear to support the more benign scenario we have built into our outlook. A second key risk to the outlook centers on the dollar. As indicated in the top left panel of exhibit 14, the U.S. current account deficit reached nearly 2 percent of world GDP last year, balanced primarily by surpluses in Japan, emerging Asia, and especially the oil-exporting countries. As shown on the right, the U.S. trade balance, while having recovered a bit from its plunge in the wake of Hurricane Katrina last fall, nevertheless remains on a deteriorating trend. Market focus on external imbalances likely explains much of the decline in the broad dollar (the black line in the middle left panel) in April and early May. However, the market’s attention to global external imbalances appeared to fade by mid-May, and the dollar has moved up since then. Neither the dollar’s decline nor its subsequent rebound could be explained by the differential between U.S. bond yields and foreign bond yields, shown on the right, which has moved little this year. The markets also apparently took no signal from the mid-June announcement of U.S. balance-of-payments data, shown in the bottom panel. As shown in line 1, the current account deficit narrowed in the first quarter, reflecting a smaller nominal trade deficit, reduced transfers abroad, and an improved balance on investment income. As for the financing of the deficit, private foreign purchases of U.S. securities, line 4, slowed sharply in April. However, neither the good news about the deficit nor the potentially bad news about its financing had much of an effect on the dollar. In projecting the future path of the dollar, we have wrestled with the usual tension between the need for the dollar to fall over the longer term to restore current account sustainability and the fact that in the shorter term the dollar can do pretty much whatever it wants. Accordingly, as indicated by the black line in the top left panel of exhibit 15, in our Greenbook projection the broad real dollar depreciates only about 2 percent annually. However, we are keenly aware that a refocusing of investor attention on sustainability could lead to a much steeper decline in the dollar. This exhibit compares our baseline projection of the external sector with a simulation of the staff’s FRB/Global model in which the dollar declines an additional 15 percent over the next year and a half; this is the same simulation summarized in the International Developments section of the Greenbook. As shown on the right, our baseline projection is for the trade balance to continue to deteriorate for the remainder of this year but to flatten out a bit next year as oil prices top out and the slowing of U.S. growth takes effect. Because of J-curve effects, the path of the nominal trade balance is roughly similar under the alternative simulation, at least during the forecast period. However, the additional depreciation leads to declines in real imports and increases in real exports. Accordingly, as shown in the next row, the contribution of net exports to real GDP growth, which is negative for most of next year in the baseline, becomes positive under the alternative simulation. A more-rapid depreciation of the dollar would affect prices as well as output. As shown on the right, in our baseline projection, core import price inflation—which we project will rise to 4 percent in the third quarter because of rising commodity prices— decelerates to 1 percent by the end of next year as commodity prices flatten out. The additional dollar depreciation in the alternative simulation adds 2 to 3 percentage points to core import inflation over the forecast period. As shown in the next row, core PCE inflation rises about ¼ percentage point, reflecting both the higher import prices and brisker economic activity. Accordingly, the Taylor rule in the model leads the federal funds rate to rise above 6 percent by the end of next year. This squeezes domestic consumption and investment somewhat and, as a result, real GDP growth in the alternative simulation rises a bit less than does the contribution of net exports to GDP. Notably, foreign growth declines a bit less than U.S. growth rises. In sum, we view a sharp decline in the dollar as unpredictable but entirely possible. Such an event likely would lead to more U.S. growth but also more inflation and a need for tighter monetary policy than currently incorporated into the Greenbook forecast." CHRG-111hhrg51698--210 Mr. Slocum," I am Tyson Slocum. I direct the Energy Program at Public Citizen. Public Citizen is one of America's largest consumer advocacy groups. We primarily get our funding from the 100,000 Americans across the country that pay dues to support our organization's work. My particular area of focus is on energy policy, and we have heard from our members and from Americans all over the country about the incredibly harmful impacts the volatility in energy prices have had on working people across the country. There is no question that this volatility is the direct result of rampant speculation, speculation made possible due to unregulated or under-regulated energy futures markets. I think that it is not a coincidence that the speculative bubble burst in crude oil at the same time that the Wall Street credit crisis occurred. These speculators were speculating on highly leveraged bets; and once the credit seized up, their ability to continue speculating also evaporated. So the huge drop in prices from $147 a barrel in just 5 months to $40 a barrel was a direct result of the ability of the speculators to continue evaporating. So the draft legislation that has been put together by Chairman Peterson does an excellent job as a first step to addressing the need to increase transparency and regulation over these futures markets. By bringing foreign exchanges under CFTC jurisdiction, by requiring mandatory clearing for OTC markets--although there is this big exemption that I am concerned about--requiring more detailed data from index traders and swaps dealers, requiring a review of all past CFTC decisions, which I believe undermined the transparency of the market, all of these are excellent things. The need to re-regulate these markets is all the more important because of the enormous consolidation that we have seen among the speculators. In response to the Wall Street crash, there has been a number of mergers between entities that had significant energy trading portfolios. There were no hearings when any of these mergers were approved; and so you had a lot of these very powerful entities become even larger and more powerful, with little or no public scrutiny over the impacts on the future of energy trading markets. So improving transparency, as the draft Derivatives Markets Transparency and Accountability Act, is an excellent start. There is an area that the legislation doesn't address that I would like to touch on for the rest of my opening statement. And that is dealing with what Public Citizen identifies as a serious matter of concern regarding the intersection of speculators like Wall Street investment banks and their ownership or control over physical energy infrastructure assets such as storage facilities, pipelines, oil refineries, and other physical energy infrastructure assets. There has been an explosion just over the last couple of years of Wall Street investment banks taking over pipeline systems and other energy infrastructure with, I believe, the sole purpose to provide them with added ability to enhance their speculative activities in the futures market. It is the only reason that I could figure why a company like Goldman Sachs would acquire 40,000 miles of petroleum product pipeline in North America through its 2006 acquisition of Kinder Morgan. Owning pipelines is a relatively low return business. With pipeline operations, their profits are heavily regulated. But owning and controlling pipeline systems gives an investment bank that has a large speculative division an insider's peek into the movement of information, of product that enhances their ability to make large speculative trades. The fact that Morgan Stanley, when I was reviewing their most recent annual report, boasted that they were going to be spending half a billion dollars in 2009 leasing petroleum storage facilities in the United States and, as Morgan Stanley said--I am quoting from their annual report--in connection with its commodities business, Morgan Stanley enters into operating leases for both crude oil and refined product storage for vessel charters. These operating leases are integral parts of the company's commodities risk management business. Just a month ago, Bloomberg reported that investment banks and other financial firms had 80 million barrels of oil stored offshore in oil tankers that were not being shipped to deliver into markets, to deliver oil and other needed products to consumers, but simply to use them to enhance their speculative hedging tactics. So, that it would be great if the Committee could examine a study by the CFTC or another appropriate entity to determine whether or not the intersection of ownership and control over physical energy assets with energy market speculative activities requires additional levels of scrutiny. Thank you very much for your time, and I look forward to your questions. [The prepared statement of Mr. Slocum follows:] Prepared Statement of Tyson Slocum, Director, Energy Program, Public Citizen, Washington, D.C.Protecting Families From Another Energy Price Shock: Restoring Transparency and Regulation to Futures Markets To Keep the Speculators Honest Thank you, Mr. Chairman and Members of Committee on Agriculture for the opportunity to testify on the issue of energy futures regulation. My name is Tyson Slocum and I am Director of Public Citizen's Energy Program. Public Citizen is a 38 year old public interest organization with over 100,000 members nationwide. We represent the needs of households by promoting affordable, reliable and clean energy. The extraordinary volatility in energy prices, particularly crude oil--which soared from $27/barrel in September 2003 to a high of $147/barrel in July 2008 before plummeting to its current price of $40/barrel--wreaked havoc with the economy while making speculators rich. The spectacular 75% decline in oil prices in just 5 months cannot be explained purely by supply and demand; rather, a speculative bubble burst, triggered by the Wall Street financial crisis. Strapped of their credit that had been fueling their highly leveraged trading operations, the credit crisis ended the speculators' ability to continue driving up prices far beyond the supply demand fundamentals. This speculation was made possible by legislative and regulatory actions that deregulated these energy futures markets. Although energy prices are no longer at record highs, it must be assumed that it is a matter of when, not if, a return to high prices will occur. Absent reregulation of the energy futures markets, aggressive government efforts to restore liquidity and unfreeze the credit markets will give new life to the Wall Street financial speculators, ushering a return to an energy commodity speculative bubble. Restoring transparency to futures markets is all the more urgent given the wave of consolidation that has occurred among the financial firms that were leading the speculative frenzy. Several major energy trading firms merged their operations in response the credit crisis: In 2007, ABN Amro was purchased by the Dutch National Government, the Royal Bank of Scotland and Spain's Banco Santander. In April 2008, J.P.Morgan Chase acquired Bear Stearns and its trading operations. In September 2008, Bank of America acquired Merrill Lynch. In October 2008, Wells Fargo and Wachovia agreed to merge. Electricite de France arranged to purchase all of Lehman Bros. energy trading operations in October 2008. Wells Fargo agreed to buy Wachovia in October 2008. In January 2009, UBS sold its energy trading operations to Barclays. Congress can take two broad actions to provide relief: providing incentives to households to give them better access to alternatives to our dependence on oil, and restoring transparency to the futures markets where energy prices are set. The former option is of course an effective long-term investment, as providing incentives to help families afford the purchase of super fuel efficient hybrid or alternative fuel vehicles, solar panel installation, energy efficient improvements to the home and greater access to mass transit would all empower households to avoid the brunt of high energy prices. The second option-restoring transparency to the futures markets where energy prices are actually set--is equally important. Stronger regulations over energy trading markets would reduce the level of speculation and limit the ability of commodity traders to engage in anti-competitive behavior that is contributing the record high prices Americans face. And as Congress considers market-based climate change legislation that would create a pollution futures trading market, the priority of establishing strong regulatory oversight over all energy- and pollution-related futures trading is the only way to effectively combat climate change, in order to ensure price transparency. Of course, supply and demand played a role in the recent rise and decline in oil prices. Gasoline demand in America is down, with Americans driving 112 billion less miles from November 2007 to November 2008,\1\ and global demand--even in emerging economies like China, India and oil exporting nations in the Middle East--has slackened in response to the global economic downturn, thereby offsetting the fact that mature, productive and easily-accessible oil fields are in decline. Claims of Saudi spare capacity are questioned due to the Kingdom's refusal to allow independent verification of the country's oil reserve claims. Simply put, oil is a finite resource with which the world--until recently--has embarked on unprecedented increased demand.--------------------------------------------------------------------------- \1\ www.fhwa.dot.gov/ohim/tvtw/tvtpage.htm.--------------------------------------------------------------------------- But there is no question that speculators and unregulated energy traders have pushed prices beyond the supply-demand fundamentals and into an era of a speculative bubble in oil markets. While some speculation plays a legitimate function for hedging and providing liquidity to the market, the exponential rise in market participants who have no physical delivery commitments has skyrocketed, from 37 percent of the open interest on the NYMEX West Texas Intermediate (WTI) contract in January 2000 to 71 percent in April 2008.\2\--------------------------------------------------------------------------- \2\ http://energycommerce.house.gov/Investigations/EnergySpeculationBinder_062308/15.pdf.--------------------------------------------------------------------------- Rather than demonize speculation generally, the goal is to address problems associated with recent Congressional and regulatory actions that deregulated energy trading markets that has opened the door to these harmful levels of speculation. Removing regulations has opened the door too wide for speculators and powerful financial interests to engage in anti-competitive or harmful speculative behavior that results in prices being higher than they would otherwise be. When oil was at $145/barrel, many estimated that at least $30 of that price was pure speculation, unrelated to supply and demand. While the Commodity Futures Trading Commission (CFTC) and Congress have taken recent small steps in the right direction, more must be done to protect consumers. While the CFTC has been disparaged by consumer advocates as being too deferential to energy traders, it has responded to recent criticism by ordering the United Kingdom to set limits on speculative trading of WTI contracts, proposing stronger disclosure for index traders and swap dealers, spearheading an interagency task force to more closely monitor energy markets and strengthening disclosure requirements in its amended Dubai Mercantile Exchange No Action letter. But these actions are hardly enough to rein in the harmful levels of speculation and anti-competitive behavior that are causing energy prices to rise. A new CFTC Chairman presents important opportunities for the agency to take a more assertive role in policing these markets. Recent Congressional action, too, has been beneficial to consumers, but the legislation has not gone nearly far enough. Title XIII of H.R. 6124 (the ``farm bill'') that became law in June 2008, closed some elements of the so-called ``Enron Loophole,'' which provided broad exemptions from oversight for electronic exchanges like ICE. But the farm bill only provides limited protections from market manipulation, as it allows the CFTC, ``at its discretion,'' to decide on a contract-by-contract basis that an individual energy contract should be regulated only if the CFTC can prove that the contract will ``serve a significant price discovery function'' in order to stop anti-competitive behavior. In December 2007, H.R. 6 was signed into law. Sections 811 through 815 of that act empower the Federal Trade Commission to develop rules to crack down on petroleum market manipulation.\3\ If these rules are promulgated effectively, this could prove to be an important first step in addressing certain anti-competitive practices in the industry.--------------------------------------------------------------------------- \3\ http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=110_cong_public_laws&docid=f:publ140.110.pdf.--------------------------------------------------------------------------- Public Citizen recommends four broad reforms to rein in speculators and help ensure that energy traders do not engage in anti-competitive behavior: [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Require foreign-based exchanges that trade U.S. energy products to be subjected to full U.S. regulatory oversight. Impose legally-binding firewalls to limit energy traders from speculating on information gleaned from the company's energy infrastructure affiliates or other such insider information, while at the same time allowing legitimate hedging operations. Congress must authorize the FTC and DOJ to place greater emphasis on evaluating anti-competitive practices that arise out of the nexus between control over hard assets like energy infrastructure and a firm's energy trading operations. Legislation introduced by U.S. Representative Collin C. Peterson, ``The Derivatives Markets Transparency and Accountability Act of 2009,'' \4\ does a great job addressing most of Public Citizen's recommendations. There are two areas, however, upon which the legislation could be improved. First, the bill should immediately subject OTC markets to the same regulatory oversight to which regulated exchanges like NYMEX must adhere. Second, the legislation should impose aggregate speculation limits over all markets to limit the ability of traders to engage in harmful speculation.--------------------------------------------------------------------------- \4\ http://agriculture.house.gov/inside/Legislation/111/PETEMN_001_xml.pdf.---------------------------------------------------------------------------Energy Trading Abuses Require Stronger OversightBackground Two regulatory lapses are enabling anti-competitive practices in energy trading markets where prices of energy are set. First, oil companies, investment banks and hedge funds are exploiting recently deregulated energy trading markets to manipulate energy prices. Second, energy traders are speculating on information gleaned from their own company's energy infrastructure affiliates, a type of legal ``insider trading.'' These regulatory loopholes were born of inappropriate contacts between public officials and powerful energy companies and have resulted in more volatile and higher prices for consumers. Contrary to some public opinion, oil prices are not set by the Organization of Petroleum Exporting Countries (OPEC); rather, they are determined by the actions of energy traders in markets. Historically, most crude oil has been purchased through either fixed-term contracts or on the ``spot'' market. There have been long-standing futures markets for crude oil, led by the New York Mercantile Exchange and London's International Petroleum Exchange (which was acquired in 2001 by an Atlanta-based unregulated electronic exchange, ICE). NYMEX is a floor exchange regulated by the U.S. Commodity Futures Trading Commission (CFTC). The futures market has historically served to hedge risks against price volatility and for price discovery. Only a tiny fraction of futures trades result in the physical delivery of crude oil. The CFTC enforces the Commodity Exchange Act, which gives the Commission authority to investigate and prosecute market manipulation.\5\ But after a series of deregulation moves by the CFTC and Congress, the futures markets have been increasingly driven by the unregulated over-the-counter (OTC) market over the last few years. These OTC and electronic markets (like ICE) have been serving more as pure speculative markets, rather than traditional volatility hedging or price discovery. And, importantly, this new speculative activity is occurring outside the regulatory jurisdiction of the CFTC.--------------------------------------------------------------------------- \5\ 7 U.S.C. 9, 13b and 13(a)(2).--------------------------------------------------------------------------- Energy trading markets were deregulated in two steps. First, in response to a petition by nine energy and financial companies, led by Enron,\6\ on November 16, 1992, then-CFTC Chairwoman Wendy Gramm supported a rule change--later known as Rule 35--exempting certain energy trading contracts from the requirement that they be traded on a regulated exchange like NYMEX, thereby allowing companies like Enron and Goldman Sachs to begin trading energy futures between themselves outside regulated exchanges. Importantly, the new rule also exempted energy contracts from the anti-fraud provisions of the Commodity Exchange Act.\7\ At the same time, Gramm initiated a proposed order granting a similar exemption to large commercial participants in various energy contracts that was later approved in April 2003.\8\--------------------------------------------------------------------------- \6\ The other eight companies were: BP, Coastal Corp. (now El Paso Corp.) Conoco and Phillips (now ConocoPhillips), Goldman Sachs' J. Aron & Co., Koch Industries, Mobil (now ExxonMobil) and Phibro Energy (now a subsidiary of CitiGroup). \7\ 17 CFR Ch. 1, available at www.access.gpo.gov/nara/cfr/waisidx_06/17cfr35_06.html. \8\ ``Exemption for Certain Contracts Involving Energy Products,'' 58 Fed. Reg. 6250 (1993).--------------------------------------------------------------------------- Enron had close ties to Wendy Gramm's husband, then-Texas Senator Phil Gramm. Of the nine companies writing letters of support for the rule change, Enron made by far the largest contributions to Phil Gramm's campaign fund at that time, giving $34,100.\9\--------------------------------------------------------------------------- \9\ Charles Lewis, ``The Buying of the President 1996,'' pg. 153. The Center for Public Integrity.--------------------------------------------------------------------------- Wendy Gramm's decision was controversial. Then-Chairman of a House Agriculture Subcommittee with jurisdiction over the CFTC, Rep. Glen English, protested that Wendy Gramm's action prevented the CFTC from intervening in basic energy futures contracts disputes, even in cases of fraud, noting that that ``in my 18 years in Congress [Gramm's motion to deregulate] is the most irresponsible decision I have come across.'' Sheila Bair, the CFTC Commissioner casting the lone dissenting vote, argued that deregulation of energy futures contracts ``sets a dangerous precedent.'' \10\ A U.S. General Accounting Office report issued a year later urged Congress to increase regulatory oversight over derivative contracts,\11\ and a Congressional inquiry found that CFTC staff analysts and economists believed Gramm's hasty move prevented adequate policy review.\12\--------------------------------------------------------------------------- \10\ ``Derivatives Trading Forward-Contract Fraud Exemption May be Reversed,'' Inside FERC's Gas Market Report, May 7, 1993. \11\ ``Financial Derivatives: Actions Needed to Protect the Financial System,'' GGD-94-133, May 18, 1994, available at http://archive.gao.gov/t2pbat3/151647.pdf. \12\ Brent Walth and Jim Barnett, ``A Web of Influence,'' Portland Oregonian, December 8, 1996.--------------------------------------------------------------------------- Five weeks after pushing through the ``Enron loophole,'' Wendy Gramm was asked by Kenneth Lay to serve on Enron's Board of Directors. When asked to comment about Gramm's nearly immediate retention by Enron, Lay called it ``convoluted'' to question the propriety of naming her to the Board.\13\--------------------------------------------------------------------------- \13\ Jerry Knight, ``Energy Firm Finds Ally, Director, in CFTC Ex-Chief,'' Washington Post, April 17, 1993.--------------------------------------------------------------------------- Congress followed Wendy Gramm's lead in deregulating energy trading contracts and moved to deregulate energy trading exchanges by exempting electronic exchanges, like those quickly set up by Enron, from regulatory oversight (as opposed to a traditional trading floor like NYMEX that remained regulated). Congress took this action during last-minute legislative maneuvering on behalf of Enron by former Texas GOP Senator Phil Gramm in the lame-duck Congress 2 days after the Supreme Court ruled in Bush v. Gore, buried in 712 pages of unrelated legislation.\14\ As Public Citizen pointed out back in 2001,\15\ this law deregulated OTC derivatives energy trading by ``exempting'' them from the Commodity Exchange Act, removing anti-fraud and anti-manipulation regulation over these derivatives markets and exempting ``electronic'' exchanges from CFTC regulatory oversight.--------------------------------------------------------------------------- \14\ H.R. 5660, an amendment to H.R. 4577, which became Appendix E of P.L. 106-554 available at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=106_cong_public_laws&docid=f:publ554.106.pdf. \15\ Blind Faith: How Deregulation and Enron's Influence Over Government Looted Billions from Americans, available at www.citizen.org/documents/Blind_Faith.pdf.--------------------------------------------------------------------------- This deregulation law was passed against the explicit recommendations of a multi-agency review of derivatives markets. The November 1999 release of a report by the President's Working Group on Financial Markets--a multi-agency policy group with permanent standing composed at the time of Lawrence Summers, Secretary of the Treasury; Alan Greenspan, Chairman of the Federal Reserve; Arthur Levitt, Chairman of the Securities and Exchange Commission; and William Rainer, Chairman of the CFTC--concluded that energy trading must not be deregulated. The Group reasoned that ``due to the characteristics of markets for nonfinancial commodities with finite supplies . . . the Working Group is unanimously recommending that the [regulatory] exclusion not be extended to agreements involving such commodities.'' \16\ In its 1999 lobbying disclosure form, Enron indicated that the ``President's Working Group'' was among its lobbying targets.\17\--------------------------------------------------------------------------- \16\ ``Over-the-Counter Derivatives Markets and the Commodity Exchange Act,'' Report of The President's Working Group on Financial Markets, pg. 16. www.ustreas.gov/press/releases/docs/otcact.pdf. \17\ Senate Office of Public Records Lobbying Disclosure Database, available at http://sopr.senate.gov/cgi-win/opr_gifviewer.exe?/1999/01/000/309/00030933130, page 7.--------------------------------------------------------------------------- As a result of the Commodity Futures Modernization Act, trading in lightly-regulated exchanges like NYMEX is declining as more capital flees to the unregulated OTC markets and electronic exchanges such as those run by the IntercontinentalExchange (ICE). Trading on the ICE has skyrocketed, with the 138 million contracts traded in 2007 representing a 230 percent increase from 2005.\18\ This explosion in unregulated and under regulated trading volume means that more trading is done behind closed doors out of reach of Federal regulators, increasing the chances of oil companies and financial firms to engage in anti-competitive practices. The founding members of ICE include Goldman Sachs, BP, Shell and TotalfinaElf. In November 2005, ICE became a publicly traded corporation.--------------------------------------------------------------------------- \18\ Available at www.theice.com/exchange_volumes_2005.jhtml.---------------------------------------------------------------------------The Players Goldman Sachs' trading unit, J. Aron, is one of the largest and most powerful energy traders in the United States, and commodities trading represents a significant source of revenue for the company. Goldman Sachs' most recent 10-k filed with the U.S. Securities and Exchange Commission show that Fixed Income, Currency and Commodities (which includes energy trading) generated 17 percent of Goldman's $22 billion in revenue for 2008.\19\ That share, however, masks the role that energy trading plays in Goldman's revenue as the company lumps under-performing activities such as securitized mortgage debt, thereby dragging down revenues for the entire segment. Indeed, Goldman touted the performance of its commodity trading activities in 2008, noting that it ``produced particularly strong results and net revenues were higher compared with 2007.''--------------------------------------------------------------------------- \19\ http://idea.sec.gov/Archives/edgar/data/886982/000095012309001278/y74032e10vk.htm.--------------------------------------------------------------------------- In 2005, Goldman Sachs and Morgan Stanley--the two companies are widely regarded as the largest energy traders in America--each reportedly earned about $1.5 billion in net revenue from energy trading. One of Goldman's star energy traders, John Bertuzzi, made as much as $20 million in 2005.\20\--------------------------------------------------------------------------- \20\ http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=109_cong_senate_committee--prints&docid=f:28640.pdf, pages 24 and 26.--------------------------------------------------------------------------- In the summer of 2006, Goldman Sachs, which at the time operated the largest commodity index, GSCI, announced it was radically changing the index's weighting of gasoline futures, selling about $6 billion worth. As a direct result of this weighting change, Goldman Sachs unilaterally caused gasoline futures prices to fall nearly 10 percent.\21\--------------------------------------------------------------------------- \21\ Heather Timmons, ``Change in Goldman Index Played Role in Gasoline Price Drop,'' The New York Times, September 30, 2006.--------------------------------------------------------------------------- Morgan Stanley held $18.7 billion in assets in commodity forwards, options and swaps at November 30, 2008. As the company noted in its annual report: ``Fiscal 2008 results reflected . . . record revenues from commodities . . . Commodity revenues increased 62%, primarily due to higher revenues from oil liquids and electricity and natural gas products.'' A deregulation action by the Federal Reserve in 2003--at the request of Citigroup and UBS--allows commercial banks to engage in energy commodity trading.\22\ Since then commercial banks have become big players in the speculation market. The total value of commodity derivative contracts held by the Citigroup's Phibro trading division increased 384 percent from 2004 through 2008, rising from $44.4 billion to $214.5 billion.\23\ Bank of America held $58.6 billion worth of commodity derivatives contracts as of September 2008.\24\ Merrill Lynch, which BoA acquired in September 2008, experienced ``strong net revenues for the [third] quarter [2008] generated from our . . . commodities businesses.'' \25\--------------------------------------------------------------------------- \22\ Regulation Y; Docket No. R-1146, www.federalreserve.gov/boarddocs/press/bcreg/2003/20030630/attachment.pdf. \23\ http://idea.sec.gov/Archives/edgar/data/831001/000104746908011506/a2188770z10-q.htm. \24\ http://idea.sec.gov/Archives/edgar/data/70858/000119312508228086/d10q.htm. \25\ http://idea.sec.gov/Archives/edgar/data/65100/000095012308014369/y72170e10vq.htm.--------------------------------------------------------------------------- Just a year after Enron's collapse, the Commodity Futures Trading Commission finalized rules allowing hedge funds to engage in energy trading without registering with the CFTC, opening the door to firms like Citadel and D.E. Shaw.\26\--------------------------------------------------------------------------- \26\ 17 CFR Part 4, RIN 3038-AB97, ``Additional Registration and Other Regulatory Relief for Commodity Pool Operators and Commodity Trading Advisors,'' final rule issued August 1, 2003.---------------------------------------------------------------------------The Consequences of Deregulation A recent bipartisan U.S. Senate investigation summed up the negative impacts on oil prices with this shift towards unregulated energy trading speculation: Over the last few years, large financial institutions, hedge funds, pension funds, and other investment funds have been pouring billions of dollars into the energy commodity markets-- perhaps as much as $60 billion in the regulated U.S. oil futures market alone . . . The large purchases of crude oil futures contracts by speculators have, in effect, created an additional demand for oil, driving up the price of oil to be delivered in the future in the same manner that additional demand for the immediate delivery of a physical barrel of oil drives up the price on the spot market . . . Several analysts have estimated that speculative purchases of oil futures have added as much as $20-$25 per barrel to the current price of crude oil . . . large speculative buying or selling of futures contracts can distort the market signals regarding supply and demand in the physical market or lead to excessive price volatility, either of which can cause a cascade of consequences detrimental to the overall economy . . . At the same time that there has been a huge influx of speculative dollars in energy commodities, the CFTC's ability to monitor the nature, extent, and effect of this speculation has been diminishing. Most significantly, there has been an explosion of trading of U.S. energy commodities on exchanges that are not regulated by the CFTC . . . in contrast to trades conducted on the NYMEX, traders on unregulated OTC electronic exchanges are not required to keep records or file Large Trader Reports with the CFTC, and these trades are exempt from routine CFTC oversights. In contrast to trades conducted on regulated futures exchanges, there is no limit on the number of contracts a speculator may hold on an unregulated OTC electronic exchange, no monitoring of trading by the exchange itself, and no reporting of the amount of outstanding contracts (``open interest'') at the end of each day.\27\--------------------------------------------------------------------------- \27\ The Role Of Market Speculation In Rising Oil And Gas Prices: A Need To Put The Cop Back On The Beat, Staff Report prepared by the Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs of the U.S. Senate, June 27, 2006, available at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=109_cong_senate_committee_prints&docid=f:28640.pdf. Thanks to the Commodity Futures Modernization Act, participants in these newly-deregulated energy trading markets are not required to file so-called Large Trader Reports, the records of all trades that NYMEX traders are required to report to the CFTC, along with daily price and volume information. These Large Trader Reports, together with the price and volume data, are the primary tools of the CFTC's regulatory regime: ``The Commission's Large Trader information system is one of the cornerstones of our surveillance program and enables detection of concentrated and coordinated positions that might be used by one or more traders to attempt manipulation.'' \28\ So the deregulation of OTC markets, by allowing traders to escape such basic information reporting, leave Federal regulators with no tools to routinely determine whether market manipulation is occurring in energy trading markets.--------------------------------------------------------------------------- \28\ Letter from Reuben Jeffrey III, Chairman, CFTC, to Michigan Governor Jennifer Granholm, August 22, 2005.--------------------------------------------------------------------------- One result of the lack of transparency is the fact that even some traders don't know what's going on. A recent article described how: Oil markets were rocked by a massive, almost instant surge in after-hours electronic trading one day last month, when prices for closely watched futures contracts jumped 8% . . . this spike stands out because it was unclear at the time what drove it. Two weeks later, it is still unclear. What is clear is that a rapid shift in the bulk of crude trading from the raucous trading floor of the New York Mercantile Exchange to anonymous computer screens is making it harder to nail down the cause of price moves . . . The initial jump ``triggered more orders already set into the system, and with prices rising, people thought somebody must know something,'' Tom Bentz, an analyst and broker at BNP Paribas Futures in New York who was watching the screen at the time, said the day after the spike. ``The more prices rose, the more it seemed somebody knew something.'' \29\--------------------------------------------------------------------------- \29\ Matt Chambers, ``Rise in Electronic Trading Adds Uncertainty to Oil,'' The Wall Street Journal, April 10, 2007. Oil companies, investment banks and hedge funds are exploiting the lack of government oversight to price-gouge consumers and make billions of dollars in profits. These energy traders boast how they're price-gouging Americans, as a recent Dow Jones article makes clear: energy ``traders who profited enormously on the supply crunch following Hurricane Katrina cashed out of the market ahead of the long weekend. `There are traders who made so much money this week, they won't have to punch another ticket for the rest of this year,' said Addison Armstrong, manager of exchange-traded markets for TFS Energy Futures.'' \30\--------------------------------------------------------------------------- \30\ Leah McGrath Goodman, ``Oil Futures, Gasoline In NY End Sharply Lower,'' September 2, 2005.--------------------------------------------------------------------------- The ability of Federal regulators to investigate market manipulation allegations even on the lightly-regulated exchanges like NYMEX is difficult, let alone the unregulated OTC market. For example, as of August 2006, the Department of Justice is still investigating allegations of gasoline futures manipulation that occurred on a single day in 2002.\31\ If it takes the DOJ 4 years to investigate a single day's worth of market manipulation, clearly energy traders intent on price-gouging the public don't have much to fear.--------------------------------------------------------------------------- \31\ John R. Wilke, Ann Davis and Chip Cummins, ``BP Woes Deepen with New Probe,'' The Wall Street Journal, August 29, 2006.--------------------------------------------------------------------------- That said, there have been some settlements for manipulation by large oil companies. In January 2006, the CFTC issued a civil penalty against Shell Oil for ``non-competitive transactions'' in U.S. crude oil futures markets.\32\ In March 2005, a Shell subsidiary agreed to pay $4 million to settle allegations it provided false information during a Federal investigation into market manipulation.\33\ In August 2004, a Shell Oil subsidiary agreed to pay $7.8 million to settle allegations of energy market manipulation.\34\ In July 2004, Shell agreed to pay $30 million to settle allegations it manipulated natural gas prices.\35\ In October 2007, BP agreed to pay $303 million to settle allegations the company manipulated the propane market.\36\ In September 2003, BP agreed to pay NYMEX $2.5 million to settle allegations the company engaged in improper crude oil trading, and in July 2003, BP agreed to pay $3 million to settle allegations it manipulated energy markets.\37\--------------------------------------------------------------------------- \32\ ``U.S. Commodity Futures Trading Commission Assesses Penalties of $300,000 Against Shell-Related Companies and Trader in Settling Charges of Prearranging Crude Oil Trades'' available at www.cftc.gov/newsroom/enforcementpressreleases/2006/pr5150-06.html. \33\ ``Commission Accepts Settlement Resolving Investigation Of Coral Energy Resources,'' available at www.ferc.gov/news/news-releases/2005/2005-1/03-03-05.asp. \34\ ``Order Approving Contested Settlement,'' available at www.ferc.gov/whats-new/comm-meet/072804/E-60.pdf. \35\ ``Coral Energy Pays $30 Million to Settle U.S. Commodity Futures Trading Commission Charges of Attempted Manipulation and False Reporting,'' available at www.cftc.gov/opa/enf04/opa4964-04.htm. \36\ www.cftc.gov/newsroom/enforcementpressreleases/2007/pr5405-07.html. \37\ ``Order Approving Stipulation and Consent Agreement,'' 104 FERC 61,089, available at http://elibrary.ferc.gov/idmws/common/opennat.asp?fileID=10414789.--------------------------------------------------------------------------- In August 2007, Oil giant BP admitted in a filing to the Securities and Exchange Commission that ``The U.S. Commodity Futures Trading Commission and the U.S. Department of Justice are currently investigating various aspects of BP's commodity trading activities, including crude oil trading and storage activities, in the U.S. since 1999, and have made various formal and informal requests for information.'' \38\--------------------------------------------------------------------------- \38\ www.sec.gov/Archives/edgar/data/313807/000115697307001223/u53342-6k.htm.--------------------------------------------------------------------------- In August 2007, Marathon Oil agreed to pay $1 million to settle allegations the company manipulated the price of West Texas Intermediate crude oil.\39\--------------------------------------------------------------------------- \39\ www.cftc.gov/newsroom/enforcementpressreleases/2007/pr5366-07.html.--------------------------------------------------------------------------- There is near-unanimous agreement among industry analysts that speculation is driving up oil and natural gas prices. Representative of these analyses is a May 2006 Citigroup report on the monthly average value of speculative positions in American commodity markets, which found that the value of speculative positions in oil and natural gas stood at $60 billion, forcing Citigroup to conclude that ``we believe the hike in speculative positions has been a key driver for the latest surge in commodity prices.'' \40\--------------------------------------------------------------------------- \40\ The Role Of Market Speculation In Rising Oil And Gas Prices: A Need To Put The Cop Back On The Beat, Staff Report prepared by the Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs of the U.S. Senate, June 27, 2006, available at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=109_cong_senate_committee_prints&docid=f:28640.pdf.--------------------------------------------------------------------------- Natural gas markets are also victimized by these unregulated trading markets. Public Citizen has testified before Congress on this issue,\41\ and a March 2006 report by four State Attorneys General concludes that ``natural gas commodity markets have exhibited erratic behavior and a massive increase in trading that contributes to both volatility and the upward trend in prices.'' \42\--------------------------------------------------------------------------- \41\ ``The Need for Stronger Regulation of U.S. Natural Gas Markets,'' available at www.citizen.org/documents/Natural%20Gas%20Testimony.pdf. \42\ The Role of Supply, Demand and Financial Commodity Markets in the Natural Gas Price Spiral, available at www.ago.mo.gov/pdf/NaturalGasReport.pdf.--------------------------------------------------------------------------- The Industrial Energy Consumers of America wrote a January 2005 letter to the Securities and Exchange Commission ``alarmed at the significant increase in unregulated hedge funds trading on the NYMEX and OTC natural-gas markets.'' \43\ In November 2004 the group wrote Congress, asking them to ``increase energy market oversight by the Commodity Futures Trading Commission.'' \44\--------------------------------------------------------------------------- \43\ www.ieca-us.com/downloads/natgas/SECletter013105.doc. \44\ www.ieca-us.com/downloads/natgas/111704LettertoCongr%23AAC2.doc.--------------------------------------------------------------------------- While most industry analysts agree that the rise in speculation is fueling higher prices, there is one notable outlier: the Federal Government. In a widely dismissed report, the CFTC recently concluded that there was ``no evidence of a link between price changes and MMT [managed money trader] positions'' in the natural gas markets and ``a significantly negative relationship between MMT positions and prices changes . . . in the crude oil market.'' \45\--------------------------------------------------------------------------- \45\ Michael S. Haigh, Jana Hranaiova and James A. Overdahl, ``Price Dynamics, Price Discovery and Large Futures Trader Interactions in the Energy Complex,'' available at www.cftc.gov/files/opa/press05/opacftc-managed-money-trader-study.pdf.--------------------------------------------------------------------------- The CFTC study (and similar one performed by NYMEX) is flawed for numerous reasons, including the fact that the role of hedge funds and other speculators on long-term trading was not included in the analysis. The New York Times reported that ``many traders have scoffed at the studies, saying that they focused only on certain months, missing price run-ups.'' \46\--------------------------------------------------------------------------- \46\ Alexei Barrionuevo and Simon Romero, ``Energy Trading, Without a Certain `E','' January 15, 2006.---------------------------------------------------------------------------Latest Trading Trick: Energy Infrastructure Affiliate Abuses Energy traders like Goldman Sachs are investing and acquiring energy infrastructure assets because controlling pipelines and storage facilities affords their energy trading affiliates an ``insider's peek'' into the physical movements of energy products unavailable to other energy traders. Armed with this non-public data, a company like Goldman Sachs most certainly will open lines of communication between the affiliates operating pipelines and the affiliates making large bets on energy futures markets. Without strong firewalls prohibiting such communications, consumers would be susceptible to price-gouging by energy trading affiliates. For example, In January 2007, Highbridge Capital Management, a hedge fund controlled by J.P.Morgan Chase, bought a stake in an energy unit of Louis Dreyfus Group to expand its oil and natural gas trading. Glenn Dubin, co-founder of Highbridge, said that owning physical energy assets like pipelines and storage facilities was crucial to investing in the business: ``That gives you a very important information advantage. You're not just screen-trading financial products.'' \47\--------------------------------------------------------------------------- \47\ Saijel Kishan and Jenny Strasburg, ``Highbridge Capital Buys Stake in Louis Dreyfus Unit,'' Bloomberg, January 8, 2007, www.bloomberg.com/apps/news?pid=20601014&sid=aBnQy1botdFo. --------------------------------------------------------------------------- Indeed, such an ``information advantage'' played a key role in allowing BP's energy traders to manipulate the entire U.S. propane market. In October 2007, the company paid $303 million to settle allegations that the company's energy trading affiliate used the company's huge control over transportation and storage to allow the energy trading affiliate to exploit information about energy moving through BP's infrastructure to manipulate the market. BP's energy trading division, North America Gas & Power (NAGP), was actively communicating with the company's Natural Gas Liquids Business Unit (NGLBU), which handled the physical production, pipeline transportation and retail sales of propane. A PowerPoint exhibit to the civil complaint against BP details how the two divisions coordinated their manipulation strategy, which includes ``assurance that [the] trading team has access to all information and optionality within [all ofBP] . . . that can be used to increase chance of success [of market manipulation] . . . Implement weekly meetings with Marketing & Logistics to review trading positions and share opportunities.'' \48\--------------------------------------------------------------------------- \48\ www.cftc.gov/files/enf/06orders/opa-bp-lessons-learned.pdf.--------------------------------------------------------------------------- And in August 2007, BP acknowledged that the Federal Government was investigating similar gaming techniques in the crude oil markets. BP is not alone. A Morgan Stanley energy trader, Olav Refvik, ``a key part of one of the most profitable energy-trading operations in the world . . . helped the bank dominate the heating oil market by locking up New Jersey storage tank farms adjacent to New York Harbor.'' \49\ As of November 2008, Morgan Stanley committed $452 million to lease petroleum storage facilities for 2009. As the company notes: ``In connection with its commodities business, the Company enters into operating leases for both crude oil and refined products storage and for vessel charters. These operating leases are integral parts of the Company's commodities risk management business.'' \50\ In 2003, Morgan Stanley teamed up with Apache Corp. to buy 26 oil and gas fields from Shell for $500 million, of which Morgan Stanley put up $300 million in exchange for a portion of the production over the next 4 years, which it used to supplement its energy trading desk.\51\ Again, control over physical infrastructure assets plays a key role in helping energy traders game the market.--------------------------------------------------------------------------- \49\ http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=109_cong_senate_committee_prints&docid=f:28640.pdf, page 26. \50\ http://idea.sec.gov/Archives/edgar/data/895421/000119312509013429/d10k.htm. \51\ Paul Merolli, ``Two Morgan Stanley M&A deals show bullish stance on gas,'' Natural Gas Week, Volume 19; Issue 28, July 14, 2003.--------------------------------------------------------------------------- The Wall Street Journal suggested that the bankruptcy of a single firm, SemGroup, served as the initial trigger of crude oil's price collapse this summer. The company operated 1,200 miles of oil pipelines and held 15 million barrels of crude storage capacity, but was misleading regulators and its own investors on the extent of its hedging practices. Data suggests that SemGroup was taking out positions far in excess of its physical delivery commitments, becoming a pure speculator. When its bets turned sour, the company was forced to declare bankruptcy.\52\--------------------------------------------------------------------------- \52\ Brian Baskin, ``SemGroup Loses Bets on Oil; Hedging Tactics Coincide With Ebb In Price of Crude,'' July 24, 2008, Page C14.--------------------------------------------------------------------------- This shows that the energy traders were actively engaging the physical infrastructure affiliates in an effort to glean information helpful for market manipulation strategies. And it is important to note that BP's market manipulation strategy was extremely aggressive and blatant, and regulators were tipped off to it by an internal whistleblower. A more subtle manipulation effort could easily evade detection by Federal regulators, making it all the more important to establish firewalls between energy assets affiliates and energy trading affiliates to prevent any undue communication between the units. Financial firms like hedge funds and investment banks that normally wouldn't bother purchasing low-profit investments like oil and gasoline storage have been snapping up ownership and/or leasing rights to these facilities mainly for the wealth of information that controlling energy infrastructure assets provides to help one's energy traders manipulate trading markets. The Wall Street Journal reported that financial speculators were snapping up leasing rights in Cushing, Ok.\53\--------------------------------------------------------------------------- \53\ Ann Davis, ``Where Has All The Oil Gone?'' October 6, 2007, Page A1.--------------------------------------------------------------------------- In August 2006, Goldman Sachs, AIG and Carlyle/Riverstone announced the $22 billion acquisition of Kinder Morgan, Inc., which controls 43,000 miles of crude oil, refined products and natural gas pipelines, in addition to 150 storage terminals. Prior to this huge purchase, Goldman Sachs had already assembled a long list of oil and gas investments. In 2005, Goldman Sachs and private equity firm Kelso & Co. bought a 112,000 barrels/day oil refinery in Kansas operated by CVR Energy, and entered into an oil supply agreement with J. Aron, Goldman`s energy trading subsidiary. Goldman's Scott L. Lebovitz & Kenneth A. Pontarelli and Kelso's George E. Matelich & Stanley de J. Osborne all serve on CVR Energy's Board of Directors. In May 2004, Goldman spent $413 million to acquire royalty rights to more than 1,600 natural gas wells in Pennsylvania, West Virginia, Texas, Oklahoma and offshore Louisiana from Dominion Resources. Goldman Sachs owns a six percent stake in the 375 mile Iroquois natural gas pipeline, which runs from Northern New York through Connecticut to Long Island. In December 2005, Goldman and Carlyle/Riverstone together are investing $500 million in Cobalt International Energy, a new oil exploration firm run by former Unocal executives.Conclusion This era of high energy prices isn't a simple case of supply and demand, as the evidence suggests that weak or non-existent regulatory oversight of energy trading markets provides opportunity for energy companies and financial institutions to price-gouge Americans. Forcing consumers suffering from inelastic demand to continue to pay high prices--in part fueled by uncompetitive actions--not only hurts consumers economically, but environmentally as well, as the oil companies and energy traders enjoying record profits are not investing those earnings into sustainable energy or alternatives to our addiction to oil. Reforms to strengthen regulatory oversight over America's energy trading markets are needed to restore true competition to America's oil and gas markets.Solutions Re-regulate energy trading markets by subjecting OTC exchanges--including foreign-based exchanges trading U.S. energy products--to full compliance under the Commodity Exchange Act and mandate that all OTC energy trades adhere to the CFTC's Large Trader reporting requirements. In addition, regulations must be strengthened over existing lightly- regulated exchanges like NYMEX. Impose legally-binding firewalls to limit energy traders from speculating on information gleaned from the company's energy infrastructure affiliates or other such insider information, while at the same time allowing legitimate hedging operations. Congress must authorize the FTC and DOJ to place greater emphasis on evaluating anti-competitive practices that arise out of the nexus between control over hard assets like energy infrastructure and a firm's energy trading operations. Incorporating energy trading operations into anti-trust analysis must become standard practice for Federal regulatory and enforcement agencies to force more divestiture of assets in order to protect consumers from abuses. Raise margin requirements so market participants will have to put up more of their own capital in order to trade energy contracts, and impose aggregate position limits on noncommercial trading to reduce speculation. Currently, margin requirements are too low, which encourages speculators to more easily enter the market by borrowing, or leveraging, against their positions. And aggregated limits over all markets--not just select ones--would preclude an energy trader from dipping their hands in multiple futures market cookie jars with the intent to speculate. " fcic_final_report_full--151 CDOs, and leverage, Cioffi’s funds earned healthy returns for a time: the High-Grade fund had returns of  in ,  in , and  in  after fees.  Cioffi and Tannin made millions before the hedge funds collapsed in . Cioffi was rewarded with total compensation worth more than  million from  to . In , the year the two hedge funds filed for bankruptcy, Cioffi made more than . mil- lion in total compensation. Matt Tannin, his lead manager, was awarded compensa- tion of more than . million from  to .  Both managers invested some of their own money in the funds, and used this as a selling point when pitching the funds to others.  But when house prices fell and investors started to question the value of mort- gage-backed securities in , the same short-term leverage that had inflated Cioffi’s returns would amplify losses and quickly put his two hedge funds out of business. CITIGROUP ’S LIQUIDITY PUTS: “A POTENTIAL CONFLICT OF INTEREST ” By the middle of the decade, Citigroup was a market leader in selling CDOs, often using its depositor-based commercial bank to provide liquidity support. For much of this period, the company was in various types of trouble with its regulators, and then-CEO Charles Prince told the FCIC that dealing with those troubles took up more than half his time.  After paying the  million fine related to subprime mort- gage lending, Citigroup again got into trouble, charged with helping Enron—before that company filed for bankruptcy in —use structured finance transactions to manipulate its financial statements. In July , Citigroup agreed to pay the SEC  million to settle these allegations and also agreed, under formal enforcement actions by the Federal Reserve and Office of the Comptroller of the Currency, to overhaul its risk management practices.  By March , the Fed had seen enough: it banned Citigroup from making any more major acquisitions until it improved its governance and legal compliance. Ac- cording to Prince, he had already decided to turn “the company’s focus from an ac- quisition-driven strategy to more of a balanced strategy involving organic growth.”  Robert Rubin, a former treasury secretary and former Goldman Sachs co-CEO who was at that time chairman of the Executive Committee of Citigroup’s board of direc- tors, recommended that Citigroup increase its risk taking—assuming, he told the FCIC, that the firm managed those risks properly.  Citigroup’s investment bank subsidiary was a natural area for growth after the Fed and then Congress had done away with restrictions on activities that could be pur- sued by investment banks affiliated with commercial banks. One opportunity among many was the CDO business, which was just then taking off amid the booming mort- gage market. In , Citi’s CDO desk was a tiny unit in the company’s investment banking arm, “eight guys and a Bloomberg” terminal, in the words of Nestor Dominguez, then co-head of the desk.  Nevertheless, this tiny operation under the command of FOMC20080625meeting--84 82,MS. PIANALTO.," Thank you, Mr. Chairman. The last two months have brought an interesting shift in my conversations with my business contacts. Their concerns have shifted from problems in financial markets to the rapid increase in input prices. Energy prices are the focus nationwide, but steel prices are also capturing the attention of the business people in my District. Several manufacturers and builders noted that the price they pay for steel has almost doubled since the beginning of this year. Clearly, businesses are worried about signs of growing price pressures, but their reactions to these price shocks tell a more complicated story. Many manufacturers have not been able to pass on price increases, resulting in a clear loss to profit margins. These businesses often report cost-containment or efficiency programs that will affect their hiring and capital decisions for months to come. Interestingly, the consumer price data show a similar dichotomy. My staff noted that our primary measures of core inflation are not providing a consistent story about the path of underlying inflation. In the May CPI report, roughly one-third of the weighted price changes increased at rates above 5 percent, and roughly one-third of prices changed by rates less than 1 percent. For example, while energy costs were up strongly and prices for a number of general service components have been drifting higher, large declines in apparel and vehicle expenses are imparting significant offsets. The 16 percent trimmed mean indicator showed an alarming 4 percent rise in prices, while the median rose just at 2.2 percent. The weight of price changes in the 1 percent to 5 percent range was unusually small, making it difficult to estimate the central tendency of the price change distribution with much confidence. So this makes it difficult to get a good read on where future prices are headed. My District business contacts remain pessimistic about growth prospects. District retail reports focused extensively on the likely effects of gasoline and food prices on the purchasing decisions of consumers. Many manufacturers, builders, and distributors are facing complicated output and investment decisions in the context of input price growth and weaker markets. Overall, most of the business people that I talk with are still quite cautious about their business plans, despite the fact that most of them have found sources of credit and terms that are not too elevated from what they have seen in previous years. In the economic projections that I submitted for this meeting, I raised my near-term forecast for output growth slightly and for headline inflation slightly more. Over the medium term, my outlook continues to be for modest growth because the housing market, in my forecast, recovers slowly, actually more slowly than in the Greenbook. My staff estimated a model for national housing starts that takes into account what has happened in the past in states that have seen major increases in foreclosures. The real estate difficulties that these states faced were much more persistent than anything that we have yet seen in the national data. The bottom line of this analysis is that, if the patterns of past housing cycles from the states that experienced the boom�bust cycles are repeated at the national level, then housing starts should remain relatively weak over the next couple of years. Supporting this analysis, three of the large regional banking organizations in my District are increasing their loan-loss provisions significantly in the second quarter based on the continued deterioration in the housing sector. Based on current projections, these institutions are projecting housing sector credit losses to accelerate in the second half of 2008 and to continue into 2009. Currently, the weak output growth contributes to my forecast of declining inflation rates, especially the core rate, but I also see evidence supporting that view in the ""less worker bargaining power"" scenario that is in the Greenbook. My contacts see very little price pressures coming from labor costs now or in the near future. Finally, implicit in my forecast for output growth and inflation is a fed funds rate path that includes increases later this year and into next year. Although additional risks to growth remain, the primary risk to my forecast concerns input prices and inflation expectations. If commodity prices continue to accelerate, they are going to put upward pressure on both headline and core inflation and downward pressure on output. That environment could lead to a highly undesirable increase in inflation expectations. On the positive side of risk to the outlook, I think that the fed funds rate actions that we have taken, in conjunction with the actions that we took in August to bolster market liquidity, have improved confidence, and I have substantially lowered the odds I had placed on financial market meltdown and on a severe recession. In that sense, since our meeting in April the downside risks to my outlook for economic growth have lessened somewhat, and the risks to my inflation outlook have moved up somewhat. Regarding the issue of providing longer-term forecasts, I have long supported efforts to clarify the underlying objectives of FOMC participants by providing our longer-term economic projections. Of the proposals that were offered by the Subcommittee on Communications, I favor reporting the average values for output growth, unemployment, and total inflation expected over a five-to-ten-year period--option 3. The features of these five-to-ten-year projections that I find attractive are that they indicate where the economy might converge and don't imply too much knowledge of the path to the long run. Thank you, Mr. Chairman. " FOMC20081007confcall--81 79,MS. DANKER.," Yes. The vote will encompass both the directive and the policy statement that were distributed earlier today, with the exception of the final sentence in the second paragraph of the draft policy statement, which says, ""Inflation has been high, but the Committee believes that the decline in energy and other commodity prices and the weaker prospects for economic activity have reduced the upside risks to inflation."" Chairman Bernanke Vice Chairman Geithner Governor Duke President Fisher Governor Kohn Governor Kroszner President Pianalto President Plosser President Stern Governor Warsh Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes " fcic_final_report_full--23 Many people chose poorly. Some people wanted to live beyond their means, and by mid-, nearly one-quarter of all borrowers nationwide were taking out interest- only loans that allowed them to defer the payment of principal.  Some borrowers opted for nontraditional mortgages because that was the only way they could get a foothold in areas such as the sky-high California housing market.  Some speculators saw the chance to snatch up investment properties and flip them for profit—and Florida and Georgia became a particular target for investors who used these loans to acquire real estate.  Some were misled by salespeople who came to their homes and persuaded them to sign loan documents on their kitchen tables. Some borrowers naively trusted mortgage brokers who earned more money placing them in risky loans than in safe ones.  With these loans, buyers were able to bid up the prices of houses even if they didn’t have enough income to qualify for traditional loans. Some of these exotic loans had existed in the past, used by high-income, finan- cially secure people as a cash-management tool. Some had been targeted to borrow- ers with impaired credit, offering them the opportunity to build a stronger payment history before they refinanced. But the instruments began to deluge the larger market in  and . The changed occurred “almost overnight,” Faith Schwartz, then an executive at the subprime lender Option One and later the executive director of Hope Now, a lending-industry foreclosure relief group, told the Federal Reserve’s Con- sumer Advisory Council. “I would suggest most every lender in the country is in it, one way or another.”  At first not a lot of people really understood the potential hazards of these new loans. They were new, they were different, and the consequences were uncertain. But it soon became apparent that what had looked like newfound wealth was a mirage based on borrowed money. Overall mortgage indebtedness in the United States climbed from . trillion in  to . trillion in . The mortgage debt of American households rose almost as much in the six years from  to  as it had over the course of the country’s more than -year history. The amount of mortgage debt per household rose from , in  to , in .  With a simple flourish of a pen on paper, millions of Americans traded away decades of eq- uity tucked away in their homes. Under the radar, the lending and the financial services industry had mutated. In the past, lenders had avoided making unsound loans because they would be stuck with them in their loan portfolios. But because of the growth of securitization, it wasn’t even clear anymore who the lender was. The mortgages would be packaged, sliced, repackaged, insured, and sold as incomprehensibly complicated debt securities to an assortment of hungry investors. Now even the worst loans could find a buyer. More loan sales meant higher profits for everyone in the chain. Business boomed for Christopher Cruise, a Maryland-based corporate educator who trained loan offi- cers for companies that were expanding mortgage originations. He crisscrossed the nation, coaching about , loan originators a year in auditoriums and classrooms. CHRG-111hhrg51698--269 Mr. Boswell," Thank you, Mr. Chairman. I had to step out. I apologize. If this has been asked, just stop me. But, to Mr. Roth, I guess we will get better acquainted as I take on the new responsibility with commodities and risk management that the Chairman has seen so fit to give me, but we will talk more as time goes on. But I am concerned. There is a lot of blame for hastening the downward spiral for the naked credit default swaps. Would you just comment some more on that? That is done through, some say, bad actors; to short a company and then drive the company down by sending market signs through the CDS market, decreases the company's ability to borrow or raise capital, while other companies require higher margin capital requirements. How would you propose Congress weighs a systemic risk to the market without lending legitimate risk mitigation strategy? " CHRG-111shrg55117--132 RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM BEN S. BERNANKEQ.1. Back in March, Secretary Geithner, who was FOMC Vice-Chair under you and Chairman Greenspan, said he now thinks easy money policies by central banks were a cause of the housing bubble and financial crisis. Do you agree with him?A.1. I do not believe that money policies by central banks in advanced economies were a significant cause of the recent boom and bust in the U.S. housing sector and the associated financial crisis. The accommodative stance of monetary policy in the United States was necessary and appropriate to address the economic weakness and deflationary pressures earlier in this decade. As I have noted previously, I believe that an important part of the crisis was caused by global saving imbalances. Those global saving imbalances increased the availability of credit to the U.S. housing sector and to other sectors of the U.S. economy, leading to a boom in housing construction and an associated credit boom. The role of global savings imbalances in the credit and housing boom and bust was amplified by a number of other factors, including inadequate mortgage underwriting, inadequate risk management practices by investors, regulatory loopholes that allowed some key financial institutions to assume very large risk positions without adequate supervision, and inaccurate assessments of risks by credit ratings agencies.Q.2. You said you think you can stop the expansion of the money supply from being inflationary. Does that mean you think the expansion of the money supply is permanent?A.2. Broad measures of the money supply, such as M2, have not grown particularly rapidly over the course of the financial crisis. By contrast, narrower measures, such as the monetary base, have grown significantly more rapidly. That growth can be attributed to the rapid expansion of bank reserves that has resulted from the liquidity programs that the Federal Reserve has implemented in order to stabilize financial markets and support economic activity. Nearly all of the increase in reserve is excess reserves--that is, reserves held by banks in addition to the level that they must hold to meet their reserve requirements. As long as banks are willing to hold those excess reserves, they will not contribute to more rapid expansion of the money supply. Moreover, as the Federal Reserve's acquisition of assets slows, growth of reserves will also slow. When economic conditions improve sufficiently, the Federal Reserve will begin to normalize the stance of monetary policy; those actions will involve a reduction in the quantity of excess reserves and an increase in short-term market rates, which will likely result in a reduction in some narrow measures of the money supply, such as the monetary base, and will keep the growth of the broad money aggregates to rates consistent with sustainable growth and price stability. As a result of appropriate monetary policy actions, the above-trend expansion of narrow measures of money supply will not be permanent and will not lead to inflation pressures.Q.3. Do you think a permanent expansion of the money supply, even if done in a noninflationary matter, is monetization of Federal debt?A.3. As noted above, growth of broad measures of the money supply, such as M2, has not been particularly rapid, and any above-trend growth of the money stock will not be permanent. Monetization of the debt generally is taken to mean a purchase of Government debt for the purpose of making deficit finance possible or to reduce the cost of Government finance. The Federal Reserve's liquidity programs, including its purchases of Treasury securities, were not designed for such purposes; indeed, it is worth noting that even with the expansion of the Federal Reserve's balance sheet, the Federal Reserve's holdings of Treasury securities are lower now than in 2007 before the onset of the crisis. The Federal Reserve's liquidity programs are intended to support growth of private spending and thus overall economic activity by fostering the extension of credit to households and firms.Q.4. Do you believe forward-looking signs like the dollar, commodity prices, and bond yields are the best signs of coming inflation?A.4. We use a variety of indicators, including those that you mention, to help gauge the likely direction of inflation. A rise in commodity prices can add to firms' costs and so create pressure for higher prices; this is especially the case for energy prices, which are an important component of costs for firms in a wide variety of industries. Similarly, a fall in the value of the dollar exerts upward pressure on prices of both imported goods and the domestic goods that compete with them. A central element in the dynamics of inflation, however, is the role played by inflation expectations. Even if firms were to pass higher costs from commodity prices or changes in the exchange rate into domestic prices, unless any such price increases become built into expectations of inflation and so into future wage and price decisions, those price increases would likely be a one-time event rather than the start of a higher ongoing rate of inflation. In this regard, it should be noted that survey measures of long-run inflation expectations have thus far remained relatively stable, pointing to neither a rise in inflation nor a decline in inflation to unwanted levels. A rise in bond yields--the third indicator you mention--could itself be evidence of an upward movement in expected inflation. More specifically, a rise in yields on nominal Treasury securities that is not matched by a rise in yields on inflation-indexed securities (TIPS) could reflect higher expected inflation. Indeed, such movements in yields have occurred so far this year. However, the rise in nominal Treasury yields started from an exceptionally low level that likely reflected heightened demand for the liquidity of these securities and other special factors associated with the functioning of Treasury markets. Those factors influencing nominal Treasury yields have made it particularly difficult recently to draw inferences about expected inflation from the TIPS market. The FOMC will remain alert to these and other indicators of inflation as we gauge our future policy actions in pursuit of our dual mandate at maximum employment and price stability.Q.5.a. Other central banks that pay interest on reserves set their policy rate using that tool. Now that you have the power to pay interest on excess reserves, are you going to change the method of setting the target rate?A.5.a. At least for the foreseeable future, the Federal Reserve expects to continue to set a target (or a target range) for the Federal funds rate as part of its procedures for conducting monetary policy. The authority to pay interest on reserves gives the Federal Reserve an additional tool for hitting its target and thus affords the Federal Reserve the ability to modify its operating procedures in ways that could make the implementation of policy more efficient and effective. Also, the Federal Reserve is in the process of designing various tools for reserve management that could be helpful in the removal of policy accommodation at the appropriate time and that use the authority to pay interest on reserves. However, the Federal Reserve has made no decisions at this time on possible changes to its framework for monetary policy implementation.Q.5.b. Assuming you were to make such a change, would that lead to a permanent expansion of the money supply?A.5.b. No. These tools are designed to implement monetary policy more efficiently and effectively. Their use would have no significant effect on broad measures of the money supply. It is possible that such a change could involve a permanently higher level of reserves in the banking system. However, the level of reserves under any such regime would still likely be much lower than at present and, in any case, would be fully consistent with banks' demand for reserves at the FOMC's target rate. As a result, the higher level of reserves in such a system would not have any implication for broad measures of money.Q.5.c. Would such an expansion essentially mean you have accomplished a one-time monetization of the Federal debt?A.5.c. No. If the Federal Reserve were to change its operating procedures in a way that involved a permanently higher level of banking system reserves, it is possible that the corresponding change on the asset side of the Federal Reserve's balance sheet would be a permanently higher level of Treasury securities, but the change could also be accounted for by a higher level of other assets--for example, repurchase agreements conducted with the private sector. The purpose of any permanent increase in the level of the Federal Reserve's holdings of Treasury securities would be to accommodate a higher level of reserves in the banking system rather than to facilitate the Treasury's debt management.Q.6. Is the Government's refusal to rescue CIT a sign that the bailouts are over and there is no more ``too-big-to-fail'' problem?A.6. The Federal Reserve does not comment on the condition of individual financial institutions such as CIT.Q.7. Do you plan to hold the Treasury and GSE securities on your books to maturity?A.7. The evolution of the economy, the financial system, and inflation pressures remain subject to considerable uncertainty. Reflecting this uncertainty, the way in which various monetary policy tools will be used in the future by the Federal Reserve has not yet been determined. In particular, the Federal Reserve has not developed specific plans for its holdings of Treasury and GSE securities.Q.8. Which 13(3) facilities do you think are monetary policy and not rescue programs?A.8. The Federal Reserve developed all of the facilities that are available to multiple institutions as a means of supporting the availability of credit to firms and households and thus buoying economic growth. Because supporting economic growth when the economy has been adversely affected by various types of shocks is a key function of monetary policy, all of the facilities that are available to multiple institutions can be considered part of the Federal Reserve's monetary policy response to the crisis. In contrast, the facilities that the Federal Reserve established for single and specific institutions would ordinarily not be considered part of monetary policy.Q.9. Given the central role the President of the New York Fed has played in all the bailout actions by the Fed, why shouldn't that job be subject to Senate confirmation in the future?A.9. Federal Reserve policy makers are highly accountable and answerable to the Government of the United States and to the American people. The seven members of the Board of Governors of the Federal Reserve System are appointed by the President and confirmed by the Senate after a thorough process of public examination. The key positions of Chairman and Vice Chairman are subject to presidential and congressional review every four years, a separate and shorter schedule than the 14-year terms of Board members. The members of the Board of Governors account for seven seats on the FOMC. By statute, the other five members of the FOMC are drawn from the presidents of the 12 Federal Reserve Banks. District presidents are appointed through a process involving a broad search of qualified individuals by local boards of directors; the choice must then be approved by the Board of Governors. In creating the Federal Reserve System, the Congress combined a Washington-based Board with strong regional representation to carefully balance the variety of interests of a diverse Nation. The Federal Reserve Banks strengthen our policy deliberations by bringing real-time information about the economy from their district contacts and by their diverse perspectives.Q.10. The current structure of the regional Federal Reserve Banks gives the banks that own the regional Feds governance powers, and thus regulatory powers over themselves. And with investment banks now under Fed regulation, it gives them power over their competitors. Don't you think that is conflict of interest that we should address?A.10. Congress established the makeup of the boards of directors of the Federal Reserve Banks. The potential for conflicts of interest that might arise from the ownership of the shares of a Federal Reserve Bank by banking organizations in that Bank's district are addressed in several statutory and policy provisions. Section 4 of the Federal Reserve Act provides that the board of directors of Reserve Banks ``shall administer the affairs of said bank fairly and impartially and without discrimination in favor of or against any member bank or banks.'' 12 U.S.C. 301. Reserve Bank directors are explicitly included among officials subject to the Federal conflict of interest statute, 18 U.S.C. 208. That statute imposes criminal penalties on Reserve Bank directors who participate personally and substantially as a director in any particular matter which, to the director's knowledge, will affect the director's financial interests or those of his or her spouse, minor children, or partner, or any firm or person of which the director is an officer, director, trustee, general partner, or employee, or any other firm or person with whom the director is negotiating for employment. Reserve Banks routinely provide training for their new directors that includes specific training on section 208, and Reserve Bank corporate secretaries are trained to respond to inquiries regarding possible conflicts in order to assist directors in complying with the statute. The Board also has adopted a policy specifically prohibiting Reserve Bank directors from, among other things, using their position for private gain or giving unwarranted preferential treatment to any organization. Reserve Bank directors are not permitted to be involved in matters relating to the supervision of particular banks or bank holding companies nor are they consulted regarding bank examination ratings, potential enforcement actions, or similar supervisory issues. In addition, while the Board of Governors' rules delegate to the Reserve Banks certain authorities for approval of specific types of applications and notices, Reserve Bank directors are not involved with oversight of those functions. Moreover, in order to avoid even the appearance of impropriety, the Board of Governors' delegation rules withdraw the Reserve Banks' authority where a senior officer or director of an involved party is also a director of a Reserve Bank or branch. Directors are also not involved in decisions regarding discount window lending to any financial institution. Finally, directors are not involved in awarding most contracts by the Reserve Banks. In the rare case where a contract requires director approval, directors who might have a conflict as a result of affiliation or stock ownership routinely recuse themselves or resign from the Reserve Bank board, and any involvement they would have in such a contract would be subject to the prohibitions in section 208 discussed above.Q.11. Do you think access to the discount window should be opened to nonbanks by Congress?A.11. The current episode has illustrated that nonbank financial institutions can occasionally experience severe liquidity needs that can pose significant systemic risks. In many cases, the Federal Reserve's 13(3) authority may be sufficient to address these situations, which should arise relatively infrequently. However, a case could be made that certain types of nonbank institutions, such as primary dealers, should have ongoing access to the discount window; any such increased access would need to be coupled with more stringent regulation and supervision. The Federal Reserve also believes that the smooth functioning of various types of regulated payment, clearing, and settlement utilities, some of which are organized as nonbanks, is critical to financial stability; a case could also be made that such organizations should be granted ongoing access to discount window credit.Q.12. Do you think any of the 13(3) facilities should be made permanent by Congress?A.12. As noted above, the issue of appropriate access to central bank credit by certain types of nonbank financial institutions deserves careful consideration by policy makers. The financial crisis has illustrated that various types of nonbank financial institutions can experience severe liquidity strains that pose risks to the entire financial system. However, whether access to the discount window should be granted to such institutions depends on a wide range of considerations and any decision would need to be based on careful study of all of the relevant issues.Q.13. For several reasons, I am doubtful that the Fed or anyone else can effectively regulate systemic risk. A better approach may be to limit the size and scope of firms so that future failures will not pose a danger to the system. Do you think that is a better way to go?A.13. I believe that it is important to improve the U.S. financial regulatory system so as to contain systemic risk and to address the related problem of ``too-big-to-fail'' financial institutions. The Federal Reserve and the Administration have proposed a number of ways to limit systemic risk and the problem of ``too-big-to-fail'' financial institutions. Imposing artificial limits on the size of scope of individual firms will not necessarily reduce systemic risk and could reduce competitiveness. A challenge of this approach would be to address the financial institutions that already are large and complex. Such institutions enjoy certain competitive benefits including global access to credit. At any point in time, the systemic importance of an individual firm depends on a wide range of factors. Size is only one relevant consideration. The impact of a firm's financial distress depends also on the degree to which it is interconnected, either receiving funding from, or providing funding to, other potentially systemically important firms, as well as on whether it performs crucial services that cannot easily or quickly be executed by other financial institutions. In addition, the impact varies over time: the more fragile the overall financial backdrop and the condition of other financial institutions, the more likely a given firm is to be judged systemically important. If the ability of the financial system to absorb adverse shocks is low, the threshold for systemic importance will more easily be reached. Judging whether a financial firm is systemically important is thus not a straightforward task, especially because a determination must be based on an assessment of whether the firm's failure would likely have systemic effects during a future stress event, the precise parameters of which cannot be fully known. I am confident that the Federal Reserve is well positioned both to identify systemically important firms and to supervise them. We look forward to working with Congress and the Administration to enact meaningful regulatory reform that will strengthen the financial system and reduce both the probability and severity of future crises.Q.14. Given your concerns about opening monetary policy to GAO review, what monetary policy information, specifically, do you not want in the hands of the public?A.14. The Federal Reserve believes that a substantial degree of transparency in monetary policymaking is appropriate and has initiated numerous measures to increase its transparency. In addition to a policy announcement made at the conclusion of each FOMC meeting, the Federal Reserve releases detailed minutes of each FOMC meeting 3 weeks after the conclusion of the meeting. These minutes provide a great deal of information about the range of topics discussed and the views of meeting participants at each FOMC meeting. Regarding its liquidity programs, the Federal Reserve has provided a great deal of information regarding these programs on its public Web site at http://www.federalreserve.gov/monetarypolicy/bst.htm. In addition, the Federal Reserve has initiated a monthly report to Congress providing detailed information on the operations of its programs, types, and amounts of collateral accepted, and quarterly updates on Federal Reserve income and valuations of the Maiden Lane facilities. This information is also available on the Web site at http://www.federalreserve.gov/monetarypolicy/bst_reportsresources.htm. The Federal Reserve believes that it should be as transparent as possible consistent with the effective conduct of the responsibilities with which it has been charged by the Congress. The Federal Reserve has noted its effectiveness in conducting monetary policy depends critically on the confidentiality of its policy deliberations. It has also noted that the effectiveness of its tools to provide liquidity to the financial system and the economy depends importantly on the willingness of banks and other entities in sound financial condition to use the Federal Reserve's credit facilities when appropriate. That willingness is supported by assuring borrowers that their usage of credit facilities will be treated as confidential by the Federal Reserve. As a result of these considerations, the Federal Reserve believes that the release of detailed information regarding monetary policy deliberations or the names of firms borrowing from Federal Reserve facilities would not be in the public interest. ------ CHRG-111hhrg63105--5 Mr. Moran," Mr. Chairman, thank you very much. I appreciate the friendship that you and I have encountered now for a long time in the House of Representatives, and I appreciate the leadership that you provide on this Subcommittee and our full House Agriculture Committee. The House Agriculture Committee has really been my home during my time as a Member of the House of Representatives, and this is a significant part of what I enjoy the most about serving in Congress. In regard to today's hearing, Mr. Chairman, I certainly believe that Congressional oversight is a good thing. And while I will not be here in the new year to chair this Subcommittee, I believe that my successor, and the incoming full Committee Chairman, Mr. Lucas, will readily exercise the House Agriculture Committee's oversight authority over the Commodity Futures Trading Commission. In regard to the topic of position limits under the Dodd-Frank Act, however, I believe it is premature to hold an oversight hearing, because the CFTC has yet to release a proposed rule. Thus we are left to hold a hearing based on hearsay, a few exchanges between CFTC's Commissioners during a hearing on another issue, and a speech and an opinion editorial released to the press by Commissioner Chilton. Having said that, I am concerned about where the Commission's position on position limits discussion is going. First, I would like to note that early on in the legislative process, both I as Ranking Member, and the Ranking Member, Mr. Lucas, of the full Committee, and other Members of the House Agriculture Committee, introduced amendments to place limits on the authority of the CFTC to impose position limits. During that debate, we were clear that the commodity futures market needed greater transparency, and we were in favor of creating mandatory reporting requirements. We were hesitant, however, to give the CFTC broader powers to impose position limits until we had adequate information about the over-the-counter markets. We felt that Congress needed to know who was trading on the OTC market, the size of the OTC market, and whether the OTC market was or was not having an adverse effect on exchange-traded markets before bestowing greater position limit authority on the Commission. Unfortunately, those amendments did not pass, and we now have a situation where a regulator may be contemplating imposing position limits without having access to the information necessary to determine the appropriate position limits, or to enforce such position limits once they are set. Despite what some believe is a mandate for the Commission to set position limits within a definite period of time, the Dodd-Frank legislation actually qualifies CFTC's position limit authority. Section 737 of the Dodd-Frank Act amends the Commodity Exchange Act so that section 4a(a)(2)(A) states: ``The Commission shall by rule . . . establish limits on the amount of positions as appro-priate . . . .'' The Act then states in subparagraph (B) for exempt commodities, the limit required under subparagraph (A) shall be established within 180 days after the date of enactment of this paragraph. When subparagraphs (A) and (B) are read in conjunction, the Act states that when position limits are required under subparagraph (A), the Commission shall set elements within 180 days under paragraph (B). Subparagraph (A) says the position limit rule should be only prescribed when appropriate. Therefore, the 180 day timetable is only triggered if position limits are appropriate. In regard to the word appropriate, the Commission has three distinct problems. First, the Commission has never made an affirmative finding that position limits are appropriate to curtail excessive speculation. In fact, to date the only reports issued by the Commission or its staff failed to identify a connection between market trends and excessive speculation. This is not to say that there is no connection, but it does say the Commission does not have enough information to draw an affirmative conclusion. The second and third issues related to the appropriateness of position limits are related to adequacy of information about OTC markets. On December 8, 2010, the Commission published a proposed rule on Swap data record-keeping and reporting requirements. This proposed rule is open for comment until February 7, 2011, and the rule is not expected to be final and effective until summer at the earliest. Furthermore, the Commission has yet to issue a proposed rulemaking about Swap data repositories. Until a Swap data repository is set up and running, it is difficult to see how it would be appropriate for the Commission to set position limits. Without additional information about trades in the OTC market, the Commission could neither have enough information to adequately determine the appropriate position limits, or have the information necessary to enforce position limits, assuming the appropriate formula could be determined without full access to OTC market information. In conclusion, I would again caution that my remarks are based on hearsay and not on an actual proposed rule. It is hard to be critical of something that does not yet exist. I hope that Chairman Gensler in his testimony today will inform the Subcommittee that the Commission is aware of the challenges surrounding the current imposition of position limits, and that the Commission hearing tomorrow will not consider enacting position limits before adequate information is obtained. I would also caution the Chairman and the other Commissioners, however, that if the Commission moves forward with a proposed position limit rule before information from the OTC markets are made available, they should be prepared for more hearings on this topic next year. Mr. Chairman, that is a longer opening statement than my usual, which suggests I am leaving the House of Representatives for someplace else. But I am grateful for the opportunity to express my opinion today. I am delighted to be with you, and I thank you, Mr. Chairman, for recognizing me, and I look forward to our continued close working relationship. [The prepared statement of Mr. Moran follows:] Prepared Statement of Hon. Jerry Moran, a Representative in Congress from Kansas Thank you, Mr. Chairman. I believe Congressional oversight is a good thing. While I will not be here to chair this Subcommittee next year, I believe my successor, and the incoming full Committee Chairman, Mr. Lucas, will readily exercise the House Agriculture Committee's oversight authority over the Commodity Futures Trading Commission (CFTC). In regard to the topic of position limits under the Dodd-Frank Act, however, I believe it is premature to hold an oversight hearing because the CFTC has yet to release a proposed rule. Thus, we are left to hold a hearing based on hearsay, a few exchanges between CFTC Commissioners during a hearing on another issue, and a speech and opinion editorial released to the press by Commissioner Chilton. Having said that, I am concerned about where the Commission's position limit discussion is going. First, I would note that early on in the legislative process, both myself, Ranking Member Lucas, and other Members of the Agriculture Committee introduced amendments to place limits on the authority of the CFTC to impose position limits. During that debate, we were clear that the commodity futures markets needed greater transparency and we were in favor of creating mandatory reporting requirements. We were hesitant, however, to give CFTC broader powers to impose position limits until we had adequate information about the over-the-counter (OTC) markets. We felt the Congress needed to know who was trading in the OTC market, the size of the OTC market, and whether the OTC market was or was not having an adverse affect on exchange-traded markets before bestowing greater position limit authority on the Commission. Unfortunately, those amendments did not pass, and we now have a situation where a regulator may be contemplating imposing position limits without having access to the information necessary to determine the appropriate position limits or to enforce such position limits once they are set. Despite what some believe is a mandate for the Commission to set position limits within a definite time period, the Dodd-Frank legislation actually qualifies CFTC's position limit authority. Section 737 of the Dodd-Frank Act amends the Commodity Exchange Act (CEA) so that Section 4a(a)(2)(A) states: ``the Commission shall by rule . . . establish limits on the amount of positions, as appropriate . . . .'' The Act then states in subparagraph (B): ``For exempt commodities, the limits required under subparagraph (A) shall be established within 180 days after the date of the enactment of this paragraph.'' When subparagraphs (A) and (B) are read in conjunction, the Act states that when position limits are required under subparagraph (A), the Commission shall set the limits within 180 days under subparagraph (B). Subparagraph (A) says position limit rules should only be prescribed when ``appropriate.'' Therefore, the 180-day timetable is only triggered if position limits are appropriate. In regard to the word ``appropriate,'' the Commission has three distinct problems. First, the Commission has never made an affirmative finding that position limits are appropriate to curtail excessive speculation. In fact, to date, the only reports issued by the Commission or its staff fail to identify a connection between market trends and excessive speculation. This is not to say that there is no connection, but it does say the Commission does not have enough information to draw an affirmative conclusion. The second and third issues related to the appropriateness of position limits are related to adequacy of information about the OTC markets. On December 8, 2010, the Commission published a proposed rule on ``Swap Data Recordkeeping and Reporting Requirements.'' This proposed rule is open for comment until February 7, 2011, and the rule is not expected to be final and effective until this coming summer at the earliest. Furthermore, the Commission has yet to issue a proposed rulemaking about swap data repositories. Until a swap data repository is up and running, it is difficult to see how it would be appropriate for the Commission to set position limits. Without additional information about trades in the OTC market, the Commission could neither have enough information to adequately determine the appropriation position limit or have the information necessary to enforce position limits, assuming an appropriate formula could be determined without full access to OTC market information. To conclude, I would again caution that my remarks are based on hearsay and not an actual proposed rule. It is hard to be critical of something that does not yet exist. I hope that Chairman Gensler, in his testimony today, will inform the Subcommittee that the Commission is aware of the challenges surrounding the current imposition of position limits and at the Commission's hearing tomorrow, he will not consider enacting position limits before adequate information is known. I would caution the Chairman and other Commissioners, however, that if the Commission moves forward with a proposed position limit rule before information from the OTC markets are made available, they should be prepared for more hearings on this topic next year. Again, thank you for recognizing me Mr. Chairman and I look forward to the testimony of today's witnesses. " fcic_final_report_full--238 Overall, of the delinquent loans and loans in foreclosure sampled by Freddie,  were put back. In  and , Freddie put back significant loan volumes to the following lenders: Countrywide, . billion; Wells Fargo, . billion; Chase Home Financial, . billion; Bank of America,  million; and Ally Financial,  mil- lion.  Using a method similar to Freddie’s to test for loan eligibility, Fannie reviewed be- tween  and  of the mortgages originated since —sampling at the higher rates for delinquent loans. From  through , Fannie put back loans to the fol- lowing large lenders: Bank of America, . billion; Wells Fargo, . billion; JP Mor- gan Chase, . billion; Citigroup, . billion; SunTrust Bank,  million; and Ally Financial,  million.  In early January , Bank of America reached a deal with Fannie and Freddie, settling the GSEs’ claims with a payment of more than . billion.  Like Fannie and Freddie, private mortgage insurance (PMI) companies have been finding significant deficiencies in mortgages. They are refusing to pay claims on some insured mortgages that have gone into default. This insurance protects the holder of the mortgage if a homeowner defaults on a loan, even though the responsibility for the premiums generally lies with the homeowner. By the end of , PMI compa- nies had insured a total of  billion in potential mortgage losses.  As defaults and losses on the insured mortgages have been increasing, the PMI companies have seen a spike in claims. As of October , the seven largest PMI companies, which share  of the market, had rejected about  of the claims (or  billion of  billion) brought to them, because of violations of origination guidelines, improper employment and income reporting, and issues with property valuation.  Separate from their purchase and guarantee of mortgages, over the course of the housing boom the GSEs purchased  billion of subprime and Alt-A private-label securities.  The GSEs have recorded  billion in charges on securities from Janu- ary ,  to September , .  Frustrated with the lack of information from the securities’ servicers and trustees, in many cases large banks, on July , , the GSEs through their regulator, the Federal Housing Finance Agency, issued  sub- poenas to various trustees and servicers in transactions in which the GSEs lost money.  Where they find that the nonperforming loans in the pools have violations, the GSEs intend to demand that the trustees recognize their rights (including any rights to put loans back to the originator or wholesaler).  While this strategy being followed by the GSEs is based in contract law, other in- vestors are relying on securities law to file lawsuits, claiming that they were misled by inaccurate or incomplete prospectuses; and, in a number of cases, they are winning. As of mid-, court actions embroiled almost all major loan originators and underwriters—there were more than  lawsuits related to breaches of representa- tions and warranties, by one estimate.  These lawsuits filed in the wake of the finan- cial crisis include those alleging “untrue statements of material fact” or “material misrepresentations” in the registration statements and prospectuses provided to in- vestors who purchased securities. They generally allege violations of the Securities Exchange Act of  and the Securities Act of . CHRG-110hhrg41184--56 Mr. Neugebauer," Thank you, Mr. Chairman. I want to turn my attention a little bit. You mentioned in your testimony a little bit about the dollar and the fact it has increased our exports, because American goods are more competitive. But, at the same time, it swings the other way in the fact that it raises prices. It has an inflationary impact on the American consumer. I believe one of the reasons that oil is $100 a barrel today is because of our declining dollar. People settled oil in dollars and I think a lot of them have obviously just increased the price of the commodity. And so I really have two questions. One is, what do you believe the continuing decline of the dollar is? What kind of inflationary impact do you think that is going to have? And then secondly, as this dollar declines, one of the things that I begin to get concerned with is all of these people who have all of these dollars have taken a pretty big hickey over the last year or so and continue to do that. At what point in time do people say, you know, we want to trade in dollars and other currencies, and what implication do you think then that has on the capital markets in the United States? " FOMC20060629meeting--116 114,CHAIRMAN BERNANKE.," Thank you. If I could try your patience for a few more minutes at the end of a long afternoon, I’d like to summarize what I’ve heard today and then just add a few comments of my own. While I’m doing that, Brian, would you distribute table 1? Table 1 in the Bluebook shows the three alternative suggestions for the statement. Since the Bluebook, we have received some suggestions, and we’ve done some wordsmithing—we’ve actually responded to a few things we heard today. The general tone of the three statements is the same, but we wanted you to see where it was today, so that you could think about it overnight and so that it would help you for your discussion tomorrow. That’s going to be coming around. Let me just briefly summarize what I heard. Certainly, a central theme of the speakers today was the increase of uncertainty and risk in the environment. It’s getting more and more difficult to forecast, and there are certainly risks both to the upside and to the downside. The central tendencies with respect to output seem to be that output is slowing to something close to potential. Some felt growth would be stronger than the Greenbook suggested; others, like the Greenbook, thought it would be falling somewhat below potential. A few people saw downside risks from previous tightening. There was some disagreement on the extent to which financial conditions are supportive of the economy, and some disagreement on consumption, although there was a view that lower-income consumers were going to do worse than higher-income consumers. Housing is certainly slowing. Some took the view that it was slowing more or less as expected, whereas some thought the slowing was somewhat worse than expected—certainly that’s a source of downside risk. The view of the labor market is that it remains reasonably healthy, that it’s difficult to find skilled workers, but there are still few signs of wage pressures in the economy. The business-sector evaluations were much more upbeat, with ongoing expansion, good sentiment, and capital investment. Finally, there seems to be considerable unease about recent inflation developments. Everyone considered these recent developments to be unwelcome. Some felt that the recent increase in inflation might be temporary. Others saw it as more persistent. But there certainly was a sense that it’s a risk to the economy. Let me add just a few thoughts about the situation. The situation is, I think, exceptionally complicated because at least three different things are going on. First of all, there’s a cyclical transition from a period of above-trend growth to what we would hope would be a period of trend growth, the normal soft-landing problem. Second, we essentially have a supply shock. It’s not exactly a supply shock because it has complicated elements to it, but oil prices and commodity prices are rising significantly, and that is creating a worsened tradeoff. Third, we are having a housing cycle that has a certain autonomous component to it because it’s like any other asset-price correction taking place on its own schedule, so to speak, and it is interacting with the other two forces. So given these three things occurring at the same time, the situation is obviously very complicated. Now, the ideal situation would be for us to move to a steady, sustainable pace without inflation. Right now, the biggest risk to that steady pace seems to be the pickup that we’ve seen recently in inflation. The main point I want to make about inflation—many points have already been made—is that it really is quite broad-based. I think there are good reasons to downweight, to some extent, owners’ equivalent rent. It is arguably a cost of living; however, the effects of monetary policy on this kind of cost of living are somewhat ambiguous. So we could get ourselves into a bad situation if we focus on it too much. But having said that, if you slice, say, core PCE in any other way—if you look, for example, at core PCE prices excluding OER, at core goods, at core PCE services excluding OER, at market-based core PCE less OER, at any of these ways of slicing inflation—you get a similar pattern in terms of the three-month, six-month, and twelve-month averages, which suggests a broad-based acceleration and one that I think we should be concerned about. We should also note that the three-month total PCE inflation rate is 5.2, which is significant because it influences inflation expectations overall. Now, a concern that we all have—and many people expressed—is that we don’t fully understand why this sudden acceleration is taking place. Some of the possibilities are, first, the supply-shock increases of energy prices; second, the tight product markets; and third, changes in inflation psychology, perhaps related to headline inflation. I guess I would just raise the possibility that these three things are interacting. Perhaps with tighter product markets it’s easier to pass through your energy costs or your commodity costs. That pass-through interacts with higher inflation psychology, and there’s maybe a vicious cycle there. The thing we should be concerned about is whether those higher prices then lead to higher wage pressures in an inverse kind of spiral. So I do have concerns about inflation, although I don’t want to exaggerate. I think we’re still looking at numbers that are historically not extremely high. The other big issue is the housing cycle. I’m going to give us a bit of perspective. It is a good thing that housing is cooling. If we could wave a magic wand and reinstate 2005, we wouldn’t want to do that because the market has to come back to equilibrium. The level of activity now is about a third bigger than it was in during the boom in the late 1990s. The housing construction industry is large, bigger than historically normal, and a controlled decline in housing obviously is helpful to us at this stage in bringing us to a soft landing in the economy. But as people have pointed out, the cooling is an asset-price correction. Like any other asset-price correction, it’s very hard to forecast, and consequently it is an important risk and one that should lead us to be cautious in our policy decisions, as we’ll talk about tomorrow. Another potential nonlinearity is in financial markets, as we’ve seen recently. We don’t have a good understanding of how changes in interest rates are affecting risk reduction and positions in financial markets right now. Just a bit of commentary on consumption: A lot of our uncertainty—I guess you’d call it model uncertainty—is the question about how a decline in housing prices will affect consumer spending. The range of views is wide, some arguing that, because of equity withdrawal and so on, the effect would be very large. I don’t know the answer to that question, obviously, but I think there are some positive factors that will support consumption going forward. To name a few, the job market remains good, unemployment insurance claims are low, unemployment is low, and I suspect that wages and incomes will start to rise sometime soon. Consumer confidence is not that bad. Gasoline prices are likely to come down. In part, they are reflecting high ethanol prices, which will come down over time. We’ve seen before that consumer confidence can be very sensitive to gasoline prices. Balance sheets remain reasonably healthy. Even if housing prices flatten out, people have accumulated a lot of equity, and the implication of that is that they can smooth their consumption through rough times, if necessary, by drawing on that equity. Finally, Kevin and Randy, I think, gave different sides of the surge in tax collections, but on the whole it is probably a positive sign. It probably suggests there is more economic activity than we are capturing. So let me just conclude by reiterating that we find ourselves in an extraordinarily complicated situation because we have these different themes—the cyclical turning point, the supply shock, and the housing cycle. The implication is that, whatever we do, we’re going to have to be very deliberate and careful; but I think we cannot ignore the inflation side of this equation. Any other comments? Well, thank you again for your patience in a long afternoon. I’m glad this is a two-day meeting. [Laughter] Everyone should have table 1; I don’t expect significant changes before tomorrow. I’ll see you tonight at the British Embassy, and we will reconvene tomorrow morning at 9:00. [Meeting recessed] June 29, 2006—Morning Session" CHRG-111shrg51290--3 STATEMENT OF SENATOR SHELBY Senator Shelby. Thank you, Mr. Chairman. There is no question that many home buyers were sold inappropriate mortgages over the past several years. We have heard their stories. We have heard some of those stories right here. There is also no question that many home buyers were willing parties to contracts that stretched them far beyond their financial means. Some of these home buyers were even willing to commit fraud to buy a new home. We have heard their stories, as well. As with any contract, there must be at least two parties to each mortgage. If either party chooses not to participate, there is no agreement. Unfortunately, during the real estate boom, willing participants were in abundance all along the transaction chain, from buyers to bankers, from Fannie and Freddie to investment banks, and from pension funds to international investors. There appeared to be no end to the demand for mortgage-backed securities. Underwriting standards seemed to go from relaxed to nonexistent as the model of lending known as originate to distribute proliferated the mortgage markets. The motto in industry seemed to be risk passed, risk avoided. However, as the risk was then passed around our financial markets like a hot potato, everyone taking their piece along the way, some of the risk was transferred back onto the balance sheets of regulated financial institutions. In many cases, banks were permitted to hold securities backed by loans that they were proscribed from originating. Interesting. How did our regulators allow this to happen? This is just one of the many facets of this crisis that this Committee will be examining over the months ahead. A key issue going forward is how do we establish good consumer protections while also ensuring the safety and soundness of our financial system? In many respects, consumer protection and safety and soundness go hand in hand. Poorly underwritten loans that consumers cannot afford are much more likely to go bad and inflict losses on our banks. In addition, an essential element of consumer protection is making sure that a financial institution has the capital necessary to fulfill its obligations to its customers. This close relationship between consumer protection and safety and soundness argues in favor of a unified approach to financial regulation. Moreover, the ongoing financial crisis has shown that fractured regulation creates loopholes and blind spots that can, over time, pose serious questions to our financial system. It is regulatory loopholes that have also spawned many of the worst consumer abuses. Therefore, we should be cautious about establishing more regulatory agencies just to create the appearance of improving consumer protections. We should also be mindful of the limits of regulation. Our regulators cannot protect consumers better than they can protect themselves. We should be careful not to construct a regulatory regime that gives consumers a false sense of security. The last thing we need to do is lead consumers to believe that they don't have to do their own due diligence. If this crisis teaches us anything, it should be that everyone, from the big banks and pension funds to small community banks and the average consumer, has to do a better job of doing their own due diligence before entering into any financial transactions. At the end of the day, self-reliance may prove to be the best consumer protection. Thank you, Mr. Chairman. " FOMC20080916meeting--90 88,MR. SHEETS.," I also will be very brief in summarizing economic developments abroad. Indeed, I would just like to make six very brief points. The first one is that the incoming data we've received since the last Greenbook for the foreign economies have been extraordinarily soft. Indeed, we've marked down our forecast or projection of the second quarter by a full percentage point. The data also suggest that we should carry forward a fair amount of that softness at least through the next year. So our foreign outlook is much softer than it was before. The second point is that this softening outlook in our view has been a key factor that has contributed to further sizable declines in oil and commodity prices. This morning, oil prices were trading around $92 a barrel, which was down another $25 a barrel from where we were at the time of the last meeting. The third point is that this deteriorating foreign outlook also seems to have triggered something of a reassessment in currency markets. Since your last meeting, the dollar has strengthened nearly 5 percent in broad nominal terms. In our view, what happened in currency markets was that the markets had priced in the expectation that the foreign economies would remain quite resilient in the face of a slowing in the United States. Now with the incoming data over the past couple of months, it is becoming clearer and clearer that the U.S. slowing is going to have a marked effect on these foreign economies, and this has shifted the relative attractiveness of the dollar and supported the appreciation that we've seen over the last couple of months. The fourth point is that, in a number of emerging market economies, we've seen a resurgence of certain sorts of financial vulnerabilities. We've seen across really a broad array of these economies rising external debt spreads and rising CDS spreads. We've seen falling equity prices and, for a number of these economies, downward pressures on their currencies. On that last point, a number of the Asians have been intervening in the foreign exchange market over the intermeeting period but have actually been intervening to try to prevent their currencies from depreciating, which is a marked change from what we've seen in the last couple of years. The fifth point is that the surprisingly strong performance of U.S. exports that we've seen appears to have continued through July. After the Greenbook went to bed, we got the July trade data, and they continue to point to a fair amount of strength in the export sector. It was particularly strong in the auto sector, but it was a broad-based strength through July. Nevertheless, our view is that, given the rise in the dollar and the softening outlook for foreign growth, we're very likely to see some slowing in export growth going forward. The final point I'd like to mention is that, also late last week after the Greenbook went to bed, we received data on import prices. These data, really for the first time in a long time, showed a marked deceleration in both material-intensive goods import prices and finished goods import prices. Our forecast for a long time has called for a deceleration in import prices in line with the projected flattening out of commodity prices and a projected flattening out of the dollar. Now it seems that we're at a point at which all those things that have been incorporated into our forecast but we haven't had a lot of evidence for are starting to materialize. We have the dollar flattened out and, indeed, somewhat stronger than in the last Greenbook. We have lower paths for commodity prices, and then the data that we recently received showed an actual deceleration in core import prices, which gives us some confidence that perhaps the rise in those import prices has peaked. I'll stop there. " CHRG-111hhrg51698--383 Mr. Taylor," Yes. Thank you for the question, and I guess I probably need to answer that within the context of cotton, which I know better than the other commodities. But we do have an exchange in China that is being used principally by the Chinese. There are a few companies that do use it. But I would echo the comments made at the end of the table that this probably is an empty threat. Participants want to go where they can trust the market, where there is reporting, there is no ``funny business'' or a minimum of ``funny business'' going on. We enjoy today a preferred position. Our market is trusted. The regulated people, participants are very comfortable using the ICE exchange. So, we need to be mindful of that risk. I do think as China develops, and China is the largest producer of cotton, the largest consumer of cotton, the largest exporter of textiles, there is that opportunity. But with their attitude with foreigners in general, and foreign investment, currencies, et cetera, it will be difficult for them to continue. " CHRG-111hhrg63105--33 Mr. Gensler," I think that you observe correctly that I had asked the General Counsel, Dan Berkovitz, as to the phased implementation schedule in essence with regard to position limits. Subsequently, he told me that the Administrative Procedures Act and case law specifically allow an agency reasonable leeway. The Commodities Exchange Act clearly permits the Commission to adopt position limits in phases, such as proposing a formula now--and I note that is what we did this past January as well--a formula now and impose the actual numerical limits once we have more data. This would be on the all-months-combined. What he was asked specifically, because I asked him the question, was could we do that? Could we propose a formula and finalize that formula but then have the formula apply to data as it comes in, maybe a number of months later? " FOMC20070918meeting--93 91,MR. FISHER.," Well, Mr. Chairman, with regard to our District, we continue to grow apparently faster than the rest of the country. There are signs of overbuilding, particularly in the multiresidential and some commercial sector areas. I will give you one data point that focuses the mind, and then I’d like to go on to a broader discussion. In the city of Austin, Texas, between 2000 and 2007, fifty condominium units priced at $1 million or more came on the market. Over that seven-year period, forty of them sold. There are now more than 560 coming onto the market. We have seen a significant boom in construction in all the major cities of our District, and that does give me pause. Nonetheless, we continue to speed along, driven not so much by energy as by medicine and the service sector. So I continue to expect that we will outpace the rest of the country. We are seeing some decline in terms of advanced airline bookings as they affect our District, but they’re not that different from the rest of the United States. What I’d like to address is the broader issue. Mr. Chairman, I am a little confused as to why we are talking about the economic situation and then skipping a beat before we talk about the proposed discount window facility. I do see the two going hand in hand. I’d like to suggest that we’re navigating a very narrow passage here in something of a fog. David, I think, was honest about that. On the one side is a serious risk of overcompensating in our navigational course and incurring a moral hazard or overcompensating for what is a perceived risk in uncharted waters. On the other side, I think we run the risk of biting off our employment growth responsibility to save our inflation-fighting face. So on the starboard shore we hear a siren called “Very Large Financial Institutions,” which infer that a reduction in the fed funds rate will rescue them from peril, however self-inflicted that peril may have been and despite the fact that they’re well capitalized according to the reports that we have put together. On the other shore, we are relying on navigational charts or uncertain landmarks or—as you said, David—rudimentary tools that are giving us mixed readings. I’m going to argue today that we should ease by 25 basis points, Mr. Chairman—I’m just showing my hand early—and indicate through our words that we might tilt the rudder a bit further if needed. Further, I am going to argue that we should defer discussion of the new discount window, and we can get to that later. My concern is that if we fail to ease, we risk steering into a recession, but if we shift the tiller too radically on the fed funds side, I believe that we risk tacking onto that siren call that I mentioned earlier and that we will indulge rather than discipline risky financial behavior. What I’m about to talk about I base on a rather in-depth sounding, just to kill the naval analogy once and for all in this discussion. [Laughter] I sent you and the Vice Chairman a list of the people I consulted. It is also based on what we’re hearing from our economists in the District and in our Bank and, very importantly, on what the Greenbook and the Bluebook have said. There is no question that our contacts report a slowing in the pace that occurs through the third quarter, and they do detect a pulling in of the horns in terms of cost controls; budgetary planning; and U.S. capital expenditures as opposed to foreign cap-ex, which they’re still planning to expand significantly—all in light of the press given to the subprime debacle, financial turmoil, and just a general sense of caution. However, there are some very bright spots, and I’m going to go through these at a bit of length because I think they’re important to recognize. AT&T, for example, a local but significant company says, “We’ve had the best quarter we’ve had on the consumer side, and on the business side it’s the hottest August in history.” Their average revenue per user has risen for the past two quarters after declining for the past two and a quarter years. Texas Instruments, an international company, reports “continued growth on the consumer side, robust industrial growth”—I’m quoting their CFO—and “strong industrial demand” and is struggling to meet demand. Just to go to the other extreme, Brinker International is a middle-income restaurant chain that employs 120,000 and operates throughout the country. Other than weakness in Southern California and Florida, traffic increases in July and August, seasonally adjusted, were “the best in twelve months.” Wal-Mart reports, according to their CEO for U.S. operations, that August was “a perfect retail month.” They’re experiencing no problems with suppliers and no shortage of supply inventory. They are feeling cost pressures from China, which I’ll turn to in just a minute. Disney reports record attendance in their theme parks, very high advanced bookings through next spring, and very strong broadcasting revenues. We are hearing the same from the other broadcasters and companies like Time-Warner, and needless to say, Exxon is a happy place right now. The law firms that we have begun to survey rather thoroughly, reminding ourselves that there are more lawyers than there are auto workers in America, are experiencing a boom in business. In short, if you take the summary offered by the CEO of Time-Warner, who also sits on a significant bank board, as many people know, he says, “I see softness but not precipitous change, whereas the bank board I sit on keeps yelling ‘Incoming.’” From a real Main Street perspective, he said that the changes are marginal. Now, to be sure, there are some weaknesses being reported. The one utility I talked to at length is TXU. The housing market has left a bit of a slowdown in demand. Hookups by big industrials, however—steel, aluminum, et cetera—are running very good loads according to their CEO. UPS reports that the package line has been flat to slightly up, with a pickup occurring in July and August. The volume declined 0.2 percent in the first and second quarters, yet that’s against a “gee whiz” first quarter of 2006. July and August have picked up 0.8 percent. According to their CFO, “We have not seen an impact from the credit crunch.” The CEO of MasterCard reports a softening, but nothing falling off the cliff. Then JCPenney, which is a middle-third retailer, sees retrenchment in discretionary spending, the so-called appointment shopping. Their back-to-school season was one of the strongest they have seen recently. If you dissect, say, Cisco’s and EDS’s data, you see a significant cutback in IT expenditures by financial institutions, which you would expect—what they call the “big box” financial houses, Citi, Morgan, et cetera—and yet, according to John Chambers, rock solid growth in commercial and service-provider categories. In summary, underlying economic growth, from the standpoint of anecdotal evidence from the contacts I’ve talked to, is stronger than it would appear from the press or from most prognosticators. I think that’s one important point to take into consideration. It is also very important, Mr. Chairman, to think of how people react to what they’re seeing. There’s no doubt an effort, if you’re worried about the future, to tighten up on cost of goods sold and to reduce your head count. Yet everybody is complaining that there’s a massive shortage of labor in every one of the companies I spoke of but one. The other thing is that you change your strategic approach. One relief that’s been provided here is that the private equity firms have been taken out so that bids of, say, seventeen times EBITDA, which is an actual case, with no due diligence, are no longer the case. Four of the companies I spoke with are now able to make strategic acquisitions, and they plan to proceed. The point is that the economy is not grinding to a halt. I won’t mention lawyers again in this discussion except here, but see how they’re being hired now. Akin Gump, very large firms—they are working on strategic acquisitions, and you can see a ramp- up in the volume that’s occurring there. So I think that’s an important thing to consider. Another very important point to consider is that price pressures have not disappeared. I believe they are being maintained by global demand. I’m going to give you just a couple of reference points, and then I’ll stop. As you know, I like to quote the Panamax shipping rates. When we last met, the spot daily rate for a Panamax ship—again, the dry bulk carriers—was $59,000 a day. Yesterday, it was $70,000. Port utilization is running at a record high. Why? Asian demand. After ten years of deflation, the major retail sources from China, according to Wal-Mart and other interlocutors, report cost increases running at 2 to 4 percent. After ten years of deflation, they’re now inflating slightly. (Although I said I wouldn’t mention lawyers, but just so you know, for the first time in history in Los Angeles, New York, and Dallas, all beginning lawyers start at $160,000. I think they are raising it to $180,000 in all markets.) Sara Lee—from an agflation standpoint I think this is important and I think we have to be aware of the public perception—just announced a 5 percent increase in the cost of bread, and they announced that they “may hike another 5 percent at the end of the month.” The spread between wheat and corn, Mr. Chairman, is the widest it has been. It is usually $2.00 to $2.50; it is now $6.00. Cooking oil prices, milk prices—even the Italians went on a one-day strike to protest the price of pasta. It wasn’t successful, but that’s what they did. The firms respond by “weighting out” the increased prices by putting less in the package here in the United States. I want to mention again that we’re hearing widespread reports of labor shortages, and I do worry, Dave, that it somehow just doesn’t square. I think your report certainly was elucidating, but it does have implications for how fast consumption can fall off, if indeed we’re suffering from a labor shortage. Finally, there are price pressures that ensue from the booming construction markets in China. Chinese demand for skilled labor last year, year over year, was up 100 percent. They’re building a huge shipbuilding market and so on. So, Mr. Chairman, I am concerned, first, that while we have made progress by any measurement, including our beloved trimmed mean measure of the PCE in Dallas, that we’re just beginning to make such progress and that there are risks out there and we need to acknowledge them. They stem largely from global demand. Second, I’m very concerned that we’re leaning the tiller too far to the side to compensate risk-takers when we should be disciplining them. So I’m going to conclude not with a sailing analogy but with a football analogy. I don’t think it’s time to throw a “Hail Mary” pass. I think it’s time just to continue to move up the field, running the ball as we’ve been doing, and I would strongly recommend a rate cut of only 25 basis points and no more. If, indeed, we accompany it with a change in the primary credit facility, then I think we have to have a very serious discussion of how far we’re willing to go on the fed funds rate. Thank you, Mr. Chairman." fcic_final_report_full--401 Towns that over several years had come to expect and rely on the housing boom now saw jobs and tax revenue vanish. As their resources dwindled, these communi- ties found themselves saddled with the municipal costs they had taken on in part to expand services for a growing population. Sinking housing prices upended local budgets that relied on property taxes. Problems associated with abandoned homes required more police and fire protection. At FCIC hearings around the country, regional experts testified that the local im- pact of the crisis has been severe. From  to , for example, banks in Sacra- mento had stopped lending and potential borrowers retreated, said Clarence Williams, president of the California Capital Financial Development Corporation. Bankers still complain to him not only that demand from borrowers has fallen off but also that they may be subject to increased regulatory scrutiny if they do make new loans. In September , when the FCIC held its Sacramento hearing, that region’s once-robust construction industry was still languishing. “Unless we begin to turn around demand, unless we begin to turn around the business situation, the employ- ment is not going to increase here in the Sacramento area, and housing is critical to it. It is a vicious circle,” Williams testified.  The effects of the financial crisis have been felt in individual U.S. households and businesses, big and small, and around the world. Policy makers on the state, national, and global levels are still grappling with the aftermath, as are the homeowners and lenders now dealing with the complications that entangle the foreclosure process. HOUSEHOLDS: “I ’M NOT EATING. I ’M NOT SLEEPING” The recession officially began in December . By many measures, its effects on the job market were the worst on record, as reflected in the speed and breadth of the falloff in jobs, the rise of the ranks of underemployed workers, and the long stretches of time that millions of Americans were and still are surviving without work. The economy shed . million jobs in —the largest annual plunge since record keep- ing began in . By December , the United States had lost another . million jobs. Through November , the economy had regained nearly  million jobs, put- ting only a small dent in the declines. The underemployment rate—the total of unemployed workers who are actively looking for jobs, those with part-time work who would prefer full-time jobs, and those who need jobs but say they are too discouraged to search—increased from . in December  to . in December , reaching . in October . This was the highest level since calculations for that labor category were first made in . As of November , the underemployment rate stood at . The average length of time individuals spent unemployed spiked from . weeks in June  to . weeks in June , and . weeks in June . Fifty-nine percent of all job seekers, according to the most recent government statistics, searched for work for at least  weeks. FOMC20070807meeting--92 90,MR. POOLE.," Thank you, Mr. Chairman. At the beginning of the break, two of our leaders made a special point of indicating that I was first up after the break. I guess that was an invitation to be fast and quick. [Laughter] I’ll try. My overall impression from my business contacts is that things are more of the same rather than anything very much different. I would note that the financial market upset is too recent to have affected the plans of companies operating in the real economy. Obviously financial firms are scrambling. There seems to be something of a disconnect between my trucking industry contacts and what I see in the industrial production numbers. The industrial production numbers suggest that goods production is rising; I don’t know how they’re moving, but they don’t seem to be moving by truck. One big over-the-road trucker says that loads are down 8 percent year over year. The company has already cut trucking capacity 10 percent. He expects another cut of 4 percent by the end of this year. He’s trimming capital spending next year for trucks. Obviously they see the business as being pretty slack. Incidentally, nobody is talking about any particular labor market pressures. Another big company probably best known for the color of its brown trucks [laughter] says that the industry overall is flat year over year. It believes that the outlook is somewhat more optimistic than recent experience. The international business is booming. The Asia-Pacific region is shipping an awful lot of goods to both the United States and Europe. My contact noted something that I thought was sort of interesting. He said that there is some diversion from air freight to water transport—I guess because of the enormous cost difference, but it suggests that there may be a little easier inventory situation or something that is making that diversion make sense. This company is very much in a cost-cutting mode because they have a big infrastructure, demand is relatively slack, and they have a lot of cost built in; and so the only thing they can do when they can’t build volume in the short run is to cut costs. That company’s major competitor is much more optimistic and has capital spending plans for fiscal ’08, which ends in May of next year, up 20 percent from this year and sees a pretty strong business situation at least going forward. A contact in the restaurant industry says that restaurant prices are rising everywhere and volumes are falling, but overall business conditions are about the same. The restaurant industry has been seeing that. A contact with a major software firm is pretty optimistic. PC sales are running at or above expectation. My contact pointed out particularly that the quality of receivables has actually improved. They’re not seeing any problem with collecting on the software that they sell, and 94 percent of the customers are current on making payments. Even that is something of an underestimate because a lot of purchasers initiate the payment at the end of a thirty-day due period, and so the payment doesn’t come for another couple of days, despite our brilliant electronic clearing of payments. A comment about the housing industry: Obviously the subprime issue is going to have a relatively permanent effect. It is just changing the characteristic of this industry. Underwriting was too lax, and that is changing. I think it is somewhat surprising that the builders have not scaled back more quickly—that they continue to sit on such a large inventory. Part of the reason is that, once a builder has started a development and has put all the infrastructure in place—the roads, the sewers, the water, and all of that—the only way to get anything out of that investment is to complete the subdivision. In addition, a subdivision that stops is a bad signal for prospective buyers because they don’t want to move into something that is sitting there mostly idle. So I think the builders have an intense interest in trying to complete these projects. But what that means, of course, is that, as they complete those projects, they are not initiating a lot because they’re taking, as Richard pointed out, some pretty big price concessions in many cases, and so they are probably not going to be initiating as many projects in the future. My own bet is that the financial market upset is not going to change fundamentally what’s going on in the real economy. First of all, bank capital is not impaired. So unlike in some past cases, when losses on real estate impaired bank capital and thus affected the lending in areas that had nothing to do with real estate, I don’t think that’s the case this time. Second, the fact that some LBO deals fall through isn’t going to change what those companies are producing. The fact that the ownership hasn’t changed doesn’t change the company’s profit-maximizing level of production in the short run. Obviously, that could change, but it seems to me that the best information that we now have is that this financial market upset is going to settle out and not have major repercussions on the real economy, putting the housing part aside. Thank you." CHRG-111hhrg48873--292 The Chairman," The gentleman from Texas. Dr. Paul. Thank you, Mr. Chairman. When the chairman of the committee opened up the committee today, he suggested that we look backward as well as forward, and that all our problems didn't come from January 20th on, and I agree with that. As a matter of fact, just looking back at the last Administration isn't quite enough. And in order to understand the problems that we face and understand the cause, we have to look back possibly even several decades. The debate today, so much of the discussion has been on technical aspects, which I think are very important, but, quite frankly, I think that deals a lot with the symptoms rather than the basic cause, and I would like to deal more with the cause, so I have a question for the entire panel, and the question keys around this cause. Right now, I think the Congress and the Treasury as well as the Fed operate on the condition that the free markets failed, and we didn't have enough regulation. Others will say that we got into this mess because we have been living with a condition of crony corporatism, inflationism, and interventionism. We had inbred into this system a lot of moral hazard which encouraged a lot of risk and a lot of guarantees, and that we would have the lender of last resort, and we really didn't have to worry. And it created, once again, a phenomenon that has been known throughout history. It is called the ``madness of crowds.'' And that certainly--that is nothing new. But there was certainly a lot of madness going in the economy and in the marketplace. But the question really comes out, who should allocate capitalism, the free market, or should the government? And I think that we had a system where the free market wasn't working, and we didn't have capitalism. The allocation of capital came from the direction of the Federal Reserve and a lot of rules and regulations by the Congress. We had essentially no savings, and capital is supposed to come from savings. And we had artificially low interest rates. So looking at all that, then this means we would have to look differently at what our solutions should be. Everybody loves the boom. That was great. Nobody questions all this. But when the bust comes, everybody hates it, and then they quickly to have decide what to do. Unfortunately, I don't see that we are addressing the real problems. We are not addressing--what we are dealing with is trying to find a victim. Who is going to soak up the derivatives, who is going to soak up the debt, who is going to be penalized? And right now it looks like Wall Street is getting bailed out, and the little guy and the middle Main Street America and all are going to pay the penalty. And I think this is--we are absolutely going in the wrong direction, whether it is AIG or the rest. So we failed because we didn't follow the marketplace, and then we do the same thing over and over again, and we don't seem to improve anything. So my question is this: How do the three of you operate in your own minds? Do you operate with the idea that capitalism failed, and they need us more than ever before to solve these problems; or do you say, no, there is some truth to this? As a matter of fact, a lot of truth to it is that we brought this upon ourselves, that we had too much government, too much interference in interest rates, too much risk, moral risk, built into the system. Because if you come from the viewpoint that says that the market doesn't work, I can understand everything you do, but if I see that you have totally rejected the market, and that we have to do something about it, I can understand why we in the Congress and you in Treasury and you in the Fed continue to do this. So where do you put the blame; on the market or on crony capitalism that we have been living with probably for 3 decades? " CHRG-111hhrg51698--172 Mr. Gooch," I would say in any bubble there is always going to be some level of fraud at the peak of the bubble. I am not blaming the person who tried to buy a home and couldn't afford it. I would blame the unscrupulous mortgage broker who encouraged someone to take a mortgage they couldn't afford, on a house that wasn't worth the mortgage, simply because they were going to get a $3,000 commission. In this circumstance where you have had 7 years of extremely cheap credit and the global, spectacular growth throughout the world's economies, that is what has driven all of these commodity prices up to record levels. I don't know enough about those energy companies. I wouldn't jump to the conclusion that they were involved in insider trading because they imagined the price of oil would go up. I mean, frankly, who knew? Right? Sitting here today we all can see that everybody right up to the highest levels of government isn't able to predict the future that clearly. " CHRG-111hhrg51698--505 Mr. Moran," Thank you. To anybody on the panel, many of our panelists believe that the bill as written that mandates clearing, with a narrow exception for the CFTC to grant a case-by-case exemption, is not practical. Looking for alternatives, if you clear your OTC trade, your trade will remain a regulated swap, exempt or excluded commodities as stated in the Chairman's draft. If you choose not to clear your over-the-counter trade, because it is not structured for clearing, or maybe you don't want to clear it for proprietary reasons, what if we established a set of core principles, similar to those which the exchanges are now subject to? Those core principles would give direction about how counterparties to an OTC trade must post margin or make adjustments to capital accounts. Would this be a method by which we would avoid mandatory clearing, and, yet, still protect traders in the market as a whole from the type of market default that we are concerned with? " CHRG-110shrg50417--150 Mr. Palm," Happy to. I think anyone who thinks that the regulatory system in the United States and elsewhere is not in need of reform has not been around for the last 6 months. That would be my first point. We fully support a thoughtful approach to putting together a new regulatory system. Whether that is one super regulator as described, which you mentioned you might be in favor of, or, you know, a tripartite one, one of which consists of investor protection separate from I will call it the soundness of the particular financial institution, et cetera, you know, can be debated. Either system in theory can be made to work. I think the current system--and obviously we are new to being a bank. One of the things that first struck me was the fact that--actually, being a lawyer of sorts, I first got a book out which told me all the different types of organizations you were regulated by if you were in a particular business, and it was mind-numbing, including both regulatory arbitrage as well as--it is not even necessarily arbitrage. It is just people found themselves regulated by different people, having different rules, and so on, and some, from what I can tell, not regulated at all, full stop. So I think it is very important to modernize and move forward. Certainly, the FSA system in London has lots of positives to it. On the other hand, if you step back for a second, even that system obviously did not save their economy from the consequences of what is going on now. So I think you want to have functional based regulation, and as I think Mr. Zubrow alluded to, systemic institutions, i.e., institutions who have global scale, you need to really have people who look after them as an entirety and understand their overall operations. We think that is important. Senator Crapo. Thank you. Dr. Wachter. Ms. Wachter. Yes, it is critically important going forward for the long run to restructure our regulatory system, and there is regulatory arbitrage, and that needs to be part of the issue that is addressed. And I do want to here agree again with Mr. Eakes. The insufficient oversight and lack of reserving for CDS issued by AIG was a critical part of the problem that we are facing today. I want to make two other points. One point, this is a global phenomenon now. We are going to need global cooperation on regulation, and it cannot just be in one nation because, as we see, capital flows are global. Second, again, FSA was not a cure-all. The U.K. had over the same period, not as much as we, but erosion of credit standards, and FSA did not see that happening or could not stop it; and at the same time as erosion of credit standards, a housing asset boom. This U.K. crisis is similar to the Japan crisis, is similar to the Asian financial crisis. So it is not just a better environment for regulation, a better structure, but it is better regulation. Senator Crapo. Thank you. Ms. Finucane. I think I will just reiterate what I think you have heard from the other banks, which is we do believe that there needs to be greater transparency for a regulator. I am not sure that we would support one super regulator. Maybe there is too much risk in that, and there are complications. Consumer regulation versus capital markets might be too big a breadth, so I think we would consider that. The last thing I would just say is clearly from the banks, I think the bank holding company structure has been what seems to be victorious in the long run, so we would start from there as well. Senator Crapo. Thank you. " fcic_final_report_full--29 Two former OCC comptrollers, John Hawke and John Dugan, told the Commis- sion that they were defending the agency’s constitutional obligation to block state ef- forts to impinge on federally created entities. Because state-chartered lenders had more lending problems, they said, the states should have been focusing there rather than looking to involve themselves in federally chartered institutions, an arena where they had no jurisdiction.  However, Madigan told the Commission that national banks funded  of the  largest subprime loan issuers operating with state charters, and that those banks were the end market for abusive loans originated by the state- chartered firms. She noted that the OCC was “particularly zealous in its efforts to thwart state authority over national lenders, and lax in its efforts to protect con- sumers from the coming crisis.”  Many states nevertheless pushed ahead in enforcing their own lending regula- tions, as did some cities. In , Charlotte, North Carolina–based Wachovia Bank told state regulators that it would not abide by state laws, because it was a national bank and fell under the supervision of the OCC. Michigan protested Wachovia’s an- nouncement, and Wachovia sued Michigan. The OCC, the American Bankers Asso- ciation, and the Mortgage Bankers Association entered the fray on Wachovia’s side; the other  states, Puerto Rico, and the District of Columbia aligned themselves with Michigan. The legal battle lasted four years. The Supreme Court ruled – in Wachovia’s favor on April , , leaving the OCC its sole regulator for mortgage lending. Cox criticized the federal government: “Not only were they negligent, they were aggressive players attempting to stop any enforcement action[s]. . . . Those guys should have been on our side.”  Nonprime lending surged to  billion in  and then . trillion in , and its impact began to be felt in more and more places.  Many of those loans were funneled into the pipeline by mortgage brokers—the link between borrowers and the lenders who financed the mortgages—who prepared the paperwork for loans and earned fees from lenders for doing it. More than , new mortgage brokers began their jobs during the boom, and some were less than honorable in their deal- ings with borrowers.  According to an investigative news report published in , between  and , at least , people with criminal records entered the field in Florida, for example, including , who had previously been convicted of such crimes as fraud, bank robbery, racketeering, and extortion.  J. Thomas Card- well, the commissioner of the Florida Office of Financial Regulation, told the Com- mission that “lax lending standards” and a “lack of accountability . . . created a condition in which fraud flourished.”  Marc S. Savitt, a past president of the Na- tional Association of Mortgage Brokers, told the Commission that while most mort- gage brokers looked out for borrowers’ best interests and steered them away from risky loans, about , of the newcomers to the field nationwide were willing to do whatever it took to maximize the number of loans they made. He added that some loan origination firms, such as Ameriquest, were “absolutely” corrupt.  CHRG-111hhrg51698--442 Mr. Short," I would just like to add one comment. I do think Mr. Masters is right that the original focus of position limits in the Commodity Exchange Act in its original form was to protect farmers who were growing their crops and needed to hedge. But it is an interesting question depending on which side of the table you happen to be on, as far as being a net producer or a net consumer of something. I would just ask people to contemplate global oil. We produce very little global oil in this country. We are a massive consumer of it. If you really want to have the producers setting the price, aren't you giving the fox the keys to guard the henhouse? Speculators keep those prices in line. And it is a more complex question than just saying that we need to hand it back over to the physical side of the market. " CHRG-111hhrg53021--5 Mr. Minnick," Chairman Peterson and Chairman Frank, I am a farm boy who grew up skeptical of Wall Street wondering how a loaf of bread could cost a dollar when it contained only a few cents worth of wheat. I also spent over 20 years as the CEO of substantial companies which relied on Wall Street and used customized derivatives to hedge currency and interest rate risk. I learned that these financial instruments are essential to the proper functioning of our 21st century economy. I have listened to many experts and studied the Administration's 84 page concept paper. If we are to craft a regulatory structure which can keep our nation from ever again repeating the financial excesses which have brought today's economy to its knees, we need to give serious consideration to the following reforms which go beyond those proposed by the Administration. First, we should merge the SEC and the Commodity Futures Trading Commission. Financial derivatives whether they originate---- " CHRG-111hhrg53021Oth--5 Mr. Minnick," Chairman Peterson and Chairman Frank, I am a farm boy who grew up skeptical of Wall Street wondering how a loaf of bread could cost a dollar when it contained only a few cents worth of wheat. I also spent over 20 years as the CEO of substantial companies which relied on Wall Street and used customized derivatives to hedge currency and interest rate risk. I learned that these financial instruments are essential to the proper functioning of our 21st century economy. I have listened to many experts and studied the Administration's 84 page concept paper. If we are to craft a regulatory structure which can keep our nation from ever again repeating the financial excesses which have brought today's economy to its knees, we need to give serious consideration to the following reforms which go beyond those proposed by the Administration. First, we should merge the SEC and the Commodity Futures Trading Commission. Financial derivatives whether they originate---- " FOMC20070131meeting--105 103,MR. STOCKTON.," Many of the factors that you’re citing as temporary on the downside regarding inflation we see as having been temporary on the upside regarding inflation as well. The higher energy prices and the pickup in import commodity prices were some factors explaining how we got above 2 percent, and their dissipation is principally the reason that we go back to 2. Now, for the extended Greenbook scenario that we show in the Bluebook, one reason for the upward pressure on inflation beyond the near term is that part of the construction of that forecast is an assumed 3 percent depreciation of the dollar that has to go on almost forever. So we have built in some upward pressure on inflation. We have to do that in the model simply to begin making some progress on the external balance. Whether that happens in 2009, in 2015, or tomorrow would be hard to say, but it is one reason that the pickup is not principally the dissipation of the temporarily good factors. It’s really more of that built-in dollar-depreciation effect." FOMC20060629meeting--192 190,CHAIRMAN BERNANKE.," It is, but logically you would have to say “ongoing productivity gains have held down the rise in unit labor costs, inflation expectations remain contained, and the moderation of the growth of aggregate demand would help to moderate.” Then you say “however,” signaling that these are the things that we are really worried about—resource utilization and prices of energy. The sentence as it stands signals to me that all these things are working to constrain inflation, but we are more concerned about resource utilization and commodity prices because we put them at the end of the sentence, at the end of the paragraph, giving them the greater emphasis. I think that putting this clause where it is conveys somewhat greater attention to aggregate demand as a new element in thinking about the inflation outlook relative to our thinking at the last meeting. I realize that it’s a subtle issue of emphasis, and as I said, I don’t think this statement is a work of art." CHRG-110shrg50369--133 Chairman Dodd," No, absolutely. I understand that. And, again, I am not trying to expand your portfolio here by suggesting an earlier intervention, but it would seem to me that there may be some signals here that may fall short of the 25 percent. I would rather have you taking a look at those things where--and come to me and say, ``I think this is''--not to me necessarily, but to say we think we ought to take a look at this, it may fall short of that absolute trigger. That is why I say objective/subjective kind of analysis as to what this could mean, so look at that. Is there any chance, any worry you have at all--coming back to the first question I raised with you, the declining value of the dollar, the 24-percent decline, the lowest since 1973, compared to the six other major currencies. Is there any chance in your mind that we would watch something moving away from a dollar denomination in these areas, in these commodities, such as oil going to the euro, for instance? Do you see any danger in that? Or is it--do you worry about that at all? " fcic_final_report_full--213 Geithner told the Commission that he and others in leadership positions could have done more to prevent the crisis, testifying, “I do not believe we were powerless.”  AIG: “I ’M NOT GETTING PAID ENOUGH TO STAND ON THESE TRACKS” Unlike their peers at Citigroup, some senior executives at AIG’s Financial Products subsidiary had figured out that the company was taking on too much risk. Nonethe- less, they did not do enough about it. Doubts about all the credit default swaps that they were originating emerged in  among AIG Financial Products executives, including Andrew Forster and Gene Park. Park told the FCIC that he witnessed Financial Products CEO Joseph Cassano berating a salesman over the large volume of credit default swaps being written by AIG Financial Products, suggesting there was already some high-level uneasiness with these deals. Told by a consultant, Gary Gor- ton, that the “multisector” CDOs on which AIG was selling credit default swaps con- sisted mainly of mortgage-backed securities with less than  subprime and Alt-A mortgages, Park asked Adam Budnick, another AIG employee, for verification. Bud- nick double checked and returned to say, according to Park, “‘I can’t believe it. You know, it’s like  or .’” Reviewing the portfolio—and thinking about a friend who had received  financing for his new home after losing his job—Park said, “This is horrendous business. We should get out of it.”  In July , Park’s colleague Andrew Forster sent an email both to Alan Frost, the AIG salesman primarily responsible for the company’s booming credit default swap business, and to Gorton, who had engineered the formula to determine how much risk AIG was taking on each CDS it wrote. “We are taking on a huge amount of sub prime mortgage exposure here,” Forster wrote. “Everyone we have talked to says they are worried about deals with huge amounts [of high-risk mortgage] exposure yet I regularly see deals with  [high-risk mortgage] concentrations currently. Are these really the same risk as other deals?”  Park and others studied the issue for weeks, talked to bank analysts and other ex- perts, and considered whether it made sense for AIG to continue to write protection on the subprime and Alt-A mortgage markets. The general view of others was that some of the underlying mortgages “were structured to fail, [but] that all the borrow- ers would basically be bailed out as long as real estate prices went up.”  The AIG consultant Gorton recalled a meeting that he and others from AIG had with one Bear Stearns analyst. The analyst was so optimistic about the housing mar- ket that they thought he was “out of his mind” and “must be on drugs or some- thing.”  Speaking of a potential decline in the housing market, Park related to the FCIC the risks as he and some of his colleagues saw them, saying, “We weren’t getting paid enough money to take that risk. . . . I’m not going to opine on whether there’s a train on its way. I just know that I’m not getting paid enough to stand on these tracks.”  By February , Park and others persuaded Cassano and Frost to stop writing FOMC20070628meeting--37 35,MR. LEAHY.," As you know from the Greenbook, recent news on foreign economic activity has been generally upbeat, supporting our view that growth abroad will continue at a solid pace. The top panel of exhibit 10 shows our weighted average of total foreign GDP growth and our outlook. If our forecast is borne out, foreign growth will soften slightly over the forecast period, to about 3½ percent, which is also our current best guess of the rate of foreign potential growth. As you can see from the chart, rates of growth of 3½ percent (the thin horizontal line) or better are not unprecedented, but a stretch of five consecutive years, like that from 2004 to 2008, would be unusual. The chart also shows foreign growth maintaining most of the momentum it developed over the past couple of years even as U.S. growth has taken a more substantial step down. This is also a bit unusual. However, as shown in the middle left panel, foreign domestic demand gained strength throughout the current expansion, leaving foreign economies less dependent on demand from the United States. Foreign investment spending, in particular, has been picking up. As shown to the right, fixed investment spending as a share of GDP has moved up a couple of percentage points since 2003. With foreign activity expanding slightly faster than potential, it is not surprising that we are seeing signs in some foreign economies that labor market slack is dwindling. The unemployment rate in Japan, shown in the bottom left panel, is at a nine-year low; in Canada, the rate is at a thirty-year low; and the euro-area rate is also at a multiyear low. Tight labor market conditions are less apparent in emerging- market economies, although we are hearing stories of labor shortages in certain sectors in China, where growth has been extremely rapid. What is more apparent is that in markets for oil and other primary commodities, shown in the bottom right panel, demand has outstripped available supply, driving prices higher. Supply capacity is expanding, however, and we are projecting, consistent with futures markets, that commodity prices will flatten out by the end of the forecast period. Before they do, our forecast calls for oil prices to rise a bit further over the remainder of 2007 and 2008. Food commodity prices are projected to move slightly higher on average as well, in part as energy-related demand for grains remains strong. If this forecast is realized, oil and energy prices should impart in coming quarters noticeable but only moderate upward pressure on headline consumer price inflation abroad. In part this is because the projected increase in oil prices is relatively modest, at least compared with what we’ve seen in recent years. In addition, the direct effect of oil prices on consumer prices in many cases is damped by tax structures or more-active government intervention in energy markets. The top panels of exhibit 11, which examine the pass-through of crude oil prices to gasoline prices, provide some evidence of how such pass-through varies across countries. These panels present local-currency prices of unleaded gasoline and imported crude oil over the past couple of years or so, plotted on a ratio scale so that vertical distances correspond to percent changes in prices. Looking across the panels, you can see that the price of imported crude oil in local currency—the black line at the bottom of each panel—moves similarly across countries. In contrast, the prices that consumers pay at the pump—the red lines—are less volatile in the foreign economies shown than in the United States and have moved up more slowly. In part, this reflects some differing movements in refinery and distribution margins, which are represented by the gap between imported crude oil prices and retail gasoline prices excluding taxes (the blue lines). This is most noticeable for Japan, where margins are proportionally higher and more of the increase in crude oil prices was absorbed than in the United States and the other countries. In addition, higher gasoline taxes abroad have inserted a greater wedge between the pre-tax price and the retail price of gasoline—the difference between the blue and the red lines. Accordingly, increased crude oil prices have pushed up retail gasoline prices proportionally less abroad than in the United States. The middle left panel presents some calculations of the rates at which the changes in crude oil prices were passed through to the retail gasoline prices between September 2004 and March of this year, the most recent observation I have for these countries. During this period, rates of pass-through were lower abroad, particularly for Japan and Germany, the countries with relatively high taxes. The smaller pass- through of oil prices to retail gasoline prices abroad has also shown through to broader measures of consumer energy prices. As shown to the right, consumer energy prices in Canada, Germany, and Japan have increased less than those in the United States over the past four years. An extra factor holding down energy price inflation in Canada over this period was the substantial appreciation of the Canadian dollar, which made imported energy relatively cheaper. Overall, this suggests that the effects of past increases in global energy prices on headline inflation, as well as on consumer sentiment and inflation expectations, were likely smaller abroad than in the United States. In many emerging market economies, gasoline and other retail energy prices are controlled or subsidized, so that energy-related fluctuations in consumer prices, if they occur at all, tend to be gradual. For this group of economies, what has left a bigger imprint on headline consumer price inflation in recent months is the global rise in food prices. The black line in the bottom left panel shows that food price inflation in Mexico has been heavily influenced in recent years by enormous, weather-induced swings in domestic tomato price inflation, shown in red (of course). [Laughter] This year, however, food price inflation has not followed tomato price inflation down. Rather, it has been sustained in part by a sharp acceleration in prices of tortillas and other corn products, shown by the green line, which are responding to the fuel-related surge in the global price of corn. Food price inflation in China, shown to the right in black, has also been boosted by higher grain prices, as higher feed costs, along with an outbreak of swine flu, have driven up meat and poultry prices. Prices for corn and other grains are forecast to level out by the end of 2008, after they have increased enough to align supply and demand growth. A risk, of course, is that further rapid expansion of demand might continue to outstrip that of supply, making food price inflation more persistent and more likely to spur inflation in other sectors. The Bank of Mexico cited such a risk following its policy tightening in April, and China’s authorities have raised concerns that food prices may exert upward pressure on wages. Evidence for emerging market economies that inflation pressures might already be spreading outside the food and energy sectors is limited so far, however. The top left panel of exhibit 12 shows core inflation rates in four of our largest emerging market trading partners. China’s core rate (in blue), which excludes only food, shows no sign of wider inflation pressures. In Brazil, inflation has declined substantially over the past few years, despite a slight uptick recently. Core inflation in Korea has been trending upward, but it is still low. Mexico’s core inflation rate has edged up toward 4 percent, a rate that concerns Mexican authorities, but this upward trend may merely reflect the fact that core inflation in Mexico does not exclude processed food such as corn tortillas. The advanced foreign economies appear to be exhibiting more broadly based inflation pressures. As shown on the right, in Canada, the euro area, and the United Kingdom, core inflation has been on a rising trend since the middle of 2006 or earlier. In response, the central banks in all three economies, as well as the Bank of Japan, are expected to tighten policy in the near term. Core inflation is still in generally acceptable ranges, however, except perhaps for the Bank of Japan, for which it might be too low, and market sentiment does not indicate concern that inflation pressures are going to rise substantially. As you can see from the middle left panel, ten-year government bond yields in the major markets have all risen since the beginning of the year. Except for Japan, most of the increases in nominal yields (the first column) can be attributed to higher real yields, shown in the second, which is consistent with stronger prospects for growth. The table to the right shows that survey measures of inflation expectations for the year 2007 rose moderately for Canada between December and June and a bit less for the United Kingdom, whereas the measures fell off some for the euro area and Japan. Longer-run inflation expectations as of the most recent survey date in April were still locked in at rates consistent with inflation targets in Canada, the euro area, and the United Kingdom. Our outlook for headline inflation abroad, shown in the bottom panels, reflects a diminishing inflationary impulse from oil and other primary commodity prices as they flatten out over the forecast period. It also incorporates the view that some further monetary policy tightening will be needed to restrain domestic demand and guide inflation in each economy toward its price stability objective by the end of the forecast period. Your last two international exhibits focus on the extent to which external adjustment is under way. A little more than a year ago, in May, was the last time we forecast that the U.S. current account deficit in 2007 would exceed $1 trillion. Since then, as shown in the top left panel of exhibit 13, our outlook for the current account has improved substantially, so much so that currently we don’t see the deficit reaching $1 trillion within our forecast period. As shown to the right, much of the improvement has come through an improved outlook for the trade balance. What surprised us? Two likely suspects fail to provide the answer. Given the recent strength of foreign growth, one might have thought that a year ago we were perhaps too pessimistic on foreign activity and consequently undershot on U.S. export performance. However, as shown in the middle left panel, our outlook today for foreign economic activity is very similar to what we had in mind a year ago. Similarly, the decline over the past year in the broad real dollar, shown to the right, which has helped curb the deterioration in the trade balance, has turned out to be not much different from our forecast a year ago. Part of the answer, it turns out, is that, even though the assumptions we fed our model for exports have not proved much off the mark, our model forecast for core exports, shown at the bottom left, failed to catch the unusually strong growth of exports in 2006. We attribute this miss to the composition of foreign demand rather than its overall magnitude. As shown in the table to the right, the largest contributors to growth of U.S. core exports in 2006 were in the categories of capital goods (line 2) and industrial supplies (line 3). With capital goods making up a large fraction of core exports, the rise in foreign investment as a share of GDP (mentioned earlier) likely provided a boost to core exports above that indicated by our aggregate measure of foreign GDP. Similarly, the global commodity boom likely favored U.S. exports of industrial supplies. Additional factors behind the improved outlook for the U.S. current account are described in exhibit 14. One is the lower path of U.S. real GDP, shown in the top left panel, which prompted real imports of core goods, shown to the right, to expand along a shallower trajectory than we had predicted last year. A third factor, illustrated in the middle left panel, is that we did not forecast the dip in the price of oil in the second half of 2006, which reduced the value of oil imports substantially. These three factors explain the bulk of the upward adjustment in our forecast for the trade balance in 2007. In addition, the improved outlook for the current account reflects an upward revision to net investment income, shown in the middle right. This adjustment results from a number of factors, including new data on U.S. holdings of direct investment abroad, new procedures for determining interest payments to foreign holders of U.S. Treasuries, and a change in the methodology used to record interest flows on cross-border holdings of other fixed-income securities. As a result of these surprises, the external accounts have clearly improved. Going forward, we expect the current account deficit to resume widening nonetheless as interest payments on the net external debt mount. But the combination of solid, demand- driven foreign growth and weaker U.S. growth has led the external accounts to make a more positive contribution to U.S. GDP growth in the near term, as shown in the table. In our current forecast, shown in the rightmost column, we project that the arithmetic contribution of real net exports to GDP growth should be roughly neutral starting in the second half of this year, as strong foreign growth helps sustain real export gains that match those of real imports." fcic_final_report_full--105 Critics argued that with this much money at stake, mortgage brokers had every in- centive to seek “the highest combination of fees and mortgage interest rates the market will bear.”  Herb Sandler, the founder and CEO of the thrift Golden West Financial Corporation, told the FCIC that brokers were the “whores of the world.”  As the hous- ing and mortgage market boomed, so did the brokers. Wholesale Access, which tracks the mortgage industry, reported that from  to , the number of brokerage firms rose from about , to ,. In , brokers originated  of loans; in , they peaked at .  JP Morgan CEO Jamie Dimon testified to the FCIC that his firm eventually ended its broker-originated business in  after discovering the loans had more than twice the losses of the loans that JP Morgan itself originated.  As the housing market expanded, another problem emerged, in subprime and prime mortgages alike: inflated appraisals. For the lender, inflated appraisals meant greater losses if a borrower defaulted. But for the borrower or for the broker or loan officer who hired the appraiser, an inflated value could make the difference between closing and losing the deal. Imagine a home selling for , that an appraiser says is actually worth only ,. In this case, a bank won’t lend a borrower, say, , to buy the home. The deal dies. Sure enough, appraisers began feeling pres- sure. One  survey found that  of the appraisers had felt pressed to inflate the value of homes; by , this had climbed to . The pressure came most fre- quently from the mortgage brokers, but appraisers reported it from real estate agents, lenders, and in many cases borrowers themselves. Most often, refusal to raise the ap- praisal meant losing the client.  Dennis J. Black, president of the Florida appraisal and brokerage services firm D. J. Black & Co. and an appraiser with  years’ experi- ence, held continuing education sessions all over the country for the National Associ- ation of Independent Fee Appraisers. He heard complaints from the appraisers that they had been pressured to ignore missing kitchens, damaged walls, and inoperable mechanical systems. Black told the FCIC, “The story I have heard most often is the client saying he could not use the appraisal because the value was [not] what they needed.”  The client would hire somebody else. Changes in regulations reinforced the trend toward laxer appraisal standards, as Karen Mann, a Sacramento appraiser with  years’ experience, explained in testi- mony to the FCIC. In , the Federal Reserve, Office of the Comptroller of the Currency, Office of Thrift Supervision, and Federal Deposit Insurance Corporation loosened the appraisal requirements for the lenders they regulated by raising from , to , the minimum home value at which an appraisal from a li- censed professional was required. In addition, Mann cited the lack of oversight of ap- praisers, noting, “We had a vast increase of licensed appraisers in [California] in spite of the lack of qualified/experienced trainers.”  The Bakersfield appraiser Gary Crab- tree told the FCIC that California’s Office of Real Estate Appraisers had eight investi- gators to supervise , appraisers.  CHRG-111hhrg51698--12 Mr. Damgard," Thank you very much, Mr. Chairman. Chairman Peterson, Ranking Member Lucas, and Members of the Committee, I am John Damgard, President of the Futures Industry Association; and, as the principal spokesman for the U.S. futures industry, FIA is pleased to be able to testify on the Derivatives Markets Transparency and Accountability Act of 2009. But before addressing the far-reaching legislation, I want to step back and try to put it in some context. In recent months, our economy has faced unprecedented financial turbulence, leading to bankruptcies and bailouts. During that time, U.S. futures markets have performed flawlessly. Fair and reliable prices have been discovered transparently, hedgers have managed price risks in liquid markets, all trades have been cleared, customers have been paid. Not a blip. This record of excellence is the best evidence possible that the regulatory system established by this Committee works superbly well. It is also the best evidence that the Commodity Futures Trading Commission has done its job, and done it well. The Committee should take pride in both the regulatory structures you put in place and the agency that you created years ago. Other agencies should learn from the CFTC. But, in any event, a simple merger is not the answer; and, in that regard, I agree with both the Chairman and the Ranking Member. The legislation before you would build on existing regulatory structure to enhance the CFTC's current powers. We support additional special call and other transparency provisions to allow the CFTC to strengthen its market surveillance capabilities, we support additional resources for the CFTC, we support coordinated oversight of linked competitive markets, and we support looking at further ways to adapt CFTC regulation to the ever-increasing pace of market innovation. But, despite our support in those areas, FIA cannot support the bill as a whole. Our major objections rest in three areas: number one, the hedge exemption; number two, mandatory clearing of all OTC instruments; and number three, the ban on naked credit default swaps. The bill's narrow hedging definition erases decades of progress to expand the use of regulated futures markets by businesses that use futures in an economically appropriate way to manage their price risks. Those companies are not anticipating higher or lower prices. They are managing a risk of higher or lower prices that they already face. In fact, if the companies do not manage that risk, they would be speculating. But if this bill becomes law and constraining positions are imposed, then automakers could not hedge gasoline prices, agribusiness could not hedge currency prices, airlines could not hedge interest rates, and utilities could not hedge weather risk. This would be bad economic policy at a time when we need stability, not uncertainty. Mandating clearing of all OTC derivatives would lead to market uncertainty or worse. You might think that I would support clearing everything, because my regular members are the clearing members whose businesses would increase if everything were cleared. But we don't support mandatory clearing for all OTC derivatives. Some derivatives are too customized and their pricing too opaque to be cleared safely and efficiently. Making it illegal not to clear an OTC derivative would, therefore, be a recipe for economic instability and litigation. FIA believes clearing should be encouraged through capital treatment or other regulatory measures. FIA also believes that if the Committee insists on a clearing mandate, it should be coupled with a flexible CFTC power to exempt classes of instruments from that mandate. Unfortunately, the draft bill's exemptive powers are so limited we fear the CFTC would only be able to exempt a sliver of the current OTC market, leaving the rest facing intolerable legal uncertainty or the ability to do this business somewhere outside the United States. Last, we oppose the ban on naked credit default swaps. The ban would remove important liquidity from our credit markets at just the wrong time for many struggling businesses. FIA would prefer to see Congress encourage clearing of CDS instruments and provide more effective, systemic risk protections through oversight of the institutions that enter into these transactions. Mr. Chairman, FIA thanks you very much for the opportunity to testify this afternoon, and I look forward to answering any questions. [The prepared statement of Mr. Damgard follows:] Prepared Statement of John M. Damgard, President, Futures Industry Association, Washington, D.C. Chairman Peterson, Ranking Member Lucas and Members of the House Agriculture Committee, I am John Damgard, President of the Futures Industry Association. The FIA is pleased to be able to testify on the discussion draft of the Derivatives Markets Transparency and Accountability Act of 2009.Introduction FIA understands well the interest of Chairman Peterson and others in crafting this draft bill. Financial derivatives are now an integral part of our national economy and have been used by many businesses to reduce the multi-faceted price risks they face. Some of these derivatives and related market structures have evolved since Congress considered major changes to the Commodity Exchange Act in 2000. Some have even become more prominent since Congress adopted important changes to the Act as part of the 2008 Farm Bill. Given this Committee's experience and history with derivatives regulation, FIA welcomes discussion with the Committee on whether we need to bolster existing regulatory systems at this time. The draft bill is far-reaching. It would make substantial revisions to the Commodity Exchange Act that would affect trading on exchange markets as well as over-the-counter transactions. While FIA is the trade association for the futures industry,\1\ and its traditional focus has been on exchange markets, we try to take a holistic view of futures and other derivatives markets in order to advise the Committee on what our members believe would be the best public policy for our country and our industry.--------------------------------------------------------------------------- \1\ FIA is a principal spokesman for the commodity futures and options industry. Our regular membership is comprised of 30 of the largest futures commission merchants in the United States. Among our associate members are representatives from virtually all other segments of the futures industry, both national and international. Reflecting the scope and diversity of its membership, FIA estimates that its members serve as brokers for more than ninety percent of all customer transactions executed on United States contract markets.---------------------------------------------------------------------------Draft Bill FIA has analyzed the draft bill through the prism of the congressional findings that form the foundation of the Commodity Exchange Act. Congress has found that the Act serves the public interest by promoting the use of liquid and fair trading markets to assume and manage price risks in all facets of our economy, while discovering prices that may be disseminated widely. CFTC regulation fosters those interests through four core objectives: preventing price manipulation, avoiding systemic risk and counterparty defaults through clearing, protecting customers, and encouraging competition and innovation. FIA supports these Congressional findings and objectives. They are valid today as they were when first enacted. In FIA's view, some of the draft bill's provisions are consistent with these findings and objectives. We support those provisions which would strengthen CFTC market surveillance capabilities and deter price manipulation, by adapting the current regulatory systems to ever evolving market innovations. We also support the pro-competition decisions embodied or implicit in the bill's provisions. But many of the draft bill's provisions would disserve the very public interests and economic policies Congress designed the CEA to serve by draining market liquidity, making hedging more costly, curbing innovation and discouraging trading in the U.S. We can not support those sections of the bill. Attached to this testimony FIA has included a section-by-section review of the draft bill which describes our positions on its specific sections.FIA's Principal Objections To summarize our objections, FIA fears the bill would: (1) increase the cost of hedging and price risk management for U.S. businesses, a bad result at any time, but one that is particularly harmful when those same businesses are struggling to cope with a deepening recession; (2) increase price volatility by removing vital market liquidity through artificial limits or outright prohibitions on participation in regulated exchange trading and OTC transactions; (3) disadvantage U.S. markets and firms by creating inadvertent incentives to trade overseas both exchange-traded and OTC derivatives; and (4) weaken CFTC regulation by saddling the agency with responsibilities that would be resource-intensive to perform with little corresponding public benefit. Our major concerns center on provisions in sections 6, 13 and 16 of the bill. Section 6 would require the CFTC, under a cumbersome and costly advisory committee system, to impose fixed speculative position limits on all commodities traded on regulated exchanges. Today those limits are set by the exchanges for all non-agricultural commodities. No evidence exists that this position limit system has caused any market surveillance difficulties or failed to stop any market manipulation. But the bill not only usurps the exchange's powers to set the limits, it would greatly expand the application of those limits by transforming into speculators many businesses that use futures in an economically appropriate manner to reduce price risks they face. Under the bill, any business becomes a speculator if its futures position is not a substitute for a transaction in the physical marketing channel or does not arise from a change in value in an asset or liability the business owns or service it provides. Under this restrictive test, for example, automobile manufacturers will not be able to hedge gasoline prices. Yet gasoline prices often play a major role in determining what cars consumers will buy and, hopefully, manufacturers will make. No one will be able to use weather derivatives to hedge climate changes of any kind (weather is not in the physical marketing channel). Agribusinesses will be unable to hedge their foreign currency risk and airlines will be unable to hedge their interest rate risk. The list of increased, unmanaged (speculative) price risk to our economy goes on and on. FIA understands that many Members of the Committee are concerned that speculation may have artificially influenced market prices in some commodities in the last year. We are still awaiting any objective fact-finding that would support that conclusion. For now, FIA has seen no evidence to distrust the market surveillance capabilities of the CFTC, especially when armed with the new special call reporting authority as the bill provides. FIA does not believe that restricting the ability of businesses to hedge or manage price risks on regulated exchange markets is an appropriate response in any event. We do not believe it is sound economic policy to force businesses that want to use U.S. futures markets to manage their price risks to trade on overseas markets or enter into OTC derivative positions. FIA urges Chairman Peterson and the Committee to reconsider section 6. Section 13 of the bill mandates clearing of all OTC derivative transactions, unless exempted by the CFTC under strict criteria. As the Committee well knows, all derivatives transactions involve counterparty credit risk. Different methods exist to deal with that risk. One of those methods is the futures-style clearing system. FIA is a strong supporter of clearing systems. Clearing removes each party's risk that its counterparty may default. As I testified before the Committee in December, FIA's regular members--the clearing firms--provide the financial backbone for futures clearing. Our members guarantee the financial performance of every trade in the system. FIA believes the futures clearing system works exceptionally well to remove counterparty risk and to reduce systemic risk. Increasing the number of transactions submitted for clearing also should be good for my members' bottom lines. In that sense, the Committee might expect FIA to support mandatory clearing of all OTC derivatives. But we don't. While a clearing mandate may have some superficial appeal, FIA is concerned that section 13 could promote economic instability in the U.S. Most directly of concern to FIA clearing members, a mandate may force derivatives clearing organizations to clear OTC products that are not sufficiently standardized to be cleared safely. Not every derivative can be cleared. The DCOs will surely try to clear what they can clear, consistent with their risk management systems. But as the experience with CDS clearing shows, developing appropriate clearing systems takes time and an indiscriminate statutory mandate for immediate clearing of OTC products would add financial risk to clearing members as well as the financial system as a whole. In addition, mandatory clearing of credit and other derivatives could lead to uncertainty in credit and other markets at a time when we are struggling to stabilize or restart those vital economic functions. It is true section 13 authorizes the CFTC to exempt classes of OTC derivatives from the clearing mandate. As drafted, however, section 13 would severely constrict the CFTC's ability to exempt OTC transactions. FIA trusts the CFTC's experience and expertise. If clearing is to be mandated at all for any transactions, we believe the CFTC could craft a workable and specific exemption if the statutory exemption criteria are sufficiently flexible. We believe that flexibility will lead to the best national economic policy. Otherwise we fear mandatory clearing of OTC derivatives could trigger a rush to overseas OTC markets that would be counter-productive to our national economic interests. FIA strongly supports one policy decision that is implicit in section 13. We know that some would mandate exchange trading of all derivatives in the U.S. FIA opposes that anti-competitive, anti-innovation approach and is pleased the draft bill does not go down that road. Consistent with section 13, FIA believes in an open, competitive system whereby classes of derivatives are first executed on exchange or dealer trading platforms as well as bilaterally and then submitted for clearing. Exchange and dealer competition for executing derivatives trades will serve well the interests of all market participants. FIA supports that approach. Unlike section 13, the provisions of section 16 are anti-competitive and anti-innovation. It appears to ban so-called naked credit default swaps in OTC dealer markets (where all CDS transactions now occur), while allowing them on exchange markets (where today none occurs). In addition to the unfair competition feature of section 16, it would remove important liquidity from our credit markets and could operate to make credit itself more expensive for those in struggling businesses that now thirst for credit. History teaches that removing liquidity provided by speculators leads to increased price volatility and costs for hedgers. Without speculators, hedgers may be forced to pay higher prices, rather than prices discovered by competitive market forces. The ban also would invite parties to the CDS market to conduct this business overseas, outside the jurisdictional reach of the U.S. financial regulatory system. That transactional exodus would complicate the job of Federal financial regulators, making it harder, if not impossible, to monitor systemic risk. FIA understands Chairman Peterson's concern that trading in credit derivative swaps could add substantial counterparty credit risks to our economy. But developing and implementing appropriate clearing systems for these instruments should address that concern. In fact, section 13 of the bill is based on that premise. FIA believes the Committee should focus on improving the clearing provisions of section 13 of the bill, rather than banning liquidity providers from the CDS market or favoring exchanges over OTC dealers.CFTC Regulation FIA understands that Congress soon may receive proposals on financial market regulatory restructuring. In that regard, one aspect of the recent financial market turmoil must be highlighted. Despite unprecedented financial turbulence that has led to bankruptcies and bailouts, the U.S. futures markets have performed flawlessly. Fair and reliable prices have been discovered transparently. Hedgers have managed price risks in liquid markets. All trades have been cleared. Customers have been paid. Not a blip. This record of excellence in an unprecedented crisis is the best evidence possible that the regulatory system this Committee has authored for decades works superbly well. It is also the best evidence that the Commodity Futures Trading Commission has done its job and done it well. This Committee should take pride in the record of the regulatory structures you put in place and the agency you created decades ago. Any efforts to rationalize Federal financial regulation should learn from the CFTC's example and make certain to preserve the best features of the futures regulatory system. One feature of the current regulatory system that must be preserved is the exclusive jurisdiction of the CFTC over all facets of futures trading and related activities. Congress long ago determined that other Federal or state regulation should not duplicate or conflict with the CFTC's regulation of the futures markets. We know this Committee has been vigilant in protecting this important public policy which has allowed CFTC-regulated futures markets to prosper for many years. The decision by this Committee to establish an experienced and specialized agency to oversee U.S. futures markets also has worked well for decades. Yet, there is always talk that simply merging the CFTC into the SEC will cure all regulatory ills. FIA knows this Committee appreciates that such a merger would not promote the public interests served by the Commodity Exchange Act and would not resolve the public policy issues that have arisen out of the latest credit market stress. We thank the Committee for its leadership in this area.Conclusion FIA thanks Chairman Peterson and the Committee for this opportunity to share our views. We would be pleased to assist your deliberations in any way we can and to answer any questions you may have. AttachmentAnalysis of Derivatives Markets Transparency and Accountability Act of 2009Section 3--Speculative Limits and Transparency of Off-Shore Trading Section 3 has three subsections. FIA opposes the first subsection and supports the other two subsections which parallel provisions in H.R. 6604 passed by the House last year. FIA supports coordinated market surveillance for linked products offered by competing U.S. and foreign exchanges. Last session, Rep. Moran offered legislation that would have addressed these issues in a comprehensive and reciprocal manner. FIA supports that approach. section 3(a), however, could spark retaliation by foreign regulators against U.S. firms and exchanges. The Moran approach is less likely to trigger that response and has broader application. FIA supports subsections 3(b) and 3(c) which afford a safe harbor and legal certainty to CFTC-registered firms that execute or clear trades for customers on foreign exchanges even if those exchanges themselves do not comply with each and every CFTC requirement. U.S. firms should not be liable for any non-compliance by foreign exchanges. Last session, H.R. 6604 contained these provisions in a form that achieved the stated objectives. In the draft bill, important language has been inadvertently dropped from subsection 3(b). FIA would support the provision if the language from H.R. 6604 is restored.Section 4--Detailed Reporting and Disaggregation of Market Data Section 4 would add a new 4(g) of the Commodity Exchange Act. FIA has no objection to having the CFTC define index traders and swap dealers. FIA also does not oppose monthly public reporting by the CFTC of the aggregate open positions held by index traders as a group and by swap dealers as a group using the data reported under the CFTC's large trader reporting system. FIA believes the CFTC also should consider other ways to make their Commitment of Trader Reports more granular and meaningful to all market participants. FIA opposes requiring index traders and swap dealers to file ``routine detailed'' reports with the CFTC. (7:18) No other large traders--speculators or commercials--are subject to such a requirement. It should be sufficient to treat index traders and swap dealers that qualify as large traders like all other large traders for reporting purposes. FIA would also recommend the deletion of the language ``in all markets to the extent such information is available.'' (8:11-12) The aggregate information included in the COT reports should be for futures and options positions only. Otherwise market participants that refer to the COT reports will receive a distorted view of the open interest and volume composition in futures and options markets.Section 5--Transparency and Recordkeeping Authorities Section 5 has three subsections. Subsection 5(a) would require a CFTC-registered futures commission merchant, introducing broker, floor trader or floor broker to make reports and keep records as required by the CFTC for ``transactions and positions traded'' by those registered professionals or their customers in, generally, OTC derivatives transactions that are exempted from the CEA and CFTC rules. FIA does not object to giving the CFTC this authority but questions whether it is at least partially duplicative of the special call provisions provided in the second part of the section. Subsection 5(b) has two parts. First, Subsection 5(b) would require any large trader of futures contracts in a commodity to maintain books and records of transactions and positions in that commodity which are otherwise generally exempt and excluded from the CEA. FIA does not object to this provision. Second, Subsection 5(b) would codify the CFTC's power to issue special calls for books and records relating to otherwise excluded or exempt transactions under the CEA when the CFTC determines it would be appropriate for market integrity purposes. FIA supports giving the CFTC this standby authority to enhance its market surveillance capabilities as circumstances require. Subsection 5(b) also requires large traders to retain the required books and record for 5 years. These required books and records shall include the ``complete details'' of all ``such transactions, positions, inventories, and commitments, including the names and addresses of all persons having an interest therein.'' (10:8-12) FIA questions whether these statutory requirements are necessary or whether it would be preferable to grant the CFTC general authority to adopt appropriate record-keeping rules for large traders that engage in otherwise exempt or excluded transactions. Subsection 5(c) contains conforming amendments to codify that the amendments in Subsections 5(a) and 5(b) create explicit exceptions to the statutory exclusions and exemptions in the CEA. FIA supports this legal certainty.Section 6--Trading Limits to Prevent Excessive Speculation. FIA opposes section 6. FIA sees no reason to repeal the exchanges' current authority to set position limits for their markets. (Today the CFTC sets position limits only for agricultural commodities.) The CFTC retains the power to review and amend any position limit set by an exchange if those limits are set in a manner that invites price manipulation or other market integrity concerns. Any member of the public is free to submit to the CFTC at any time a recommendation for changes to an exchange set position limit or accountability level. A formal advisory committee process is costly and unwarranted. The major deficiency in section 6 is its restrictive hedging definition. If a business establishes a futures position ``which is economically appropriate to the reduction of risks in the conduct and management of the commercial enterprise,'' that business is not a speculator. Instead, the business is managing an economic risk it faces in its business. Section 6 would misclassify that business as a speculator unless it also meets the ``substitute transaction'' and ``change of held assets/liabilities'' tests to become a physical hedger. These restrictions are bad economic policy and would impose unwarranted restrictions on businesses that want to use futures markets to hedge. Section 6 also would consider a swaps dealer to be a speculator if its futures positions are established to reduce the dealer's price risk on its net swaps position simply because some of its swaps counterparties are not physical hedgers. The swaps dealer is managing its price risk prudently and doing so in a transparent market through transactions without counterparty credit risk. That swaps dealer should be subject to all the market surveillance oversight faced by all large traders. But it should not be treated as a speculator because it is not speculating; it is trading futures to reduce its price risk in an economically appropriate manner. Section 6 conflicts with the policy of promoting price risk management through exchange-traded and cleared markets. FIA strongly recommends that the Committee drop the hedging definition in section 6 and instead direct the CFTC to conduct a rulemaking to define, for position limit purposes, speculation, hedging and price risk management consistent with the public interests to be served by the CEA.Section 7--CFTC Administration FIA supports section 7's authorization of at least 200 new full time employees for the CFTC.Section 8--Review of Prior Actions FIA opposes requiring the CFTC to spend its resources reconsidering all of its currently effective regulatory actions as well as those of the exchanges to determine if they are consistent with the provisions of the bill. CFTC has not yet adopted regulations to implement the provisions enacted in the farm bill in 2008, which would enhance customer protection and market surveillance. Before reviewing past actions, FIA believes the CFTC should implement the farm bill's reforms. FIA appreciates that the CFTC is given no deadline for completing this ``prior action'' review. We are sure the CFTC will move expeditiously to implement this bill's regulatory provisions, if enacted, as well as the farm bill provisions from last year. The key is providing the CFTC with adequate resources to do the job and section 7 is an important step in this direction.Section 9--Review of Over-the-Counter Markets FIA does not oppose having the CFTC study eventually whether position limits should be imposed on exempt transactions in physically-based agricultural or energy commodities when those transactions are fungible with regulated futures contracts and significant price discovery contracts. FIA also does not oppose including in that study whether it would be good policy for the CFTC to adopt umbrella limits for futures, swaps and any other fungible transactions in such commodities. FIA would urge the Committee, however, to remove the deadlines and timelines for such studies. The CFTC should be able first to adopt and implement its rules for Significant Price Discovery Contracts as required in the 2008 Farm Bill. Then, after it has had experience with such rules, the CFTC could tackle the required study. At this point, it seems to be premature to study what contracts are fungible with SPDC contracts, especially where the CFTC has not yet implemented its SPDC authority.Section 10--Study Relating to International Regulation of Energy Commodity Markets FIA does not oppose having the Comptroller General study the international regime for regulating the trading of energy commodity futures and derivatives. Some of the terms used in the study outline should be clarified. For example, it is not clear what is meant by ``commercial and noncommercial trading'' (21:8-9). It is also not clear what constitutes ``excessive speculation'' (21:23-24) or ``price volatility'' (21:25). Last, the study contemplates a proper functioning market ``that protects consumers in the United States.'' (22:34) The phrase suggests that markets should have a downward price bias to serve the interests of consumers. FIA instead believes that markets should reflect accurately market fundamentals, including the forces of supply and demand. FIA recommends that the Committee adjust the study outline to ensure it will provide beneficial, not skewed, results for further deliberations.Section 11--Over-The-Counter Authority FIA has no objection to having the CFTC analyze whether any exempt or excluded transaction is fungible with transactions traded on a registered entity, including an electronic facility that lists a Significant Price Discovery Contract. If such fungible contracts are found, and if the CFTC also finds that such contracts have the potential to harm the price discovery process on a registered entity, section 11 provides that the CFTC may use its existing emergency authority in section 8a(9) to impose position limits on such fungible contracts. This new authority would parallel the CFTC's new Significant Price Discovery Contract authority provided in the 2008 Farm Bill. As written, however, FIA can not support this provision. FIA is concerned about the breadth of the language ``have the potential to'' (22:24) harm market integrity on registered entities. The CFTC should be empowered to use these regulatory authorities only if it finds an actual emergency condition to exist which affects trading on registered entities. Otherwise the CFTC could use a mere possibility of an impact on a registered entity to restrain or prevent competition from arising among trading facilities or dealer markets with exchange markets. FIA also believes the Committee should make clear in section 11 that the CFTC should not apply its authority to restrict fair competition.Section 12--Expedited Process FIA has no objection generally to allowing the CFTC to use expedited procedures to implement the authorities in this bill if the CFTC deems it to be necessary. FIA does not believe the authority in section 12 itself is necessary because the Administrative Procedure Act provides the CFTC and other agencies with appropriate powers to expedite the kinds of rule making actions the bill contemplates. FIA does object to this provision if it is misread to authorize the CFTC to expedite and disregard APA or even Constitutionally-required procedural protections whenever the CFTC believes it to be necessary. That sweeping and standardless grant of authority could allow the agency to disregard well-established administrative procedural protections that have been adopted for many years to ensure reasoned and impartial agency decisions.Section 13--Certain Exemptions and Exclusions Available Only for Certain Transactions Settled and Cleared Through Registered Derivatives Clearing Organizations FIA supports encouraging market participants to clear appropriately standardized derivatives transactions. But FIA does not believe that mandatory clearing of all OTC derivatives is sound public policy. Clearing should only be available to those instruments that regulated clearing facilities decide they can safely clear. To date, no clearing facility believes it could or should clear all OTC derivatives. And even if a clearing facility believed it could clear a particular class or type of OTC derivative (and some do now), FIA would want that private entity's judgment confirmed by an expert Federal regulatory body, like the CFTC. FIA believes that clearing should be encouraged with incentives, not mandates, and only when the clearing entity and its government regulator agree that the particular class of OTC derivative could be submitted safely for clearing. Mandating clearing in a vacuum and without the necessary safety and soundness predicates, as section 13 appears to do, would be most unwise. Section 13 does grant to the CFTC the authority to declare spot and forward contracts immune from the mandatory clearing requirement. (31:12-17) The CFTC's authority is appropriately broad and flexible. But given the structure of section 13 and the traditional meanings of the terms spot and forward contracts, FIA is uncertain whether most or all OTC derivatives could fall into the spot or forward category. If not, the provisions in section 13 granting the CFTC the power to exempt classes of OTC transactions from the clearing mandate become particularly important. Unfortunately, the criteria in section 13 that would guide the CFTC's exemption decisions are much too rigid and constraining. As written, the CFTC would have to find a class of derivatives is ``highly customized;'' ``transacted infrequently;'' ``serves no price discovery function;'' and ``being entered into by parties with demonstrated financial integrity.'' (29:23-30:9) It would be difficult, if not impossible, for the CFTC to craft an appropriate exemption under these mandatory criteria. The result would be that section 13 would operate as a ban on all non-cleared OTC derivatives transactions in the U.S. and an invitation to market participants to enter into OTC transactions outside the jurisdictional reach of the CEA. Removing that significant market liquidity and making transactions more opaque to U.S. regulators would be detrimental to the public interest. FIA strongly opposes section 13.Section 14--Treatment of Emission Allowances and Off-Set Credits FIA supports defining emission allowances and off-set credits as ``exempt commodities'' like all other energy-related commodities. Section 14, however, excludes these commodities from the ``exempt commodity'' definition and would treat them like agricultural commodities. FIA does not know of any public policy reason to constrain the development of market innovations, including multilateral electronic trading facilities or clearing, for trading in these instruments in these energy commodities. Achieving energy policy goals will require promoting and expanding innovation, not restricting it. The Committee should reconsider the policy implications of treating these energy commodities like agricultural commodities.Section 15--Inspector General of the CFTC FIA has no objection to creating the Inspector General of the CFTC as a Presidential appointment, subject to Senate confirmation. At the same time, we do not believe the absence of an IG appointed by the President is a weakness in the current CFTC structure.Section 16--Limitation on Eligibility to Purchase a Credit Default Swap FIA opposes the ban on naked credit default swaps. Section 16 will effectively terminate the U.S. CDS market and send it overseas. CDS transactions have fostered many economic benefits and it would be better to improve regulation and oversight of this market rather than jettisoning it to foreign shores. FIA does support the provision that defines a credit default swap and allows registered entities that list for trading or clear CDS instruments to operate without having to comply with regulatory conditions imposed by the SEC. (38:1-9) " CHRG-111hhrg56847--28 Mr. Bernanke," Well, you pointed to a number of them. Certainly we look at resource utilization and price and wage pressure, which is very low right now. With the increases in productivity we are seeing, unit labor costs are actually declining. So firms are finding that their labor costs are actually falling rather than rising. Inflationary expectations are very, very important. And we take some comfort from the fact that as measured through a variety of mechanisms they have been quite stable. And we look broadly at the economy, at commodity prices and a variety of other indicators to see what markets are anticipating. So it is a very eclectic process. I guess what I would like to say is that even though we have indeed expanded our balance sheet, as you know and understand, I have given some testimonies in the last few months where I have laid out in some detail how we can exit from those extraordinary policies as needed, when needed without leaving any monetary or inflationary bias in the system. So we are comfortable that we have those tools. " FinancialCrisisReport--289 In contrast to decades of actual performance data for 30-year mortgages with fixed interest rates, the new subprime, high risk products had little to no track record to predict their rates of default. In fact, Moody’s RMBS rating model was not even used to rate subprime mortgages until December 2006; prior to that time, Moody’s used a system of “benchmarking” in which it rated a subprime mortgage pool by comparing it to other subprime pools Moody’s had already rated. 1118 Lack of Data During Era of Stagnant or Falling Home Prices. In addition, the models operated with subprime data for mortgages that had not been exposed to stagnant or falling housing prices. As one February 2007 presentation from a Deutsche Bank investment banker explained, the models used to calculate “subprime mortgage lending criteria and bond subordination levels are based largely on performance experience that was mostly accumulated since the mid-1990s, when the nation’s housing market has been booming.” 1119 A former managing director in Moody’s Structured Finance Group put it this way: “[I]t was ‘like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.” 1120 In September 2007, after the crisis had begun, an S&P executive testified before Congress that: “[W]e are fully aware that, for all our reliance on our analysis of historically rooted data that sometimes went as far back as the Great Depression, some of that data has proved no longer to be as useful or reliable as it has historically been.” 1121 The absence of relevant data for use in RMBS modeling left the credit rating agencies unable to accurately predict mortgage default and loss rates when housing prices stopped climbing. The absence of relevant performance data for high risk mortgage products in an era of stagnant or declining housing prices impacted the rating of not only RMBS transactions, but also CDOs, which typically included RMBS securities and relied heavily on RMBS credit ratings. Lack of Investment. One reason that Moody’s and S&P lacked relevant loan performance data for their RMBS models was not simply that the data was difficult to obtain, but 1117 9/30/2007 email from Belinda Ghetti to David Tesher, and others, Hearing Exhibit 4/23-33. 1118 See 2008 SEC Examination Report for Moody’s Investor Services Inc., PSI-SEC (Moodys Exam Report)-14- 0001-16, at 3. 1119 2/2007 “Shorting Home Equity Mezzanine Tranches,” Deutsche Bank Securities Inc., DBSI_PSI_EMAIL01988773-845, at 776. See also 6/4/2007 FDIC memorandum from Daniel Nuxoll to Stephen Funaro, “ALLL Modeling at Washington Mutual,” FDIC_WAMU_000003743-52, at 47 (“Virtually none of the data is drawn from an episode of severe house price depreciation. Even introductory statistics textbooks caution against drawing conclusions about possibilities that are outside the data. A model based on data from a relatively benign period in the housing market cannot produce reliable inferences about the effects of a housing price collapse.”). 1120 “Triple-A Failure,” New York Times (4/27/2008). 1121 Prepared statement of Vickie Tillman, S&P Executive Vice President, “The Role of Credit Rating Agencies in the Structured Finance Market,” before U.S. House of Representatives Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, Cong.Hrg. 110-62 (9/27/2007), S&P SEN-PSI 0001945-71, at 46-47. that both companies were reluctant to devote the resources needed to improve their modeling, despite soaring revenues. fcic_final_report_full--567 Bloomberg. 29. Ibid., pp. 197–205; Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000), pp. 36–54, 77–84, 94–105, 123–30. 30. “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” pp. 11–12. 31. William J. McDonough, president of the Federal Reserve Bank of New York, statement before the House Committee on Banking and Financial Services, 105th Cong., 2nd sess., October 1, 1998. 32. GAO, “Long-Term Capital Management: Regulators Need to Focus Greater Attention on Systemic Risk,” GAO/GGD-00-3 (Report to Congressional Requesters), October 1999, p. 39. 33. “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” pp. 13–14. 34. Lowenstein, When Genius Failed, pp. 205–18. 35. McDonough, statement before the House Committee on Banking and Financial Services, October 1, 1998. 36. Andrew F. Brimmer, “Distinguished Lecture on Economics in Government: Central Banking and Systemic Risks in Capital Markets,” Journal of Economic Perspectives , no. 2 (Spring 1989) (lecture by a for- mer Fed governor, analyzing the Fed’s market interventions in 1970, 1980 and 1987, and concluding that the Fed had consciously assumed a “strategic role as the ultimate source of liquidity in the economy at large”); Keith Garbade, “The Evolution of Repo Contracting Conventions in the 1980s,” Federal Reserve Bank of New York Economic Policy Review (May 2006): 33. 37. Harvey Miller, interview by FCIC, August 5, 2010. 38. Stanley O’Neal, interview by FCIC, September 16, 2010. 39. Fed Chairman Alan Greenspan, “Do efficient financial markets mitigate financial crises?” remarks before the 1999 Financial Markets Conference of the Federal Reserve Bank of Atlanta, October 19, 1999 (www.federalreserve.gov/boarddocs/speeches/1999/19991019.htm). 40. “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” p. 16. 41. Ibid. 42. Ibid. 43. Philip Goldstein, et al. v. SEC, Opinion, Case No. 04-1434 (D.C. Cir.  June 23, 2006). 44. Time, February 15, 1999; Bob Woodward, Maestro: Greenspan’s Fed and the American Boom (New York: Simon & Schuster, 2000). 45. SIFMA (Securities Industry and Financial Markets Association), Fact Book 2008, pp. 9–10. 46. Board of Governors of the Federal Reserve System, Federal Reserve Statistical Release Z.1: Flow of Funds Accounts of the United States, 4th Qtr. 1996, p. 88 (Table L.213, line 18); 4th Qtr. 2001, p. 90 (Table L.213, line 20). 47. SEC Chairman William H. Donaldson, “Testimony Concerning Global Research Analyst Settle- ment,” before the Senate Committee on Banking, Housing and Urban Affairs, 108th Cong., 1st sess., May 7, 2003. 48. SEC, “SEC Fact Sheet on Global Analyst Research Settlements,” April 30, 2003; Financial Industry Regulatory Authority news release, “NASD Fines Piper Jaffray $2.4 Million for IPO Spinning,” July 12, 2004. 49. Arthur E. Wilmarth Jr., “Conflicts of Interest and Corporate Governance Failures at Universal Banks During the Stock Market Boom of the 1990s: The Cases of Enron and WorldCom,” George Wash- ington University Public Law and Legal Theory Working Paper 234 (2007). 50. Fed Chairman Alan Greenspan, “International Financial Risk Management,” remarks before the Council on Foreign Relations, Washington, DC, November 19, 2002. 51. Ferguson, “The Future of Financial Services—Revisited.” 52. Spillenkothen, “Notes on the performance of prudential supervision in the years preceding the fi- nancial crisis,” p. 28. 53. “First the Put; Then the Cut?” Economist, December 16, 2000, p. 81. 54. Fed Chairman Alan Greenspan, “Risk and Uncertainty in Monetary Policy,” remarks at the Meet- ings of the American Economic Association, San Diego, California, January 3, 2004. See also Fed Gover- nor Ben S. Bernanke, “Asset-Price ‘Bubbles’ and Monetary Policy,” remarks before the N.Y. Chapter of the National Association of Business Economics, New York, October 15, 2002. 55. Fed Chairman Alan Greenspan, “Reflections on Central Banking,” remarks at a symposium spon- sored by the Federal Reserve Board of Kansas City, Jackson Hole, Wyoming, August 26, 2005. 56. Lawrence Lindsey, interview by FCIC, September 20, 2010. 57. The NYSE decided in 1970 to allow members to be publicly traded. See Andrew von Norden- flycht, “The Demise of the Professional Partnership? The Emergence and Diffusion of Publicly-Traded Professional Service Firms” (draft paper, Faculty of Business, Simon Fraser University, September 2006), pp. 20–21. 58. Peter Solomon, written testimony for the FCIC, First Public Hearing of FCIC, day 1, panel 2: Fi- nancial Market Participants, January 13, 2010, p. 2. 59. Brian R. Leach, interview by FCIC, March 4, 2010, p. 22. 60. Jian Cai, Kent Cherny, and Todd Milbourn, “Compensation and Risk Incentives in Banking and CHRG-111shrg49488--72 Chairman Lieberman," Thank you, Senator McCaskill. Thanks for participating this afternoon. We will do a second round insofar as Members want to be here or can be here. The Paulson plan, the Treasury Department's plan, issued last March, as you probably know, envisioned a regulatory system similar to Australia's, which was objectives based. The report was controversial here, although, unfortunately, it got overwhelmed by the growing crisis, so it did not receive the discussion I think it deserved. But it called for consolidation and dissolution of some existing agencies. One controversial reform, which we have referred to briefly here this morning, was the consolidation of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). I wanted to ask our three witnesses from outside the United States--I think I know the answer, but not totally--if any of the three countries divide the regulation of securities and futures the way we do here in the United States, or are they regulated under one roof? Mr. Green, everything is under one roof? " FOMC20060808meeting--14 12,MS. JOHNSON.," If I could just comment on the worldwide aspect of your point, I’d say that the one piece that’s missing is that globally we have not seen this inflation pressure translate into an acceleration in wages and labor compensation—not so much here in the United States and not in rest of the world. Even in places where central banks are tightening monetary policy in recognition of the inflation that they are experiencing in their consumer prices, one is not hearing stories about an acceleration of wages. So there’s truth in everything you’ve said, and I wouldn’t disagree that it’s worrisome, but we’ve seen huge changes in the structure of global economic activity. Those changes may have effected significant changes in relative prices, particularly of energy on the one hand and of other kinds of primary commodities on the other. We keep saying that those price changes are going to end, right? Every FOMC I come here, and I tell you that those prices are flattening out starting this morning. [Laughter] Then I come back six weeks later, and I say it again—and that’s not lost on me. However, there is a question in my mind as to trend versus relative price effects here, and I think there are surely some of both types of effects. It may be wrong to attribute the pressure entirely to a relative price shock that’s going to go away immediately, but it’s certainly also wrong to call it all inflation trend with no relative price component." CHRG-111hhrg51698--621 Mr. Rosen," I wouldn't want to make the knee-jerk reaction that as soon as the government does something that is potentially unpleasant that people will close off their access to or from the United States. I do think that if it was perceived that the standards that would be applied in the United States did not reflect the judgments of the international community, and that the manner in which the objective of sort of controlling speculation were being imposed prescriptively by the United States, there could be a couple of reactions. One reaction is in the regulatory community. I think it could invite retaliation and just another view that the United States is yet again being imperious when it is not necessary to do that. But to the extent that the market perceives that those constraints that are created by the imposition of those requirements on a foreign board of trade are going to impair the market, you could expect that. This is not just the foreign board of trade provision, Congressman Moran. I think it is related to a lot of the other provisions that impose constraints. If they are perceived as not conducive to the efficient operation of the market, there are no major traders certainly in the financial space that I am aware of who are not able to organize their affairs so that they can trade on foreign exchanges without a nexus to the United States. And I do have a concern that if we rush to judgment and try to solve short-term problems with long-term solutions that undermine the efficiency of the market, or are perceived by the market to undermine the market efficiency, those folks will be trading those products abroad. There is no reason why West Texas Intermediate crude is the price discovery contract for crude oil, other than the fact that we have been successful in developing highly efficient and low-cost markets. Most of the world transacts in forms of crude oil other than WTI. It is a small percentage, as you know. So I do have a concern that, if that were to transpire, there are many commodities that could be traded on foreign markets; and we would lose control over the regulation of those markets entirely. And if those markets are outside the United States, those markets will not even necessarily trade in U.S. dollars. It is not necessary for crude oil on the world stage to trade in U.S. dollars. I am not sure how it would advantage us to encourage the development of foreign markets driving the prices of stable commodities that our economy depends upon, and move those in a direction of trading in currencies other than the U.S. dollar. I think we do need to be concerned about those effects. " CHRG-111hhrg49968--26 Mr. Bernanke," Well, of course, we always have to keep modifying our models and addressing new situations. But we have a lot of ways of checking on expectations, including monthly surveys of both businesses and households, the daily behavior of the TIPS market, the daily behavior of commodity prices, and other factors. And, in particular, you know, inflation expectations can only result in inflation if they actually affect wage and price setting. And what we are seeing in the markets is that prices of manufactured goods, for example, and wages in nominal terms are not showing any signs of a wage-price spiral. To the contrary, they are showing quite a slow rate of growth. So, first of all, I want to say that in the medium to longer term we are very focused on the price stability issue, and I understand your concerns about that. But, as best we as can tell within the uncertainties of the forecasting, we don't see any inflation risk in the near term. " CHRG-110shrg38109--28 STATEMENT OF SENATOR JACK REED Senator Reed. Thank you, Mr. Chairman, and thank you, Chairman Bernanke, for joining us today. Your task in setting the right course of monetary policy is complicated by fiscal policy and international imbalances. We no longer have the fiscal discipline that we had in the 1990's which allowed for a monetary policy that was more encouraging of robust investment and long-term growth. The present large and persistent budget deficits have led to an ever-widening trade deficit that forces us to borrow vast amounts from abroad and puts us at risk of a major financial collapse if foreign lenders suddenly stop accepting our IOU's. Continued budget and trade deficits will be a drag on the growth of our standard of living and leave us ill prepared to deal with the effects of the retirement of the baby-boom generation. Strong investment, financed by our own national saving, not foreign borrowing, is the foundation of a strong and sustained economic growth and rising standards of living. One final issue that I would like to raise is the growing inequality of income earnings and wealth in the U.S. economy. Between 2003 and 2005, GDP grew at a rate of 3.5 percent per year. However, after adjusting for inflation, the typical weekly earnings of full-time wage and salary workers at the median of the earnings distribution went up only 0.6 percent between the end of 2000 and the end of 2006. Obviously, these median workers are not sharing in that robust GDP. Data from the Federal Reserve Board Survey of Consumer Finances show that household wealth is very unevenly distributed. The wealthiest 1 percent of families held more of the country's wealth than the bottom 90 percent of families combined. Even more disturbing is the large number of families, particularly African-American and Hispanic communities, that have little or no net wealth. Chairman Bernanke, I was heartened to read you comments in Omaha last week emphasizing the importance of education and training in reducing this economic inequality. And I know you share the concern that widening inequality is not good for our democracy and the fabric of the country. So, I hope you will agree there is an inconsistency at best in the Administration's pursuit of tax breaks for those who are already well off, including the permanent elimination of the estate tax, while continuing to propose cuts to elementary and secondary education, student aid and loan assistance for higher education, and job training for displaced workers. The challenges facing our economy are compounded by the disarray that characterizes our fiscal policy. We have been running unsustainable fiscal deficits, and in order to make the necessary investments in training and education, we must reverse this course. And I would be remiss if I did not note that the lead story today in most of the wire services is that Chrysler is cutting 13,000 jobs. I suspect that will probably raise the stock of Chrysler, make the investors happy, and investment bankers who are structuring the transformation of the company; it is necessary perhaps to do. But for 13,000 Americans who used to have good jobs with good health benefits, they are in a quandary, and our obligation is to them as well as it is to the shareholders of that company. So, I think we have to do a lot more, and I think you do sense that, and I think together, hopefully, we can make some progress. " CHRG-111hhrg55811--160 Mr. Hu," I think perhaps an illustration may be helpful in terms of answering this question. Right now, in terms of the world of security-based swaps, those based on broad-based swaps basically fall within the Commodity Futures Trading Commission's jurisdiction. The narrow-based securities-based swaps fall within the SEC's jurisdiction. In fact, in the real world, with clever hedge funds and others, you can use two different credit default swaps, or two different security-based swaps involving broad-based indices, to get very targeted exposure. So you might have a system where, in effect, one falls within securities law and pure securities law considerations apply. The other may deal with exactly the same kind of concerns and yet be subject to a wider range of perspectives. So you may end up with gaps between the two approaches. And this is one of the reasons why we think that close economic substitutes ought to be treated the same. " FinancialCrisisReport--379 Goldman Sachs Mortgage Department. In 2006 and 2007, the time period reviewed by the Subcommittee, the most senior Goldman executives were the Chairman of the Board and Chief Executive Officer Lloyd Blankfein; Chief Operating Officer and Co-President Gary Cohn; Co-President Jon Winkelried; and Chief Financial Officer David Viniar. Goldman’s Chief Risk Officer, Craig Broderick, was head of the Market Risk Management & Analysis area of the firm, which monitored and measured risk for the firm as a whole and for each business unit. Goldman’s Treasurer, Sarah Smith, was in charge of the Controllers area of the firm, which was responsible for financial accounting, profit and loss statements, customer credit, collateral/margin matters, and position valuation verification. 1520 In 2006 and 2007, Goldman Sachs’ operating activities were divided into three segments: Investment Banking, Trading and Principal Investments, and Asset Management and Securities Services. 1521 The Trading and Principal Investments Segment was divided into three businesses: Fixed Income, Currency and Commodities (FICC); Equities; and Principal Investments. 1522 FICC had five principal businesses: commodities; credit products; currencies; interest rate products; and mortgage related securities and loan products and other asset backed instruments. 1523 In its mortgage business, Goldman Sachs acted as a market maker, underwriter, placement agent, and proprietary trader in residential and commercial mortgage related securities, loan products, and other asset backed and derivative products. 1524 The Mortgage Department was responsible for buying and selling virtually all of the firm’s mortgage related assets. It originated and invested in residential and commercial mortgage backed securities; developed, traded, and marketed structured products and derivatives backed by mortgages; and traded mortgage market products on exchanges. 1525 In 2006 and 2007, the head of the Mortgage Department was Daniel Sparks. Goldman Co-Presidents Gary Cohn and Jon Winkelried, as well as CFO David Viniar, had been involved in Mr. Sparks’ earlier career at Goldman, and he maintained frequent, direct contact with them regarding the Mortgage Department. 1526 In 2006, Mr. Sparks formally reported first to Jonathan Sobel, who had run the Mortgage Department prior to Mr. Sparks. 1527 He next reported to Richard Ruzika, who was then co-head of Commodities. 1528 In late 2006, Mr. Sparks began reporting directly to Thomas Montag, who was co-head of Global Securities for the Americas, which included both the FICC Division and the Equities Division. 1529 In mid-2007, Mr. Sparks 1520 Subcommittee interviews of David Viniar (4/13/2010), Craig Broderick (4/9/2010), and Daniel Sparks (4/15/2010). 1521 1522 1523 1524 1525 1526 1527 1528 1529 2/6/2007 Goldman Sachs Form 10-K filing with the SEC. Id. Id. Id. Id. Subcommittee interview of Daniel Sparks (4/15/10). Id. Id. Id. began reporting to Donald Mullen, who was head of U.S. Credit Sales & Trading, and Mr. CHRG-110shrg50369--105 Mr. Bernanke," If commodity prices come down, including energy prices and raw food prices, I would expect to see, perhaps with a lag, finished food prices come down as well. As we have been discussing, the commodity prices, both food and energy, have been the primary source of the recent inflation. If they stabilize, even if they remain high, then inflation will moderate. And I expect that would happen, at least over time, at the finished level as well as at the raw level. Senator Tester. OK. Thank you very much, and I want to thank Senator Schumer again. Thank you very much. Senator Schumer. My pleasure. Two questions, Mr. Chairman. The first involves these sort of combination, creating problems now, of marking to market and the credit crunch, freeze, call it what you will. You know, when I first got here on the Banking Committee, banks really did not mark to market, and we regarded it as great progress that they now have to mark to market, like securities firms and others always did. It is a proper valuation of their assets. The problem here is nobody knows how to mark to market because there is no market. In too many areas, no one is buying. And so you do not know what they do when they make a valuation. I have heard from many people that that valuation is--they make it artificially low, and that further exacerbates. It is a vicious cycle because then they do not have the capital, they cannot do any more lending, and everything is frozen up. Is there a way to deal with that problem now? Is there a way to say, yes, you have to mark to market, but in these unusual circumstances you can do it 6 months from now, or something to that effect, quarterly, yearly? I am not an expert here, but I do know it is a real problem. How do you mark to market when there is no market? And because there is no market, rare, almost never occurred in such large parts of the credit market before, is this an unusual circumstance where this does not work? And my second question--and I will ask you to answer both--is this: The worry I think people have--and we have seen some questions on this--is that it is a lot easier to get the economy going than to shut inflation off. And the worry is that we go back to the situation in the late 1970s where the economy was stalling, rates were lowered, and then there was nothing that the Fed could do other than very late and drastic action to curb inflation. It was a difficult struggle. We went through it in the 1980s, and I remember paying 21 percent on my mortgage when I first signed my mortgage in 1982. Do we have better tools now that can control, you know, if inflation should start going beyond what you imagine for all the--we are global economy. You have less experience and less tests in this interconnected world than you did 20 years ago. Do we have better tools? Are you worried that if inflation really starts chugging along, that even a quick raise in interest rates will not be able really to head it off without really severe damage to the economy? So those are my two questions. " fcic_final_report_full--120 But as house prices rose after , the /s and /s acquired a new role: help- ing to get people into homes or to move up to bigger homes. “As homes got less and less affordable, you would adjust for the affordability in the mortgage because you couldn’t really adjust people’s income,” Andrew Davidson, the president of Andrew Davidson & Co. and a veteran of the mortgage markets, told the FCIC.  Lenders qualified borrowers at low teaser rates, with little thought to what might happen when rates reset. Hybrid ARMs became the workhorses of the subprime securitiza- tion market. Consumer protection groups such as the Leadership Conference on Civil Rights railed against /s and /s, which, they said, neither rehabilitated credit nor turned renters into owners. David Berenbaum from the National Community Rein- vestment Coalition testified to Congress in the summer of : “The industry has flooded the market with exotic mortgage lending such as / and / ARMs. These exotic subprime mortgages overwhelm borrowers when interest rates shoot up after an introductory time period.”  To their critics, they were simply a way for lenders to strip equity from low-income borrowers. The loans came with big fees that got rolled into the mortgage, increasing the chances that the mortgage could be larger than the home’s value at the reset date. If the borrower could not refinance, the lender would foreclose—and then own the home in a rising real estate market. Option ARMs: “Our most profitable mortgage loan” When they were originally introduced in the s, option ARMs were niche prod- ucts, too, but by  they too became loans of choice because their payments were lower than more traditional mortgages. During the housing boom, many borrowers repeatedly made only the minimum payments required, adding to the principal bal- ance of their loan every month. An early seller of option ARMs was Golden West Savings, an Oakland, Califor- nia–based thrift founded in  and acquired in  by Marion and Herbert San- dler. In , the Sandlers merged Golden West with World Savings; Golden West Financial Corp., the parent company, operated branches under the name World Sav- ings Bank. The thrift issued about  billion in option ARMs between  and .  Unlike other mortgage companies, Golden West held onto them. Sandler told the FCIC that Golden West’s option ARMs—marketed as “Pick-a- Pay” loans—had the lowest losses in the industry for that product. Even in —the last year prior to its acquisition by Wachovia—when its portfolio was almost entirely in option ARMs, Golden West’s losses were low by industry standards. Sandler attrib- uted Golden West’s performance to its diligence in running simulations about what would happen to its loans under various scenarios—for example, if interest rates went up or down or if house prices dropped , even . “For a quarter of a cen- tury, it worked exactly as the simulations showed that it would,” Sandler said. “And we have never been able to identify a single loan that was delinquent because of the structure of the loan, much less a loss or foreclosure.”  But after Wachovia acquired Golden West in  and the housing market soured, charge-offs on the Pick-a-Pay portfolio would suddenly jump from . to . by September . And fore- closures would climb. fcic_final_report_full--224 Unfortunately, of the three competitive factors, rating quality is proving the least powerful given the long tail in measuring performance. . . . The real problem is not that the market does underweights [sic] ratings quality but rather that, in some sectors, it actually penalizes quality by awarding rating mandates based on the lowest credit enhancement needed for the highest rating. Unchecked, competition on this basis can place the entire financial system at risk. It turns out that ratings quality has surprisingly few friends: issuers want high ratings; investors don’t want rating downgrades; and bankers game the rating agencies for a few extra basis points on execution.  Moody’s employees told the FCIC that one tactic used by the investment bankers to apply subtle pressure was to submit a deal for a rating within a very tight time frame. Kolchinsky, who oversaw ratings on CDOs, recalled the case of a particular CDO: “What the trouble on this deal was, and this is crucial about the market share, was that the banker gave us hardly any notice and any documents and any time to an- alyze this deal. . . . Because bankers knew that we could not say no to a deal, could not walk away from the deal because of a market share, they took advantage of that.”  For this CDO deal, the bankers allowed only three or four days for review and final judgment. Kolchinsky emailed Yoshizawa that the transactions had “egregiously pushed our time limits (and analysts).”  Before the frothy days of the peak of the housing boom, an agency took six weeks or even two months to rate a CDO.  By , Kolchinsky described a very different environment in the CDO group: “Bankers were pushing more aggressively, so that it became from a quiet little group to more of a machine.”  In , Moody’s gave triple-A ratings to an average of more than  mortgage securities each and every working day.  Such pressure can be seen in an April  email to Yoshizawa from a managing director in synthetic CDO trading at Credit Suisse, who explained, “I’m going to have a major political problem if we can’t make this [deal rating] short and sweet because, even though I always explain to investors that closing is subject to Moody’s timelines, they often choose not to hear it.”  The external pressure was summed up in Kimball’s October  memorandum: “Analysts and [managing directors] are continually ‘pitched’ by bankers, issuers, in- vestors—all with reasonable arguments—whose views can color credit judgment, sometimes improving it, other times degrading it (we ‘drink the kool-aid’). Coupled with strong internal emphasis on market share & margin focus, this does constitute a ‘risk’ to ratings quality.”  The SEC investigated the rating agencies’ ratings of mortgage-backed securities and CDOs in , reporting its findings to Moody’s in July . The SEC criticized Moody’s for, among other things, failing to verify the accuracy of mortgage informa- tion, leaving that work to due diligence firms and other parties; failing to retain doc- umentation about how most deals were rated; allowing ratings quality to be compromised by the complexity of CDO deals; not hiring sufficient staff to rate fcic_final_report_full--477 PRECIPITATED A FINANCIAL CRISIS Although the Commission never defined the financial crisis it was supposed to investigate, it is necessary to do so in order to know where to start and stop. If, for example, the financial crisis is still continuing, then the effect of government policies such as the Troubled Asset Repurchase Program (TARP) should be evaluated. However, it seems clear that Congress wanted the Commission to concentrate on what caused the unprecedented events that occurred largely in the fall of 2008, and for this purpose Ben Bernanke’s definition of the financial crisis seems most appropriate: The credit boom began to unravel in early 2007 when problems surfaced with subprime mortgages—mortgages offered to less-creditworthy borrowers—and house prices in parts of the country began to fall. Mortgage delinquencies and defaults rose, and the downturn in house prices intensified, trends that continue today. Investors, stunned by losses on assets they had believed to be safe, began to pull back from a wide range of credit markets, and financial institutions—reeling from severe losses on mortgages and other loans—cut back their lending. The crisis deepened [in September 2008], when the failure or near-failure of several major financial firms caused many financial and credit markets to freeze up.” 45 In other words, the financial crisis was the result of the losses suffered by financial institutions around the world when U.S. mortgages began to fail in large numbers; the crisis became more severe in September 2008, when the failure of several major financial firms—which held or were thought to hold large amounts of mortgage-related assets—caused many financial markets to freeze up. This summary encapsulates a large number of interconnected events, but it makes clear that the underlying cause of the financial crisis was a rapid decline in the value of one specific and widely held asset: U.S. residential mortgages. The next question is how, exactly, these delinquencies and losses caused the financial crisis. The following discussion will show that it was not all mortgages and mortgage-backed securities that were the source of the crisis, but primarily NTMs— including PMBS backed by NTMs. Traditional mortgages, which were generally prime mortgages, did not suffer substantial losses at the outset of the mortgage meltdown, although as the financial crisis turned into a recession and housing prices continued to fall, losses among prime mortgages began to approach the level of prime mortgage losses that had occurred in past housing crises. However, those levels were far lower than the losses on NTMs, which reached levels of delinquency and default between 15 and 45 percent (depending on the characteristics of the loans in question) because the loans involved were weaker as a class than in any previous housing crisis. The fact that they were also far larger in number than any 45 Speech at Morehouse College, April 14, 2009. 471 previous bubble was what caused the catastrophic housing price declines that fueled the financial crisis. 1. How Failures Among NTMs were Transmitted to the Financial System FOMC20060808meeting--8 6,MS. JOHNSON.," From the perspective of the global economy, one of the important revisions in this forecast from last time is the projected path for crude oil prices. We have incorporated into the baseline forecast a path for both West Texas intermediate (WTI) prices and the U.S. oil import price that is more than $5 per barrel higher in the fourth quarter of this year and nearly $7 higher by the fourth quarter of next year than was the case in the June Greenbook. It is still true, however, that the projected path, based as usual on market futures prices at the time the forecast was made final, is quite flat. The sizable jump in oil prices this time reflects the volatility that we have seen in market prices for oil since late June, when the previous Greenbook was being finalized. Spot prices for WTI moved from below $70 per barrel at that time to a recent peak of $77 in mid-July and again yesterday, following BP’s announcement that pipeline repair in Alaska will shut in about 400,000 barrels per day of crude oil. Price fluctuations during the intermeeting period reflected market concerns about the potential effect on supply of ongoing events in the Middle East, some disruptions to production in Nigeria, and a slight reduction in output by Saudi Arabia, as well as an awareness that hurricane season has arrived. No doubt the underlying strength of the global economy is contributing by maintaining overall demand as well. As of close of business yesterday, the futures path for WTI oil prices during the remainder of this year and next year was about $2 per barrel above the Greenbook baseline path. Clearly, further moves in oil prices are a risk to the forecast. Another important element in the foreign outlook is the continued elevated level of nonfuel commodity prices, especially the industrial metals. Metals prices are down from their highs in May, but they are also up from their near-term lows in June. During the intermeeting period, spot prices for copper and zinc rose through mid-July and then partially reversed their recent increases but since have moved up again. On balance, metals prices are modestly higher since the time of the June Greenbook, but prices of other primary commodities are somewhat lower. As a result, our projected path for nonfuel commodity prices in this forecast is very similar to that of last time. The elevated level of these prices means that they will continue to have lagged effects on U.S. import and export price inflation for a time. The flatness of the path going forward means that we anticipate that the implications for import price inflation will abate noticeably in 2007, contributing to a sharp drop in the rate of inflation for core imports. Further fluctuation in the prices for these global commodities is also a risk to our baseline forecast. These developments in global commodity prices, both fuel and nonfuel, along with other data released over the intermeeting period, led us to revise up some our forecast for inflation abroad through mid-2007. We expect that the upward pressures on inflation in the industrial countries will be felt in the near term, particularly this quarter, whereas those in the emerging market economies will be evident later this year and into next. The revisions are small, in part because foreign industrial countries have to date been very successful at containing the inflation consequences of higher crude oil prices and several have tightened monetary policy and in part because emerging market economies have continued to suppress domestic energy prices, delaying their effects in the process. Some monetary policy tightening has also been implemented by a number of Asian central banks. We continue to read the evidence for foreign real GDP growth as indicating a solid pace of expansion, with the possible exception of Canada, where output growth slowed in the second quarter. We have fine-tuned our outlook for expansion abroad a bit—strengthening last quarter and this quarter and lessening the pace just a little next year; but the overall path for foreign real GDP is about the same as in June. Indicators from most of our important trading partners—for example, from Japan, the euro area, and China—suggest considerable momentum in foreign economic expansion at the present time. Global financial markets confirm a generally favorable climate for continued strong growth, and many of the signs of increased risk concerns and heightened volatility from earlier in the year have faded. Over the intermeeting period, stock prices in many of our trading partners have risen. Equity price indexes in emerging market countries, in particular, have rebounded from the lows of mid-June but generally have not returned to the levels reached in early May. Other than in the United Kingdom and Japan, yields on ten-year sovereign bonds have moved down 10 or more basis points in the major foreign industrial countries since your June meeting, and spreads on dollar-denominated emerging market sovereign debt have partially retraced previous increases and are not far above the lows observed in early May, with the exception of spreads for Turkish debt. On balance, the dollar is down just a little over the period. The bottom line is that the staff’s picture of the global economy implies an essentially neutral effect of the external sector on U.S. GDP growth over the forecast period, although one must remember that there are risks on both sides to that picture. The arithmetic contribution of real net exports to GDP growth for the rest of this year and next year is essentially zero—with a small positive contribution over the second half of this year, unusual for us, followed by a small negative contribution in 2007 as a whole. Exports of both goods and services are expected to grow strongly, supported by steady expansion of real GDP growth abroad. The step-down in U.S. real GDP growth should restrain import growth somewhat over the next six quarters. The nominal trade deficit on goods and services is projected to widen about $75 billion from the estimated figure for the second quarter to that for the fourth quarter of 2007. The change in the non-oil nominal trade balance accounts for only one-third of that $75 billion. This change in the overall trade balance is sufficiently small that the projected ratio of the trade deficit to GDP is steady at about 6 percent. Nevertheless, the current account deficit is projected to exceed $1 trillion at the end of 2007, and the ratio of the current account deficit to GDP rises from 6.5 percent to 7 percent next year. A growing net deficit in investment income flows largely explains the further deterioration in the current account balance. That change, in turn, is accounted for by a substantial widening of the deficit on portfolio income that more than offsets a gain in the balance of direct investment income. The financing requirements of our external deficit remain large and will continue to grow as long as the level of the trade balance remains far from zero. David and I will be happy to answer any questions." fcic_final_report_full--406 The introduction in October  of the Commercial Paper Funding Facility, un- der which the Federal Reserve loaned money to nonfinancial entities, enabled the commercial paper market to resume functioning at more normal rates and terms. But even with the central bank’s help, nearly  of banks tightened credit standards and lending in the fourth quarter of .  And small businesses particularly felt the squeeze. Because they employ nearly  of the country’s private-sector workforce, “loans to small businesses are especially vital to our economy,” Federal Reserve Board Governor Elizabeth Duke told Congress early in .  Unlike the larger firms, which had come to rely on capital markets for borrowing, these companies had gen- erally obtained their credit from traditional banks, other financial institutions, nonfi- nancial companies, or personal borrowing by owners. The financial crisis disrupted all these sources, making credit more scarce and more expensive. In a survey of small businesses by the National Federation of Independent Business in ,  of respondents called credit “harder to get.” That figure compares with  in  and a previous peak, at around , during the credit crunch of .  Fed Chairman Ben Bernanke said in a July  speech that getting a small busi- ness loan was still “very difficult.” He also noted that banks’ loans to small businesses had dropped from more than  billion in the second quarter of  to less than  billion in the first quarter of .  Another factor—hesitancy to take on more debt in an anemic economy—is cer- tainly behind some of the statistics tracking lending to small businesses. Speaking on behalf of the Independent Community Bankers of America, C. R. Cloutier, president and CEO of Midsouth Bank in Lafayette, Louisiana, told the FCIC, “Community banks are willing to lend. That’s how banks generate a return and survive. However, quality loan demand is down. . . . I can tell you from my own bank’s experience, cus- tomers are scared about the economic climate and are not borrowing. . . . Credit is available, but businesses are not demanding it.”  Still, creditworthy borrowers seeking loans face tighter credit from banks than they did before the crisis, surveys and anecdotal evidence suggest. Historically, banks charged a  percentage point premium over their funding costs on business loans, but that premium had hit  points by year-end  and had continued to rise in , raising the costs of borrowing.  Small businesses’ access to credit also declined when the housing market col- lapsed. During the boom, many business owners had tapped the rising equity in their homes, taking out low-interest home equity loans. Seventeen percent of small em- ployers with a mortgage refinanced it specifically to capitalize their businesses.  As housing prices declined, their ability to use this option was reduced or blocked alto- gether by the lenders. Jerry Jost told the FCIC he borrowed against his home to help his daughter start a bridal dress business in Bakersfield several years ago. When the economy collapsed, Jost lost his once-profitable construction business, and his daughter’s business languished. The Jost family has exhausted its life savings while struggling to find steady work and reliable incomes.  FOMC20081007confcall--23 21,MR. SHEETS.," Since the last Greenbook, the economic indicators for the foreign economies have generally surprised us on the downside, notwithstanding the fact that our expectations in the Greenbook for foreign growth were already pretty grim. In the euro area, measures of consumer and business sentiment have continued to retreat. Industrial production has moved down, and retail sales have been soft. Recent data for the United Kingdom have continued to point to a mild contraction during the second half of this year, and notably house prices there continue to fall. In Japan, industrial production plummeted in August, recording its biggest monthly decline in more than five years, and survey data point to further declines in business and consumer confidence. Finally, in the emerging market economies, industrial production has fallen in a broad set of countries, and exports have softened significantly. In light of these data, we now see foreign growth in the second half of this year as likely to come in at a little less than 1� percent, down � percentage point from our last forecast, with these markdowns spread about evenly between the advanced economies and the emerging market economies. We have reduced our projections for growth in 2009 almost as much. This weakening outlook for global activity has been largely driven, as Bill has described, by a marked deterioration in financial conditions in both the advanced and the emerging market economies. Since the last FOMC meeting, equity markets have fallen sharply in numerous countries. Risk premiums on many types of assets have risen, and conditions in short-term funding markets have worsened further. These difficult financial conditions threaten the outlook for foreign growth going forward both by weighing on sentiment in financial markets and by potentially limiting the flow of credit to the economy. If there is any good news for me to report, it's that the softening outlook for global growth has continued to put downward pressure on the price of oil and other commodities. Oil prices have been extraordinarily volatile over the last month, lurching up and down in response to a number of factors, including the effects of the two hurricanes, shifting expectations regarding global growth, and financial turbulence. On net, as Larry mentioned, the price of WTI is down about $13 a barrel since the Greenbook and down over $55 per barrel from its peak in mid-July. Prices for many nonfuel commodities have fallen sharply since the FOMC meeting, including price declines of more than 10 percent for copper, nickel, and rubber, and more than 20 percent for corn and soybeans. Headline inflation remains elevated in the advanced foreign economies. Notably, U.K. inflation in August reached 4� percent, a 15-year high. In contrast, the most recent CPI data for the euro area hint at some deceleration, with inflation moving down from over 4 percent in July to 3.6 percent in September. Going forward, there are good reasons to expect inflation in these economies to abate, given the recent sharp decline in commodity prices and emerging slack in their economies. Inflation rates in the emerging market economies appear to be cresting for similar reasons. In the midst of these events, the dollar has remained quite resilient, rising about 3 percent since the last FOMC meeting. In our view the currency markets earlier this year had priced in expectations that the major foreign economies would remain largely resilient despite U.S. slowing. As the growth prospects for the foreign economies have deteriorated, the relative attractiveness of the dollar has increased. This, along with the sustained demand for dollar funding in global financial markets, seems to have buoyed the dollar of late. Finally, given the weaker path of foreign activity and the stronger dollar, we now expect export growth to be somewhat less robust than was the case in our previous forecast and, consequently, net exports to be less supportive of U.S. economic growth over the next two years. Nevertheless, net exports are still expected to contribute a positive 0.5 percentage point to growth in the second half of this year and about 0.3 percentage point in 2009. We are happy to take your questions now. " CHRG-109hhrg23738--6 The Chairman," The gentlelady's time has expired. The gentlelady from Ohio, Judge Pryce? Ms. Pryce. Thank you, Chairman Oxley. Welcome, Chairman Greenspan. Thank you for taking time to discuss with us your insightful thoughts on monetary policy and the state of our economy. I am pleased to read in your testimony that you believe overall the economy remains steady. Many financial analysts have credited the strong, vibrant housing market as a vital segment of the health of our economy. Recent studies have found that housing accounted for more than one-third of economic growth during the previous 5 years. Many observers, including yourself, have noted that mortgage refinancing provided crucial support to the economy during the past recession, enabled homeowners to reduce their debt burdens and maintain adequate levels of consumer spending by tapping into the equity of their homes. I for one took great advantage of that. Despite these latest gains in home ownership, I am concerned about the recent surge in home prices in many metropolitan areas. In most countries, the recent surge in home prices has gone hand in hand with a much larger jump in household debt than in previous booms. Not only are new buyers taking out bigger mortgages, but existing owners have increased their mortgages to turn capital gains into cash that they can spend. So I hope to hear your views on the current status of this country's housing market and whether a nationwide bubble exists, also what effect a measured rise in inflation will have on the housing market. As we have seen in the Australian economy, they experienced a surge and were able to slowly raise rates and control real estate speculation, keeping that economy healthy after the market peaked. So I look forward to talking more about that with you. Shifting gears, I would also like to know--and I will ask later--whether you feel the recent string of data security breaches has affected consumer confidence in our payment systems. As you know, Mr. Chairman, I, along with many of my colleagues on both sides of the aisle here, are working hard on some legislation that will provide uniform national standards for consumer protection and data breach notification, and we would appreciate any insights you care to share. Data security breaches are something that all of us are concerned with, as we see more and more instances of breaches in the headlines every day. I am pleased to be working with many members, Congressman Castle and LaTourette, Moore, Hooley, even Mr. Frank, on these important issues. And we appreciate the leadership of Chairman Oxley and Chairman Baucus as well. But under Gramm-Leach-Bliley, financial services firms already have an obligation to keep consumer information secure and confidential, and we need to extend those safeguards to information brokers and others. When a breach occurs that could lead to financial fraud or misuse of sensitive financial identity information, customers have the right to be informed about the breach and what steps they should take to protect themselves. I believe there should be one federal standard for data security and for notification. Disparate standards that vary from state to state are an administrative nightmare and make compliance very difficult. Varying standards can cause consumer confusion, and customers should be assured that when their information is breached, they receive the same notification no matter where they live. So, thank you, Mr. Chairman, for your appearance today. I look forward to your testimony. And thank you, Chairman Oxley. I yield back. " CHRG-111hhrg51698--23 Mr. Duffy," Thank you; and let me echo my fellow panelists and thank you, Chairman Peterson and Ranking Member Lucas, for the opportunity to present our views. The CME Group Exchanges are neutral marketplaces. Our Congressionally mandated role is to operate markets that foster price discovery and hedging in a transparent, efficient, self-regulated environment overseen by the CFTC. We provide producers and processors with necessary information to make important economic decisions and serve their global risk management needs. We offer a comprehensive selection of benchmark products in all major asset classes. We are also joining market users to operate a green exchange. This exchange will provide trading and clearing services to serve cap and trade programs respecting emissions and allowances. Additionally, we are joint venturers with Citadel to provide trading and clearing platforms for credit default swaps. Our risk analytics and financial safeguards have been thoroughly examined by the CFTC, the Federal Reserve, and the SEC. So we appreciate the proposed clarification that will enhance our ability to provide clearing services for credit default swap contracts. We also appreciate that it will not infringe on the SEC's regulatory responsibilities and will permit competition in this very important market. The draft bill is offered as an amendment to the Commodity Exchange Act to bring greater transparency and accountability to commodity markets. We support the bill's purpose to enhance the enforcement capabilities and structure of the CFTC, but it is essential that care be taken to avoid constraints on U.S. markets that would further weaken the already fragile U.S. economy, damage the competitiveness of U.S. markets, hurt U.S. consumers, produce less transparency, and deprive the Commission of vital information. We understand that there may be some markets in which excessive speculation, as defined in the Commodity Exchange Act, may cause price distortion. All agricultural and natural resource futures and options contracts are subject to either Commission or exchange spot month speculative position limits. The CFTC and the exchanges enforce those limits. We do not agree that hard position limits play a constructive role, either with commodities that are not physically delivered or with commodities whose trading does not affect any physically delivered market. We do not agree that the CFTC should be the front-line regulator setting hard limits. We also disagree with the creation of advisory committees for setting hard limits in agriculture and energy products. The proposed committees are dominated by long and short hedgers who are not constrained by any standards, and who do not operate subject to a defined process. We are concerned that these committees may excessively influence the setting of limits. Also, they may adversely affect the ability of our markets to efficiently perform their price discovery function. In addition, we believe the bill's direction to the Commission is overly restrictive in defining a direct hedging transaction; and it is restrictive with respect to dealers, funds, and others who have assumed risks in the over-the-counter market which are consistent with their legitimate businesses. We are strong proponents of the benefits of central counterparty clearing. It is an effective means to collect and provide timely information to regulators. It also greatly reduces systemic risk imposed on financial systems by unregulated bilateral OTC transactions. We would benefit from section 13 of the draft bill, but we are not confident that it is workable. If the OTC dealers do not embrace clearing, they can easily transact in another jurisdiction. In that way, they could avoid the obligations imposed by the draft bill. This could cause significant damage to a valuable domestic industry. We urge the Committee to shape its bill in recognition of the reality of markets that operate in a global economy. Trading systems are electronic, banking is international, and every important trader has easy access to markets that are not regulated by the CFTC and not constrained by this bill. We are concerned with prohibitions or costly impediments to legitimate business activities in the United States. We believe they will divert business to jurisdictions that adopt other regulatory measures to protect against future meltdowns. We are eager to work with the Committee and the industry to help shape incentives that will encourage clearing and other provisions that support the goal of this bill. My written testimony highlights several technical issues in the draft. More importantly, it offers our pledge to work with the Committee and help assure that U.S. futures markets remain positive contributors to our economy. Thank you, sir. [The prepared statement of Mr. Duffy follows:] Prepared Statement of Hon. Terrence A. Duffy, Executive Chairman, CME Group Inc., Chicago, IL I am Terrence Duffy, Executive Chairman of Chicago Mercantile Exchange Group Inc. (``CME Group'' or ``CME''). Thank you Chairman Peterson and Ranking Member Lucas for this opportunity to present our views.CME Group Exchanges CME Group was formed by the 2007 merger of Chicago Mercantile Exchange Holdings Inc. and CBOT Holdings Inc. CME Group is now the parent of CME Inc., The Board of Trade of the City of Chicago Inc., NYMEX and COMEX (the ``CME Group Exchanges''). The CME Group Exchanges are neutral market places. They serve the global risk management needs of our customers and producers and processors who rely on price discovery provided by our competitive markets to make important economic decisions. We do not profit from higher or lower commodity prices. Our Congressionally mandated role is to operate fair markets that foster price discovery and the hedging of economic risks in a transparent, efficient, self-regulated environment, overseen by the CFTC. The CME Group Exchanges offer a comprehensive selection of benchmark products in all major asset classes, including futures and options based on interest rates, equity indexes, foreign exchange, agricultural commodities, energy, and alternative investment products such as weather and real estate. We are in the process of joining with market users to operate a green exchange to provide trading and clearing services that will serve cap and trade programs respecting emissions and allowances. We are joint venturers with Citadel to provide trading and clearing platforms for credit default swaps. Our risk analytics and financial safeguards have been thoroughly vetted by the CFTC, the Federal Reserve and the SEC. Our efforts to open our doors have been complicated by jurisdictional issues, but we are very close to a launch of the service. We also offer order routing, execution and clearing services to other exchanges as well as clearing services for certain contracts traded off-exchange. CME Group is traded on NASDAQ under the symbol ``CME.''Executive Summary The draft bill that was recently circulated is purposed as an amendment ``to the Commodity Exchange Act to bring greater transparency and accountability to commodity markets.'' We support that statement of the bill's purpose. We unequivocally support enhancing the enforcement capabilities and machinery of the CFTC, but it is essential that care be taken to avoid constraints on U.S. markets that will further weaken the already fragile U.S. economy; damage the competitiveness of U.S. markets; hurt U.S. consumers and produce less transparency and deprive the Commission of vital information. We understand that there may be some markets in which ``excessive speculation,'' as defined in the CEA, may cause price distortion; we set hard limits in those markets or enforce CFTC limits. We do not agree that hard position limits play a constructive role with respect to commodities that are not physically delivered and commodities whose trading does not affect any physical delivery market. We do not agree that the CFTC should be the front-line regulator setting hard limits. We disagree with the creation of ``advisory'' committees for setting hard limits in agriculture and energy products. The proposed committees are dominated by long and short hedgers, who are not constrained by any standards and who do not operate subject to a defined process. We are concerned that these committees will inordinately influence the setting of limits and will adversely affect the ability of our markets to efficiently perform their price discovery function. We believe that the bill's direction to the Commission to define a bona fide hedging transaction is overly restrictive both with respect to direct hedgers and its constraints on the ability of dealers, funds and others who have assumed risks in the over the counter market, which are consistent with their legitimate businesses. We are strong proponents of the benefits of central counterparty clearing as an effective means to collect and provide timely information to prudential and supervisory regulators and to greatly reduce systemic risk imposed on the financial system by unregulated bilateral OTC transactions. We would be a major beneficiary of section 13 of the draft bill, but we are not confident that it is practicable. If the OTC dealers do not embrace clearing, they can easily transact in another jurisdiction, avoid the obligations imposed by the draft bill and cause significant damage to a valuable domestic industry. We urge the Committee to shape its bill in recognition of the reality of markets that operate in a global economy. Trading systems are electronic, banking is international, and every important trader has easy access to markets that are not regulated by the CFTC and not constrained by this bill. Prohibitions or costly impediments to legitimate business activities in the U.S. will simply divert business to jurisdictions that adopt rational measures to deal with the causes and protection against future financial meltdowns. We are eager to work with the Committee and the industry to shape incentives that will encourage clearing in appropriate cases and bring us quickly to the end position envisioned by the bill. Finally, we appreciate the proposed clarification that will enhance our ability to provide clearing services for credit default swap contracts in a manner that does not infringe on the SEC's regulatory responsibilities and that will permit competition in this important market across regulatory regimes. We are concerned, however, that the bill will foreclose trading of CDSs in the U.S.Drafting and Technical Issues We welcome a dialogue with the Committee's staff to resolve our technical and philosophical concerns with the draft. For convenience, we describe our most serious concerns below.Sec. 3. Speculative Limits and Transparency of Offshore Trading. Subpart (a) directs the Commission to preclude direct access from the U.S.: ``to the electronic trading and order matching system of the foreign board of trade with respect to an agreement, contract, or transaction that settles against any price (including the daily or final settlement price) of one or more contracts listed for trading on a registered entity,'' unless the foreign board of trade satisfies a broad set of conditions respecting position limits, information sharing, and the definition of bona fide hedging. The draft bill is calibrated appropriately to focus only on a narrow range of contracts that might be traded on a foreign board of trade, although we wonder why it is restricted to financially settled contracts and does not include substantially identical physically settled contracts. We are, nonetheless, concerned that this effort may provoke retaliatory behavior from foreign governments or regulatory agencies that could severely impair our business.Sec. 4. Detailed Reporting and Disaggregation of Market Data. Section 4 amends the CEA to require that the Commission issue a ``rule defining and classifying index traders and swap dealers (as those terms are defined by the Commission) for purposes of data reporting requirements and setting routine detailed reporting requirements for any positions of such entities . . . .'' The draft requires the Commission to impose ``routine detailed reporting requirements'' on such traders. It is unclear that a higher level of routine reporting for such traders is necessary or appropriate; the Commission is empowered to issue special calls for information without demonstrating any cause. Section 4 also requires swap dealers and index traders to report all positions on foreign boards of trade, without regard to whether those positions implicate any U.S. regulatory interests. It is not clear that this was intended; it is not necessary and imposes an unnecessary burden on the CFTC. Section 4 also includes a reporting provision that we do not understand. The Commission is required to publish: ``data on speculative positions relative to bona fide physical hedgers in those markets to the extent such information is available.'' The Commission does not have information on hedgers who do not exceed speculative limits: in consequence this number is likely to be highly misleading.Sec. 5. Transparency and Recordkeeping Authorities. Subpart (a) extends the reporting requirements for CFTC registrants beyond trading on any board of trade in the United States or elsewhere to include OTC ``trading of transactions and positions traded pursuant to subsection (d), (g), (h)(1), or (h)(3) of section 2, or any exemption issued by the Commission by rule, regulation or order.'' We agree that these transactions should not escape CFTC scrutiny but question whether subsection (a) is necessary in light of the special call provisions in subpart (b).Sec. 6. Trading Limits To Prevent Excessive Speculation. Section 6 requires the Commission to: ``establish limits on the amount of positions, as appropriate, other than bona fide hedge positions, that may be held by any person . . .'' The mandatory limits apply to all commodities traded on regulated markets, without regard to whether excess speculation has ever been an issue in the commodity or whether it is a foreseeable danger. The standard that the Commission must apply is: ``(B) to the maximum extent practicable, in its discretion-- (i) to diminish, eliminate, or prevent excessive speculation as described under this section; (ii) to deter and prevent market manipulation, squeezes, and corners; (iii) to ensure sufficient market liquidity for bona fide hedgers; and (iv) to ensure that the price discovery function of the underlying market is not disrupted; and (C) to the maximum extent practicable, in its discretion, take into account the total number of positions in fungible agreements, contracts, or transactions that a person can hold in other markets.'' We are concerned that the bill imposes conflicting standards and offers no guidance to the Commission on how those conflicts are to be resolved other than that each is to be fulfilled to the maximum extent practicable. Position limits are a device to promote liquidation and orderly delivery in physical contracts. If position limits are not being used for those purposes they artificially impose restrictions on access to markets and are more likely to prevent prices from reaching a true equilibrium than to serve a positive purpose. Moreover, position limits are not appropriate for all commodity contracts. Where the final price of the futures contract is determined by reference to an externally calculated index that is not impacted by the futures market, for example rainfall during a fixed period, position limits cannot be justified. Most financial futures traded on CME Group are not settled by delivery of an underlying commodity and therefore are not readily susceptible to market manipulation. In such a case, accountability levels are more appropriate than position limits. Mandating position limits in non-spot month physical delivery contracts is unnecessary because those contracts do not have a close, direct impact on the price discovery function for the cash market of the underlying commodity. Accountability levels are sufficient to deter and prevent market manipulation in non-spot months. CME Group has numerous surveillance tools, which are used routinely to ensure fair and orderly trading on our markets. Monitoring the positions of large traders in our market is a critical component of our market surveillance program. Large trader data is reviewed daily to monitor reportable positions in the market. On a daily basis, we collect the identities of all participants who maintain open positions that exceed set reporting levels as of the close of business the prior day. Generally, we identify in excess of 85% of all open positions through this process. This data, among other things, are used to identify position concentrations requiring further review and focus by Exchange staff. Any questionable market activity results in an inquiry or formal investigation. Section 6 also requires that the Commission establish advisory committees with respect to agriculture based futures and energy based futures to advise the Commission on speculative position limits. These advisory committees are, by law, dominated by enterprises that have a direct interest in the markets on which they are advising. In addition to this inherent conflict, the bill offers no standard to direct the deliberations of these advisory committees. Instead, it puts 19 or 20 people, with diverging financial interests, in a room and tells them to make a decision. We strongly oppose this process, which empowers market participants whose objectives differ materially from the CEA's purpose in establishing position limits. Regulated futures markets and the CFTC have the means and the will to limit speculation that might distort prices or distort the movement of commodities in interstate commerce. Former CFTC Acting Chairman Lukken's testimony before the Subcommittee on Oversight and Investigations of the Committee on Energy and Commerce United States House of Representatives (December 12, 2007) offers a clear description of these powers and how they are used: All agricultural and natural resource futures and options contracts are subject to either Commission or exchange spot month speculative position limits--and many financial futures and options are as well. With respect to such exchange spot month speculative position limits, the Commission's guidance specifies that DCMs should adopt a spot month limit of no more than \1/4\ of the estimated spot month deliverable supply, calculated separately for each contract month. For cash settled contracts, the spot month limit should be no greater than necessary to minimize the potential for manipulation or distortion of the contract's or underlying commodity's price. For the primary agricultural contracts (corn, wheat, oats, soybeans, soybean meal, and soybean oil), speculative limits are established in the Commodity Exchange Act and changes must be approved via a petition and public rulemaking process. http://www.cftc.gov/stellent/groups/public/@newsroom/documents/ speechandtestimony/opalukken-32.pdf. Subsection (2) directs the Commission to define a bona fide hedge, which permits traders to exceed the hard speculative limits. Proposed subpart (A) pertains to hedgers acting for their own accounts. Subpart (B) governs swap dealers and others who are hedging risks assumed in the OTC market. We believe that subpart (A) has unintended and highly detrimental consequences respecting the ability of regulated futures exchanges to provide hedging opportunities for important business enterprises. The bill provides that a futures position does not qualify as a bona fide hedge unless it: ``(A)(i) represents a substitute for transactions made or to be made or positions taken or to be taken at a later time in a physical marketing channel . . . .'' This interpretation is compelled by the linking of clauses (i), (ii) and (iii) by the conjunctive ``and,'' which requires that all three conditions be satisfied.\1\ As a result, the provisions in (ii) and (iii), which currently operate as independent grounds for a hedge exemption, are nullified. This works perfectly for a grain elevator or farmer who shorts his inventory or expected crop. Futures markets, however, are also used for more sophisticated hedging.--------------------------------------------------------------------------- \1\ ``(2) For the purposes of contracts of sale for future delivery and options on such contracts or commodities, the Commission shall define what constitutes a bona fide hedging transaction or position as a transaction or position that-- ``(A)(i) represents a substitute for transactions made or to be made or positions taken or to be taken at a later time in a physical marketing channel; ``(ii) is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise; and ``(iii) arises from the potential change in the value of-- ``(I) assets that a person owns, produces, manufactures, processes, or merchandises or ant- icipates owning, producing, manufacturing, processing, or merchandising; ``(II) liabilities that a person owns or anticipates incurring; or ``(III) services that a person provides, purchases, or anticipates providing or purchasing;''--------------------------------------------------------------------------- Obviously, this limitation precludes electric utilities from hedging capacity risks associated with weather events by use of degree day unit futures contracts. That hedge involves no substitute for a transaction in a physical marketing channel. Insurance companies may not hedge hurricane or other weather risks. Enterprises that consume a commodity that is not used in a ``physical marketing channel'' such as airlines that use fuel, generating facilities that use gas and produce electricity, freight companies whose loads depend on geographic pricing differentials and hundreds of other important examples that readily present themselves, will not be entitled to a hedge exemption from mandatory speculative limits. Even if ``or'' were substituted, a significant number of clearly legitimate hedging transactions are precluded. Subpart (B) offers swap dealers a very narrow window within which to qualify for a hedge exemption. The position being hedged must reduce: ``risks attendant to a position resulting from a transaction that--. . . was executed opposite a counterparty for which the transaction would qualify as a bona fide hedging transaction . . . .'' On a practical basis, swap dealers use the futures market to reduce their overall risk; we do not believe that particular futures positions can be linked to identified OTC transactions. Thus, the utility of futures markets as a risk transfer venue will be seriously impaired. We are happy to work with the staff to devise language that will eliminate the use of OTC intermediaries as a mask for trading that would otherwise violate position limits. We believe that the bill's direction to the Commission to define a bona fide hedging transaction set out in section 6(2) is overly restrictive with respect to its constraints on the ability of dealers, funds and others who have assumed risks in the over-the-counter market, which are consistent with their legitimate businesses, to transfer the net risk of their OTC positions to the futures markets. CME Group is concerned that this limitation on hedge exemptions for swap dealers will limit the ability of commercial enterprises to execute strategies in the OTC market to meet their hedging needs. For example, commercial participants often need customized OTC deals that can reflect their basis risk for particular shipments or deliveries. In addition, not all commercial participants have the skill set necessary to participate directly in active futures markets trading. Swap dealers assume that risk and lay it off in the futures market. This restriction contravenes the otherwise clear intent of the draft bill to limit systemic risk by driving OTC generated risk into a central counterparty clearing context. The consequences of this constraint are magnified by the simultaneous imposition of hard position limits on financial futures that are settled by reference to prices that are not susceptible to manipulation, such as Eurodollars or currencies.Sec. 8. Review of Prior Actions. Section 8 of the proposed bill imposes a burden on the Commission that is not justified and that will divert it from the important responsibilities assigned to it in section 7. It requires the Commission to: ``review, as appropriate, all regulations, rules, exemptions, exclusions, guidance, no action letters, orders, other actions taken by or on behalf of the Commission, and any action taken pursuant to the Commodity Exchange Act by an exchange, self- regulatory organization, or any other registered entity, that are currently in effect, to ensure that such prior actions are in compliance with the provisions of this Act.'' No guidance is offered as to what is appropriate, and we are unaware of any action that the Commission has taken, including those with which we have disagreed, that could be found to be ``not in compliance with the `provisions of this Act.' '' The review of the rules of the rules of registered entities and the NFA will be a massive undertaking, given the size and complexity of the rule books, interpretations and notices that govern the business of the registered entities and the NFA and the lack of direction. We are not aware of any significant dissatisfaction with the Commission's actions or the actions of the registered entities and the SRO's that would compel so wide-reaching a review.Sec. 11. Over-The-Counter Authority. Section 11 authorizes the Commission to impose position limits on transactions exempted or excluded from the CEA by ``subsections (d), (g), (h)(1), and (h)(3) of section 2,'' if it first finds that such contracts are: ``fungible (as defined by the Commission) with agreements, contracts, or transactions traded on or subject to the rules of any board of trade or electronic trading facility with respect to a significant price discovery contract . . . .'' We are surprised by the use of the term ``fungible,'' which is generally limited to contracts that may be offset. We assume that this power should apply when the contracts are close economic substitutes. Second, the reference to the defined term ``board of trade'' rather than the phrase ``designated contract markets and derivatives transaction execution facilities'' or ``registered entity'' (as is ordinarily used in the bill) is bound to be afforded some significance, which escapes us. While we are generally in agreement with the purposes of this section, we expect that representative of the participants in the OTC market are best positioned to discuss the impact of this provision and any other technical drafting issues.Sec. 12. Expedited Process. Section 12 grants the Commission authority to act in an expedited manner ``to carry out this Act if, in its discretion, it deems it necessary to do so.'' The Commission currently has comprehensive authority to respond to an emergency. This provision eliminates the salutary requirement that there be an emergency before the Commission is empowered to act precipitously and we do not agree that it is either necessary or appropriate to grant such powers.Sec. 13. Certain Exclusions and Exemptions Available Only for Certain Transactions Settled and Cleared Through Registered Derivatives Clearing Organizations. Section 13 is intended to force certain transactions that were exempted from the exchange trading requirement and most other Commission regulations by 2(d)(1)(C), 2(d)(2)(D), 2(g)(4), 2(h)(1)(C), or 2(h)(3)(C) of the Act either onto a regulated trading platform or to be cleared by a CFTC Designated Clearing Organization or a comparable clearing house. While this section appears to favor our organization and advances our goals, we are concerned that it will fail to produce the desired result and negatively impact the U.S. derivatives industry. We discussed this point in the introductory portion of this testimony.Sec. 14. Treatment of Emission Allowances and Offset Credits. Section 14 authorizes the trading of: ``any allowance authorized under law to emit a greenhouse gas, and any credit authorized under law toward the reduction in greenhouse gas emissions or an increase in carbon sequestration.'' The CEA was already sufficiently broadly worded to permit such contracts to be traded on futures exchanges subject to the Commission's exclusive jurisdiction. We are concerned that the specific description may, in the future, be read as a limitation on the authority to create futures contracts relating to the greening of America and we believe that the Committee needs to generalize the language to avoid that implication.Sec. 16. Limitation on Eligibility To Purchase A Credit Default Swap. Section 16, which makes it: ``unlawful for any person to enter into a credit default swap unless the person would experience financial loss if an event that is the subject of the credit default swap occurs'' is worded in a manner that prohibits the use of credit default swaps for any purpose. The language requires both the buyer and seller of credit protection to suffer a loss if the event were to occur and there was no credit default swap in place. Obviously, only the buyer of credit protection qualifies. However, even if the language were corrected, we are opposed to this provision as an unwarranted restriction on functioning of free markets. This provision punishes the instrument and legitimate users of the instrument for the excesses of the management of AIG. The instrument was innocent as were the vast bulk of the users of the instrument and the markets in which the instruments were transacted. We do not purport to be the appropriate spokesperson for the industry, but we can assure you that all of our plans to clear CDSs will come to naught if this provision is adopted. Credit default contracts serve an important economic purpose in an unfortunately imperfect manner. At the ideal level, credit default contracts permit investors to hedge specific risk that a particular enterprise will fail or that the rate of failure of a defined group of firms will exceed expectations. However, because credit default contracts are not insurance, investors who are not subject to any specific risk can assume default risk to enhance yield or buy protection against a default to speculate on the fate of a company or the economy generally. Credit default contracts are also an excellent device to short corporate bonds, which otherwise could not be shorted. If such contracts are executed in a transparent environment, if the regulators responsible for controlling systemic risk can easily keep track of the obligations of the banks, brokers and other participants in the market and if a well regulated clearing house acts as the central counterparty for such contracts, we believe that they can serve an important role in our economy without imposing undue systemic risks.Conclusion: Futures markets perform two essential functions--they create a venue for price discovery and they permit low cost hedging of risk. Futures markets depend on short and long term speculators to make markets and provide liquidity for hedgers. Futures markets could not operate effectively without speculators and speculators will not use futures markets if artificial barriers or tolls impede their access. CFTC-regulated futures markets have demonstrated their importance to the economy, the nation's competitive strength and America's international financial leadership. We have the means and the power to protect our markets against speculative excesses and are committed to doing so. " CHRG-111shrg62643--105 Mr. Bernanke," There would certainly be a short-run effect on those particular industries, but I would point out that there is not much correlation over a longer period of time between overall employment or unemployment and our current account deficit, that where resources are not being utilized in one industry, they tend over time to be deployed in other industries. So maybe there is some misallocation across industry, but overall employment doesn't depend too much on the current account. Senator Brown. That is a story that would ring hollow to lots of cities in my State, large and small alike, like your city in South Carolina, understanding how capital moves and families can't often. But if, in fact, and I will wrap up with this, Mr. Chairman. I see my time has expired. Current account deficit notwithstanding, if the currency is so, your term, if the undervalued currency is an effective subsidy, doesn't that always mean lost jobs in a bilateral relationship when trade is going back and forth--more back than forth--on these commodities or these manufactured goods? " fcic_final_report_full--159 Through May , Goldman received  million from IKB, Wachovia, and TCW as a result of the credit default swaps against the A tranche. As was common, some of the tranches of Abacus - found their way into other funds and CDOs; for example, TCW put tranches of Abacus - into three of its own CDOs. In total, between July , , and May , , Goldman packaged and sold  synthetic CDOs, with an aggregate face value of  billion.  Its underwriting fee was . to . of the deal totals, Dan Sparks, the former head of Goldman’s mortgage desk, told the FCIC.  Goldman would earn profits from shorting many of these deals; on others, it would profit by facilitating the transaction between the buyer and the seller of credit default swap protection. As we will see, these new instruments would yield substantial profits for investors that held a short position in the synthetic CDOs—that is, investors betting that the housing boom was a bubble about to burst. They also would multiply losses when housing prices collapsed. When borrowers defaulted on their mortgages, the in- vestors expecting cash from the mortgage payments lost. And investors betting on these mortgage-backed securities via synthetic CDOs also lost (while those betting against the mortgages would gain).  As a result, the losses from the housing collapse were multiplied exponentially. To see this play out, we can return to our illustrative Citigroup mortgage-backed securities deal, CMLTI -NC. Credit default swaps made it possible for new market participants to bet for or against the performance of these securities. Syn- thetic CDOs significantly increased the demand for such bets. For example, there were about  million worth of bonds in the M (BBB-rated) tranche—one of the mezzanine tranches of the security. Synthetic CDOs such as Auriga, Volans, and Neptune CDO IV all contained credit default swaps in which the M tranche was ref- erenced. As long as the M bonds performed, investors betting that the tranche would fail (short investors) would make regular payments into the CDO, which would be paid out to other investors banking on it to succeed (long investors). If the M bonds defaulted, then the long investors would make large payments to the short investors. That is the bet—and there were more than  million in such bets in early  on the M tranche of this deal. Thus, on the basis of the performance of  million in bonds, more than  million could potentially change hands. Goldman’s Sparks put it succinctly to the FCIC: if there’s a problem with a product, synthetics increase the impact.  The amplification of the M tranche was not unique. A  million tranche of the Glacier Funding CDO -A, rated A, was referenced in  million worth of syn- thetic CDOs. A  million tranche of the Soundview Home Equity Loan Trust -EQ, also rated A, was referenced in  million worth of synthetic CDOs. A  million tranche of the Soundview Home Equity Loan Trust -EQ, rated BBB, was referenced in  million worth of synthetic CDOs.  In total, synthetic CDOs created by Goldman referenced , mortgage securities, some of them multiple times. For example,  securities were referenced twice. In- deed, one single mortgage-backed security was referenced in nine different synthetic fcic_final_report_full--227 The summer of  also saw a near halt in many securitization markets, includ- ing the market for non-agency mortgage securitizations. For example, a total of  billion in subprime securitizations were issued in the second quarter of  (already down from prior quarters). That figure dropped precipitously to  billion in the third quarter and to only  billion in the fourth quarter of . Alt-A issuance topped  billion in the second quarter, but fell to  billion in the fourth quarter of . Once-booming markets were now gone—only  billion in subprime or Alt- A mortgage-backed securities were issued in the first half of , and almost none after that.  CDOs followed suit. From a high of more than  billion in the first quarter of , worldwide issuance of CDOs with mortgage-backed securities as collateral plummeted to  billion in the third quarter of  and only  billion in the fourth quarter. And as the CDO market ground to a halt, investors no longer trusted other structured products.  Over  billion of collateralized loan obligations (CLOs), or securitized leveraged loans, were issued in ; only  billion were is- sued in . The issuance of commercial real estate mortgage–backed securities plummeted from  billion in  to  billion in .  Those securitization markets that held up during the turmoil in  eventually suffered in  as the crisis deepened. Securitization of auto loans, credit cards, small business loans, and equipment leases all nearly ceased in the third and fourth quarters of . DELINQUENCIES: “THE TURN OF THE HOUSING MARKET ” Home prices rose  nationally in , their third year of double-digit growth. But by the spring of , as the sales pace slowed, the number of months it would take to sell off all the homes on the market rose to its highest level in  years. Nationwide, home prices peaked in April . Members of the Federal Reserve’s Federal Open Market Committee (FOMC) dis- cussed housing prices in the spring of . Chairman Ben Bernanke and other members predicted a decline in home prices but were uncertain whether the decline would be slow or fast. Bernanke believed some correction in the housing market would be healthy and that the goal of the FOMC should be to ensure the correction did not overly affect the growth of the rest of the economy.  In October , with the housing market downturn under way, Moody’s Econ- omy.com, a business unit separate from Moody’s Investors Service, issued a report authored by Chief Economist Mark Zandi titled “Housing at the Tipping Point: The Outlook for the U.S. Residential Real Estate Market.” He came to the following conclusion: Nearly  of the nation’s metro areas will experience a crash in house prices; a double-digit peak-to-trough decline in house prices. . . . These sharp declines in house prices are expected along the Southwest coast of Florida, in the metro areas of Arizona and Nevada, in a number of Cali- fornia areas, throughout the broad Washington, D.C. area, and in and around Detroit. Many more metro areas are expected to experience only house-price corrections in which peak-to-trough price declines remain in the single digits. . . . It is important to note that price declines in vari- ous markets are expected to extend into  and even . FOMC20080430meeting--180 178,MR. KOHN.," Thank you, Mr. Chairman. I think I can be brief by just associating myself with the comments of President Stern. This is a difficult decision. You could make a case for either of these. But on balance, I think we should be lowering interest rates 25 basis points, as under alternative B. As President Stern said, I don't think just subtracting past inflation from the nominal federal funds rate is a good metric for where the stance of policy is today. It would be if financial conditions were consistent with historical relationships, but they're not. We have very tight credit conditions in many sectors of the market, and a zero or negative federal funds rate means a very different thing today than it did even in the early 1990s, Gary, because then you had the banking system broken but the securities markets working. Now you have the banking system broken and the securities markets not working very well. So I think we have stronger--I guess Greenspan called them ""50 mile an hour""--headwinds. I would say they are 60 or 70 today, at least for now. We expect the headwinds to abate; and as they abate, policy will look a lot more accommodative. But I don't think we really have insurance right now against the contingency that the headwinds don't abate very quickly or even get worse, or against the contingency that the staff is right and we are entering a recessionary period in which consumption and investment fall short of what the fundamentals would suggest. I think that 25 basis points probably won't buy us much, if any, insurance, but it will get policy calibrated a little better to the situation that we are facing today. I expect a small decrease in the funds rate to be consistent with further increases in the unemployment rate--and everybody does, I think, judging from the central tendencies of the forecast--which will put downward pressure and help to contain inflation. I agree that there is an upside risk from continued increases in commodity prices that feed through, as President Plosser noted, into core inflation. I think that this is a very different situation from the 1970s. I looked this morning at the Economic Report of the President, at those tables in the back. The stage for the 1970s was set in the 1960s. Core inflation rose from 1� percent in the mid-1960s to 6� percent in 1969. That's a situation, obviously, in which inflation expectations can become unanchored, and then these relative price shocks feed through much more into inflation expectations. Looking in the Greenbook, Part 2, page II-32, every measure of core inflation for 2007 was lower than the measure of core inflation for 2006, and half of them--these are Q4-to-Q4 measures of core inflation--are lower than for 2005. So we are not in a situation of a gradual upcreep in core inflation, which I think was what set the stage for the 1970s. I don't expect a small decrease in interest rates to result in higher inflation through this dollar�commodity price�inflation expectations channel either. The decrease in interest rates is already in the markets. If anything, a statement like alternative B might firm rates a bit; and taking out ""downside risks"" and ""act in a timely manner"" reinforces the notion that the Federal Reserve is not poised to ease any more. I wouldn't expect interest rates to go down; therefore, I wouldn't expect the dollar to go down, and I wouldn't expect commodity prices to go up from this. I think the markets reacted very well over the intermeeting period to incoming data. They saw the tail risk decrease. They raised interest rates. The dollar firmed. They put a U shape in our interest rate path. It seems to me that path is very close to what many of us said we expected and thought was appropriate, give or take � point, for the federal funds rate over the coming couple of years. I don't see any reason to act in a way that changes those expectations; I think the market expectations are fine. I wouldn't lower interest rates � point just to confirm market expectations. I think it is the right thing to do, and I don't see any reason to lean against it to change expectations. I think that expectations are lined up pretty well with our objectives. Thank you, Mr. Chairman. " CHRG-111hhrg51698--438 Mr. Masters," So the idea is, this is a different kind of situation, so limits apply at each commodity. And the way the bill is structured, there would be an advisory panel made up of physical hedgers that would suggest position limits. By the way, exchanges would not be included, because exchanges have a built in conflict of interest to have the highest limits possible because they want volume on the exchange. So what we need is sufficient speculation to provide the needs of Mr. Taylor and his constituency, and other kinds of constituencies, in the futures markets to provide liquidity that physical hedgers need. We need some speculation, but not too much speculation, not excessive speculation. And the idea would be that since these markets are for physical hedgers, that a panel of physical hedgers would be best justified in setting the limits. After all, they are not going to cut off their nose to spite their face. They also want enough liquidity. But they don't want the markets driven by excessive speculation where their markets lose all reality of supply and demand forces in their market. They just want them big enough. " fcic_final_report_full--428 II. Housing bubble. Beginning in the late s and accelerating in the s, there was a large and sustained housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida. Many factors contributed to the housing bubble, the bursting of which created enormous losses for home- owners and investors. III. Nontraditional mortgages. Tightening credit spreads, overly optimistic as- sumptions about U.S. housing prices, and flaws in primary and secondary mortgage markets led to poor origination practices and combined to in- crease the flow of credit to U.S. housing finance. Fueled by cheap credit, firms like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance originated vast numbers of high-risk, nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to repay. At the same time, many homebuyers and homeowners did not live up to their responsibilities to understand the terms of their mort- gages and to make prudent financial decisions. These factors further ampli- fied the housing bubble. IV. Credit ratings and securitization. Failures in credit rating and securitization transformed bad mortgages into toxic financial assets. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies er- roneously rated mortgage-backed securities and their derivatives as safe in- vestments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages. V. Financial institutions concentrated correlated risk. Managers of many large and midsize financial institutions in the United States amassed enor- mous concentrations of highly correlated housing risk. Some did this know- ingly by betting on rising housing prices, while others paid insufficient attention to the potential risk of carrying large amounts of housing risk on their balance sheets. This enabled large but seemingly manageable mortgage losses to precipitate the collapse of large financial institutions. VI. Leverage and liquidity risk. Managers of these financial firms amplified this concentrated housing risk by holding too little capital relative to the risks they were carrying on their balance sheets. Many placed their firms on a hair trigger by relying heavily on short-term financing in repo and commercial paper markets for their day-to-day liquidity. They placed solvency bets (sometimes unknowingly) that their housing investments were solid, and liq- uidity bets that overnight money would always be available. Both turned out to be bad bets. In several cases, failed solvency bets triggered liquidity crises, causing some of the largest financial firms to fail or nearly fail. Firms were in- sufficiently transparent about their housing risk, creating uncertainty in mar- kets that made it difficult for some to access additional capital and liquidity when needed. CHRG-111hhrg51698--533 Mr. Book," Chairman Peterson, Ranking Member Lucas, Members of the Committee, I appreciate the opportunity to testify before you today. I thank the Committee for calling this hearing on this important piece of legislation. I am Thomas Book, a Member of the of the Executive Boards of Eurex and Eurex Clearing. I have overall responsibility for management of the clearing business. Eurex Clearing is one of the leading clearinghouses in the world and is by far the largest European clearinghouse. It is licensed and supervised by the German Federal Financial Supervisor Authority. It is also recognized by the U.K.'s Financial Services Authority. Eurex and Eurex Clearing understands the importance of public confidence in the derivative markets. We support the Committee's efforts to increase transparency and to ensure appropriate regulation of the over-the-counter markets. Eurex Clearing strongly endorses the provision of section 13 of the draft bill that permits any number of clearinghouses to act as CCP for OTC transactions in excluded commodities. Eligible CCPs could be supervised by the CFTC, the SEC, the Federal Reserve, or by a foreign regulator that meets appropriate standards. Such a non-U.S. clearinghouse is termed a multilateral clearing organization. This approach recognizes the high degree of competence of each of the U.S. financial regulators, and of many foreign regulators, to establish and enforce an appropriate level of supervision and oversight of the activities of the CCPs. However, for overseas transactions in exempt commodities, such as contracts on energy or precious or base metals are, the bill would permit only a CFTC-recognized derivatives clearing organization to act as a CCP. Eurex Clearing strongly encourages the Committee to amend the bill and permit non-U.S. multilateral clearing organizations to clear OTC contracts on exempt commodities if the CFTC has found that the applicable foreign regulator meets appropriate standards. Turning now to section 3 of the bill, foreign boards of trade such as Eurex, that are eligible to permit their U.S. members to directly access their markets, would be required to meet certain enhanced conditions with respect to contracts that settle to the prices of U.S. markets. It should be noted that the information collection systems of other countries may differ. For example, non-U.S. markets may collect information on large positions only during the spot month or only during the period preceding contract expiration. Accordingly, we recommend that the bill be modified to include room for such differences by explicitly permitting the CFTC to accept comparable alternative methods of market surveillance on the part of the foreign board of trade or the foreign regulatory authority. One of the boldest provisions of the proposed bill is the section 13 requirement that all derivative transactions, unless exempted by the CFTC, be submitted for central counterparty clearing. Eurex Clearing strongly supports clearing of OTC transactions as a means of safeguarding market integrity and the stability of the financial system. We firmly believe that the enhanced transparency of a neutral clearinghouse would have alerted market participants to the risk of their positions at an earlier time, resulting in much smaller losses. However, not all OTC transactions will be suitable for CCP-style clearing. Such noncleared transactions, nevertheless, serve bona fide economic purposes. To address this reality, the bill provides a mechanism whereby the CFTC can exempt certain kinds of nonstandardized transactions from the clearing requirement. Eurex Clearing believes that it is important that this exemptive authority be implemented in a practical way that preserves the vitality of the OTC markets. We believe that the CFTC should use its exemptive authority liberally. I would also note that we are concerned by the proposal in the draft bill to prohibit naked purchase of credit default swaps. We believe that this provision would seriously impair the functioning of the CDS market to the detriment of its many legitimate and valuable uses. Finally, I would like to share with you the same thoughts we have expressed to the European Commission. We have strongly supported the Internal Market Commissioner Charlie McCreevy's call for action to improve market infrastructure for OTC clearing, and, in particular, for credit default swap clearing. We believe that improvements in Europe are of common interest to all market participants because they will also contribute to market stability on a global scale. This Committee's deliberations provide an important opportunity to improve market infrastructure and the efficiency of the global financial system. For this reason we applaud Chairman Peterson for driving much-needed change to the OTC market structures. I appreciate the opportunity to discuss these critically important issues with the Committee and I am happy to answer your questions. [The proposed statement of Mr. Book follows:] Prepared Statement of Thomas Book, Member of the Executive Boards, Eurex and Eurex Clearing AG, Frankfurt am Main, Germany Chairman Peterson, Ranking Member Lucas, Members of the Committee, on behalf of Eurex Deutschland (``Eurex'') and Eurex Clearing AG (``Eurex Clearing'') I would like to express our appreciation for this opportunity to testify before you today and to thank the Committee for calling this hearing on this important piece of legislation, the ``Derivatives Markets Transparency and Accountability Act of 2009.'' My name is Thomas Book. I am a Member of the Executive Board of Eurex as well as Eurex Clearing and have overall responsibility for management of Eurex Clearing. Eurex and Eurex Clearing are part of the Deutsche Borse Group. Eurex and Eurex Clearing understand the importance of public confidence in the derivatives markets and support the Committee's efforts to increase transparency and ensure appropriate regulation of these markets. As Reto Francioni, the Deutsche Borse Group CEO, emphasized last week at the Group's annual New Year's reception: At Deutsche Borse . . . we have always seen it as an advantage--in terms of transparency and fairness--that we are subject to regulation and supervi sion . . . . Through the crisis, we have seen--and still see-- that particularly where market organization was neither effectively and efficiently regulated . . . those cases were characterized by unfairness and opaqueness and resulted in extraordinary damages.Eurex and Eurex Clearing are key international exchange and clearing services providers As I testified previously before this Committee,\1\ Eurex is one of the largest derivatives exchanges in the world today. Eurex is in fact the largest exchange for Euro-denominated futures and options contracts. While it is headquartered in Frankfurt, Germany, Eurex has 405 members located in 22 countries around the world, including 74 in the United States.--------------------------------------------------------------------------- \1\ Hearing To Review the Role of Credit Derivatives in the U.S. Economy: Hearing before the House Committee on Agriculture, 110th Cong, 2d sess. (December 8, 2008) (statement of Thomas Book, Member of the Executive Board, Eurex and Eurex Clearing).--------------------------------------------------------------------------- Eurex Clearing is one of the leading clearinghouses in the world and by far the largest European clearinghouse. Eurex Clearing acts as the central counterparty (``CCP'') for all Eurex transactions and guarantees fulfillment of all transactions in futures and options traded on Eurex, all transactions on other Deutsche Borse Group exchanges and trading platforms, transactions on several independent exchanges, and transactions executed over-the-counter (``OTC''). Eurex Clearing is directly connected with a number of national and international central securities depositories, thereby simplifying the settlement processes of physical securities for its clearing members. As Europe's largest and one of the world's leading clearing houses, Eurex Clearing clears more than two billion transactions each year. Eurex Clearing has over 125 clearing members. It currently does not operate in the United States and has no U.S. clearing members,\2\ although through its clearing members it does indirectly clear trades on behalf of Eurex's U.S. members.--------------------------------------------------------------------------- \2\ However, a number of its members are European affiliates or parents of U.S. entities. In addition, Eurex Clearing has an agreement with The Clearing Corporation relating to the operation of a clearing link between Germany and the United States.--------------------------------------------------------------------------- Eurex Clearing is highly experienced in offering fully automated and straight-through post trade services for derivatives, equities, repo, energy and fixed income transactions. Besides clearing transactions executed on exchange, Eurex Clearing also accepts, novates, nets and guarantees a broad range of derivatives transactions from the over-the-counter markets on the same basis that it clears exchange-traded contracts. Eurex Clearing's OTC clearing business is growing and accounted for about 40% of the total cleared derivatives volume last year. As we discussed in our Testimony to this Committee last December, like a number of other major derivatives clearinghouses, Eurex Clearing is developing clearing services for the Credit Default Swaps market.High Degree of Regulation Applies Eurex Clearing is required to be licensed as a CCP by the German Federal Financial Supervisory Authority (``BaFin''). In addition, on January 16, 2007, Eurex Clearing was recognized by the United Kingdom's Financial Services Authority (``FSA'') as a Recognized Overseas Clearing House (``ROCH''), on the basis that the regulatory framework and oversight of Eurex Clearing in its home jurisdiction is based on common principles and practices to those of the FSA. As noted in our prior testimony to this Committee, the German Banking Act (``Banking Act'') provides the legal foundation for the supervision of banking business, financial services and the services of a CCP in Germany. The activity of credit and financial services institutions is restricted by the Banking Act's qualitative and quantitative general provisions. These broad, general obligations are similar to the Core Principles of the Commodity Exchange Act which apply to U.S. Derivatives Clearing Organizations (``DCOs''). A fundamental principle of the Banking Act is that supervised entities must maintain complete books and records of their activities and keep them open to supervisory authorities. BaFin approaches its supervisory role using a risk-based philosophy, adjusting the intensity of supervision depending on the nature of the institution and the type and scale of the financial services provided. The Banking Act requires that a CCP have in place suitable arrangements for managing, monitoring and controlling risks and appropriate arrangements by means of which its financial situation can be accurately gauged at all times. In addition, a CCP must have a proper business organization, an appropriate internal control system and adequate security precautions for the deployment of electronic data processing. Furthermore, the institution must ensure that the records of executed business transactions permit full and unbroken supervision by BaFin for its area of responsibility. BaFin has the authority to take various sovereign measures in carrying out its supervisory responsibilities. Among other things, BaFin may issue orders to a CCP and its Executive Board to stop or prevent breaches of regulatory provisions or to prevent or overcome undesirable developments that could endanger the safety of the assets entrusted to the institution or that could impair the proper conduct of the CCP's banking or financial services business. BaFin may also impose sanctions to enforce compliance. BaFin has the authority to remove members of the Executive Board of an institution or, ultimately, to withdraw the institution's authorization to do business. In addition, the German Federal Bank (``Deutsche Bundesbank'') coordinates and cooperates, with BaFin, the primary regulator, in the supervision of Eurex Clearing. Deutsche Bundesbank plays an important role in virtually all areas of financial services and banking supervision, including the supervision of Eurex Clearing. Under the Banking Act, Deutsche Bundesbank exercises continuing supervision over such institutions, including evaluating auditors' reports, annual financial statements and other documents and auditing banking operations. Deutsche Bundesbank also assesses the adequacy of capital and risk management procedures and examines market risk models and systems. Deutsche Bundesbank adheres to the guidelines issued by BaFin. As appropriate, Deutsche Bundesbank also plays an important role in crisis management. Both supervisory authorities use a risk-based approach to oversight, under which the supervisory authority must review the supervised institutions' risk management at least once a year to evaluate current and potential risks. In so doing, the supervisory authority takes into account the scale and importance of the risks for the supervised institution and the importance of the institution for the financial system. Institutions classified as of systemic importance, including Eurex Clearing, are subject to intensified supervision by both supervisory authorities.The Derivatives Markets Transparency and Accountability Act of 2009 As many have observed, the derivatives markets, both exchange-traded and OTC, are global in nature. Accordingly, Eurex and Eurex Clearing have a critical interest in, and potentially will be affected by, this Committee's deliberations. Eurex and Eurex Clearing view the proposed Derivatives Markets Transparency and Accountability Act of 2009 (the ``DMTAA'') as an important piece of legislation which will increase oversight and transparency of the OTC and exchange-traded derivatives markets. We commend the Committee for taking the initiative to address some of the thorniest issues that confront the financial markets in this period of economic crisis and support the Committee's efforts to ensure that these markets are appropriately regulated. With that as background, I am pleased to provide specific comments on the draft DMTAA.The DMTAA Appropriately Recognizes Global Markets Section 3 of DMTAA has three sub-sections. The first would establish conditions that the Commodity Futures Trading Commission (``Commission'') must apply in granting Foreign Boards of Trade (``FBOT'') permission to provide direct market access to their trade matching system from the U.S. for contracts that settle against any price of a U.S. registered entity. These conditions include providing transparency with respect to certain daily trading information relating to such contracts, providing similar position accountability or speculative position limits as the U.S. registered entity imposes and providing information to the Commission with respect to large trader information. Although Eurex has been granted permission to provide direct market access to its U.S. members,\3\ it does not currently list any contracts which would be subject to the additional section 3 requirements. Nevertheless, if in the future Eurex determines to list such a contract and make it available by direct market access from the U.S., it would be subject to these conditions.--------------------------------------------------------------------------- \3\ See Letter of the Commodity Futures Trading Commission Division of Trading and Markets, dated August 10, 1999, at: http://www.cftc.gov/tm/letters/99letters/tmeurex_no-action.htm.--------------------------------------------------------------------------- First, it should be noted that section 3 of the DMTAA builds upon the foundation of the current procedures for reviewing and considering requests by FBOTs to provide direct market access from the U.S.\4\ Eurex strongly supports the current procedures. The current process is premised upon the underlying concept of ``mutual recognition'' of international regulatory frameworks. It is based upon two broad principles: (1) the conduct by the Commission of a thorough pre-admission due diligence review to ensure that the FBOT is a bona fide market subject to a comparable regulatory scheme, and (2) recognition that the home country regulator is responsible in the first instance for regulation and oversight of the operation of the foreign market.--------------------------------------------------------------------------- \4\ The Commission on November 2, 2006, adopted a formal policy statement with respect to the procedure to be used in reviewing and granting permission to FBOTs to provide direct market access to their trade matching engines from the U.S. ``Boards of Trade Located Outside of the United States and No-action Relief from the Requirement to Become a Designated Contract Market or Derivatives Transaction Execution Facility,'' 71 Fed. Reg. 64443 (November 2, 2006) (``Commission Policy Statement'').--------------------------------------------------------------------------- This U.S. approach has been widely accepted internationally and with the application by foreign regulatory authorities of broadly similar procedures to permit direct market access by U.S. exchanges in their jurisdictions, provides an important base-line of international regulatory requirements which has been critical to the ability of both U.S. and foreign derivatives exchanges to operate global electronic trading systems. This has been accompanied by an increased level of consultation and cooperation between and among national regulators. The pre-admission due diligence review conducted by the Commission is extensive and thorough. In permitting FBOTs to establish direct market access from the U.S., the Commission imposes conditions that the FBOT must fulfill.\5\ The DMTAA builds upon this foundation, requiring that additional transparency, reporting and other requirements apply for direct market access by the foreign market with respect to contracts that settle to prices of a U.S. registered entity.--------------------------------------------------------------------------- \5\ These conditions include, among others, appointment by the FBOT of a U.S. agent for receipt of Commission communications, assent by the FBOT's members operating under a No Action letter to the jurisdiction of the Commission and appointment of a U.S. agent to receive legal process, a number of requirements relating to maintenance and accessibility of original books and records and required reporting by the FBOT to the Commission of specified information both on a periodic and special request basis. FBOTs must also keep the Commission informed of any material changes to their operations and the home country regulations under which they operate and must stand ready to demonstrate compliance with the conditions of the No-action relief. Finally, the FBOT must notify the Commission ten days prior to listing new contracts for trading from its U.S. terminals and must request supplemental relief with respect to contracts subject to section 2(a)(1)(B) of the Commodity Exchange Act. See e.g. http://www.cftc.gov/tm/letters/tmeurex_no-action.htm at 14.--------------------------------------------------------------------------- The DMTAA provides that where markets are linked through the use of one another's settlement prices, enhanced conditions for access will be applied. However, not all jurisdictions apply speculative position limits or position accountability rules in the same manner as U.S. markets. Markets may rely on other regulatory powers or authorities to fulfill their market surveillance obligations, especially for commodities that do not have limited deliverable supplies. Accordingly, we recommend that the DMTAA be modified to explicitly permit the Commission to accept comparable or alternative methods of market surveillance on the part of the FBOT or the foreign regulatory authority. In this regard, it should be noted that foreign markets or jurisdictions may collect information on large positions, but may do so only during the spot month or only during the period preceding contract expiration, or may not routinely aggregate such information across trading members' accounts. Such a framework should be understood nevertheless as being able to meet the conditions of section 3 of the DMTAA. The second subsection of section 3 of the DMTAA provides that a Commission registrant shall not be found to have violated the Commodity Exchange Act (``Act'') if the registrant believes the futures contract is traded on an authorized FBOT and the Commission has not found the FBOT to be in violation of the exchange-trading requirement of the Act. The third subsection provides that a contract executed on a FBOT will be enforceable even if the FBOT fails to comply with any provision of the Act. Eurex supports both of these provisions which will provide greater legal certainty with respect to trading on non-U.S. markets. This greater level of legal certainty is appropriate in the face of the increasing globalization of trading. Although Eurex endeavors to be in compliance at all times with all provisions of the Act that apply to it, the third subsection will provide all U.S. participants in a foreign market with greater certainty with respect to the enforceability and finality of the contracts which they trade.The DMTAA will encourage clearing of OTC derivatives, including CDS Section 13 of the DMTAA seeks to bring greater transparency and accountability to the derivatives markets by requiring that OTC contracts, agreements and transactions in excluded commodities (mainly interest rates, equity indexes and other types of financial instruments) be cleared by: (1) a DCO registered by the CFTC; (2) by an SEC registered clearing agency; (3) by a banking institution subject to the supervision of the Federal Reserve System; or (4) by a clearing organization that is supervised by a foreign financial regulator that a U.S. financial regulator has determined satisfies appropriate standards. This last category of approved clearing organization is a multi-lateral clearing organization (``MCO'') recognized under section 409(b)(3) of the Federal Deposit Insurance Corporation Improvement Act of 1991 (``FDICIA''). Section 13 of the DMTAA further provides that OTC contracts, agreements or transactions in exempt commodities (mainly energy, precious metals and possibly emissions or carbon rights) would be required to be cleared through a CFTC-registered DCO. Eurex Clearing strongly supports clearing of OTC transactions as a means of safeguarding market integrity and the stability of the financial systems. Eurex Clearing believes that clearing OTC derivatives provides undeniable benefits not only to the individual clearing participant but to the entire financial market as well by enhancing transparency, avoiding undue concentrations of risk positions, and providing a system to contain and reduce systemic failures. We firmly believe that the enhanced transparency of central counterparty clearing by a neutral clearinghouse would have alerted market participants to the risk of their positions at an earlier time, resulting in much smaller trading losses, and potentially avoiding some of the extraordinary mitigation efforts that have ensued. To be sure, a derivatives clearinghouse is not a panacea, but, with regard to our current financial turmoil, clearing might in many instances have prevented entities from building unsustainable positions. The twin disciplines of marking positions to market and collecting collateral, or margin, are market mechanisms that are the very heart of the value of CCP clearing. These market mechanisms are very efficient at discouraging the build-up of unaffordable risk. Also, direct access to clearing services is, by its nature, limited to creditworthy institutions--the clearing members--who are willing and able to mutualize their counterparty risk. Because of this structure, exchange-traded derivatives or those that were traded OTC but subsequently submitted for CCP clearing, have not been an issue during the current market crises. Derivatives clearinghouses on both sides of the Atlantic have functioned well and, by doing so, have assured that CCP-cleared derivatives markets continue to provide their crucial risk shifting and price discovery functions. CCP clearing has previously not been available for credit default swaps (``CDS''). Eurex Clearing is confident that CCP clearing of CDS will help ameliorate systemic risk for the financial markets by mitigating counterparty risk and by enhancing transparency regarding exposures, the sufficiency of risk coverage, operational weaknesses, and technical capacity shortfalls. Given the huge, widely held exposure in CDS contracts, robust clearinghouses are needed to act as the central counterparty to these trades. As we detailed in our prior Testimony to this Committee, Eurex Clearing has been working with ISDA, Deriv/SERV, international banks and dealers, major buy-side firms and European public authorities to launch clearing services for Euro-denominated CDS by the end of this calendar quarter.The DMTAA appropriately encourages competition among providers of OTC clearing services We note that one of the boldest provisions of the proposed bill is the requirement that all derivatives transactions, unless exempted by the Commission, be cleared. We further note that OTC contracts in excluded commodities could be cleared by a registered DCO, by a clearing house supervised by the SEC or the Fed, or by an MCO supervised by a foreign regulator that has been recognized by a U.S. regulator as meeting appropriate standards (``Foreign Regulated MCO''). Eurex supports DMTAA's provision of permitting a number of clearing houses to offer clearing services for OTC contracts, agreements or transactions in excluded commodities. The alternative of mandating that only a single clearinghouse be licensed by an identified regulator to clear all OTC transactions world-wide would be contrary to the public interest. That type of mandated industry-wide monopoly or utility generally has reduced incentives to maximize efficiencies and innovation. Accordingly, Eurex Clearing supports the approach adopted by DMTAA of permitting market participants to decide which clearinghouse to use from a number of possible clearing houses. Moreover, the DMTAA's provision which would permit such clearinghouses to be supervised by one of several possible U.S. regulators or by a foreign regulator that has been found by a U.S. financial regulator to meet appropriate standards recognizes the high degree of competence of each of the U.S. financial regulators, and of many foreign regulators, to establish and enforce an appropriate level of supervision and oversight of the activities of the CCPs. In this regard, the DMTAA addresses possible issues of overlap and duplication among the several regulators by requiring consultation by the Commission with the other regulators and by sharing of information. Eurex commends this legislation for addressing these potential problems.The DMTAA Should Permit Foreign Regulated MCOs to Clear Exempt Commodity Transactions Section 13 of the DMTAA would require that all CCPs for transactions with respect to OTC contracts, agreements or transactions on exempt commodities be registered with the Commission as a DCO. Although DMTAA may be premised on the assumption that the Commission should exercise oversight of CCP clearing of OTC transactions in which the underlying is a commodity and not a financial instrument, section 13(b) of the DMTAA unnecessarily restricts a Foreign Regulated MCO from acting as a CCP for such transactions. As currently drafted, the DCO requirement in the DMTAA seems to erect an unnecessary barrier to well-regulated foreign competition which may undermine the Act's general promotion of competition to assure efficiency and encourage innovation. Eurex Clearing currently does not operate in the United States but would like to consider offering clearing and other services here in the future with respect to OTC contracts, agreements and transactions on excluded commodities, and may also consider offering such services with respect to exempt commodities. At the moment, Eurex Clearing is not registered with the CFTC. In this regard, Eurex Clearing notes that it is in discussions with staff of the Commission regarding applying for Commission recognition as a Foreign Regulated MCO. We further note that several non-U.S. clearinghouses previously have been so recognized. Of the currently recognized Foreign Regulated MCOs, all may act as CCPs for OTC contracts on exempt commodities.\6\ Eurex Clearing strongly encourages the Committee to amend the DMTAA to include transaction clearing of OTC contracts on exempt commodities by a Foreign Regulated MCO so long as the Commission has approved the foreign regulator of the MCO as meeting appropriate standards.--------------------------------------------------------------------------- \6\ They are, ICE Clear Europe, MCO Order issued on August 31, 2008; NetThruPut, Order Issued February 27, 2006; and Nos Clearing Asa, Order issued January 11, 2002. At least two, NetThruPut and Nos Clearing act as CCPs for exempt commercial markets on exempt commodities.--------------------------------------------------------------------------- This change would reflect the fact that the Commission, in administering the provisions of section 409 of FDICIA, has significant experience in reviewing the standards of foreign regulatory authorities to ensure that they are appropriate. In this regard, the Foreign Regulated MCO process is a form of mutual recognition which facilitates the operation in the U.S. of foreign clearing organizations which the CFTC has found are subject to comparable regulation in jurisdictions with comparably rigorous regulation. Furthermore, the CFTC requires that adequate information-sharing agreements with the foreign regulator are in place. In reviewing applications by a Foreign Regulated MCO for an Order under section 409 FDICIA, the Commission determines whether the foreign CCP is subject to oversight by its home country regulator comparable to that which the Commission requires of U.S. DCOs in meeting the Core Principles. Accordingly, the Commission reviews both applications for DCO registration as well as requests for an Order recognizing a Foreign Regulated MCO in relation to the standards established by the Core Principles for Derivatives Clearing Organizations. For this reason, Eurex Clearing also supports the DMTAA provision that would require a Foreign Regulated MCO to comply with requirements similar to the requirements of section 5b and 5c of the Act and the DMTAA's addition of three new Core Principles relating to daily publication of pricing information, fitness standards and disclosure of operational information. Eurex Clearing already meets all existing and proposed Core Principles and believes that these are an appropriate requirement for any foreign CCP wishing to operate in the U.S. as a Foreign Regulated MCO.DMTAA Provides a Useful Mechanism for Exempting Transactions from the Clearing Requirement Eurex Clearing firmly believes that central clearing services are the most suitable option effectively to mitigate counterparty risk and to improve market transparency. These are key elements in any effort toward a sustainable reduction in risk on a global scale and we support all voluntary efforts to increase the availability and use of CCP clearing for OTC transactions. In this vein, we applaud the Committee's recognition of the important role that derivatives clearinghouses provide in stabilizing the world's financial markets. As the DMTAA recognizes, not all OTC transactions will be suitable for CCP style clearing. Such transactions may nevertheless serve bona fide economic purposes. To address this reality, the DMTAA provides a mechanism whereby the Commission can exempt certain types of non-standardized transactions from the clearing requirement. The Commission's determination would be based upon several factors, including the degree of customization of the transaction, the frequency of such transactions, whether the contract serves a price discovery function and whether the parties have provided for the financial integrity of the agreement. Eurex Clearing believes that these factors are the correct criteria to consider in making a determination that a transaction or class of transactions should be exempt from the clearing requirement.Conclusion Eurex Clearing supports the Committee in its efforts to encourage greater use of CCPs. We are ourselves working to secure the commitment by financial institutions to participate in the development of and to use the services of our CDS clearing offering. Eurex Clearing understands the importance of public confidence in these markets and is committed to the utmost level of cooperation with the regulatory authorities in Europe and the U.S. We appreciate the opportunity to work with the U.S. regulatory authorities with respect to our plans to offer clearing services for CDS transactions. Eurex Clearing also believes that the existing treatment of derivatives clearinghouses which envisions the possibility of more than one CCP offering its services to the OTC markets supervised by any one of the qualified financial regulators offers an appropriate, workable and sound legal and regulatory framework. Eurex Clearing also notes that within the framework of the DMTAA, the possibility exists for CCPs that are regulated in their home countries comparably to the requirements of the Core Principles that apply to Derivatives Clearing Organizations to be able to offer their services in the United States as a multi-lateral clearing organization. We urge the Committee to permit Eurex Clearing (once its status has been recognized by the Commission) and the other MCOs that have already received recognition as such from the CFTC to clear OTC contracts, agreements and transactions not just on excluded commodities but also on exempt commodities. Eurex Clearing supports the application of the additional proposed Core Principles to Derivatives Clearing Organizations and to Foreign Regulated Multi-lateral Clearing Organizations. In this spirit, I would like to share with you the same thoughts we have expressed to the European Commission. We have strongly supported the Internal Markets Commissioner Charlie McCreevey's call for action to improve market infrastructure for OTC clearing and in particular for credit default swap clearing. We believe that improvements in Europe are of common interest to all market participants because they will also contribute to market stability on a global scale. Furthermore, we believe that there should be an alignment of regulatory policy regarding OTC clearing, first across the Atlantic and then globally. We recognize that that will take time to achieve and that the European regulators believe that decisive action may be appropriate now. Finally, I note that this is the second time that I have testified before this Committee on behalf of Eurex and Eurex Clearing and we are deeply honored to have been invited back to present our views to this Committee. We very much appreciate the opportunity to discuss these critically important issues with the Committee. I am happy to answer your questions. Mr. Holden [presiding.] Thank you, Mr. Book. " Mr. Kaswell," FOMC20081216meeting--140 138,MR. STOCKTON.," We are looking for about minus 0.5 percent in December and minus 0.1 in January. We are also not expecting the core figures to remain as low as they have been running for the past month or two. We do think that they have been held down by some very significant declines in air fares. That could continue for another month or two--again, as the energy price pass-through works. They have also been held down by some very large declines in lodging away from home, which is a volatile series, and it is not likely to sustain this level. Despite the fact that we don't see them as low as they have been the past two months--that is, declining to flat--we are expecting some fairly small increases going forward. We have core inflation heading down, and all of these exhibits have shown a significant reduction in price pressures coming from import prices, from energy prices, and from broader commodity prices as well as the increase in slack that, as Stephanie pointed out, is keeping a real lid on labor costs. " CHRG-110shrg50409--111 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System July 15, 2008 Chairman Dodd, Senator Shelby, and Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. The U.S. economy and financial system have confronted some significant challenges thus far in 2008. The contraction in housing activity that began in 2006 and the associated deterioration in mortgage markets that became evident last year have led to sizable losses at financial institutions and a sharp tightening in overall credit conditions. The effects of the housing contraction and of the financial headwinds on spending and economic activity have been compounded by rapid increases in the prices of energy and other commodities, which have sapped household purchasing power even as they have boosted inflation. Against this backdrop, economic activity has advanced at a sluggish pace during the first half of this year, while inflation has remained elevated. Following a significant reduction in its policy rate over the second half of 2007, the Federal Open Market Committee (FOMC) eased policy considerably further through the spring to counter actual and expected weakness in economic growth and to mitigate downside risks to economic activity. In addition, the Federal Reserve expanded some of the special liquidity programs that were established last year and implemented additional facilities to support the functioning of financial markets and foster financial stability. Although these policy actions have had positive effects, the economy continues to face numerous difficulties, including ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil, food, and some other commodities. Let me now turn to a more detailed discussion of some of these key issues. Developments in financial markets and their implications for the macroeconomic outlook have been a focus of monetary policymakers over the past year. In the second half of 2007, the deteriorating performance of subprime mortgages in the United States triggered turbulence in domestic and international financial markets as investors became markedly less willing to bear credit risks of any type. In the first quarter of 2008, reports of further losses and write-downs at financial institutions intensified investor concerns and resulted in further sharp reductions in market liquidity. By March, many dealers and other institutions, even those that had relied heavily on short-term secured financing, were facing much more stringent borrowing conditions. In mid-March, a major investment bank, The Bear Stearns Companies, Inc., was pushed to the brink of failure after suddenly losing access to short-term financing markets. The Federal Reserve judged that a disorderly failure of Bear Stearns would pose a serious threat to overall financial stability and would most likely have significant adverse implications for the U.S. economy. After discussions with the Securities and Exchange Commission and in consultation with the Treasury, we invoked emergency authorities to provide special financing to facilitate the acquisition of Bear Stearns by JPMorgan Chase & Co. In addition, the Federal Reserve used emergency authorities to establish two new facilities to provide backstop liquidity to primary dealers, with the goals of stabilizing financial conditions and increasing the availability of credit to the broader economy. \1\ We have also taken additional steps to address liquidity pressures in the banking system, including a further easing of the terms for bank borrowing at the discount window and increases in the amount of credit made available to banks through the Term Auction Facility. The FOMC also authorized expansions of its currency swap arrangements with the European Central Bank and the Swiss National Bank to facilitate increased dollar lending by those institutions to banks in their jurisdictions.--------------------------------------------------------------------------- \1\ Primary dealers are financial institutions that trade in U.S. government securities with the Federal Reserve Bank of New York. On behalf of the Federal Reserve System, the New York Fed's Open Market Desk engages in the trades to implement monetary policy.--------------------------------------------------------------------------- These steps to address liquidity pressures coupled with monetary easing seem to have been helpful in mitigating some market strains. During the second quarter, credit spreads generally narrowed, liquidity pressures ebbed, and a number of financial institutions raised new capital. However, as events in recent weeks have demonstrated, many financial markets and institutions remain under considerable stress, in part because the outlook for the economy, and thus for credit quality, remains uncertain. In recent days, investors became particularly concerned about the financial condition of the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. In view of this development, and given the importance of these firms to the mortgage market, the Treasury announced a legislative proposal to bolster their capital, access to liquidity, and regulatory oversight. As a supplement to the Treasury's existing authority to lend to the GSEs and as a bridge to the time when the Congress decides how to proceed on these matters, the Board of Governors authorized the Federal Reserve Bank of New York to lend to Fannie Mae and Freddie Mac, should that become necessary. Any lending would be collateralized by U.S. government and Federal agency securities. In general, healthy economic growth depends on well-functioning financial markets. Consequently, helping the financial markets to return to more normal functioning will continue to be a top priority of the Federal Reserve. I turn now to current economic developments and prospects. The economy has continued to expand, but at a subdued pace. In the labor market, private payroll employment has declined this year, falling at an average pace of 94,000 jobs per month through June. Employment in the construction and manufacturing sectors has been particularly hard hit, although employment declines in a number of other sectors are evident as well. The unemployment rate has risen and now stands at 5\1/2\ percent. In the housing sector, activity continues to weaken. Although sales of existing homes have been about unchanged this year, sales of new homes have continued to fall, and inventories of unsold new homes remain high. In response, homebuilders continue to scale back the pace of housing starts. Home prices are falling, particularly in regions that experienced the largest price increases earlier this decade. The declines in home prices have contributed to the rising tide of foreclosures; by adding to the stock of vacant homes for sale, these foreclosures have, in turn, intensified the downward pressure on home prices in some areas. Personal consumption expenditures have advanced at a modest pace so far this year, generally holding up somewhat better than might have been expected given the array of forces weighing on household finances and attitudes. In particular, with the labor market softening and consumer price inflation elevated, real earnings have been stagnant so far this year; declining values of equities and houses have taken their toll on household balance sheets; credit conditions have tightened; and indicators of consumer sentiment have fallen sharply. More positively, the fiscal stimulus package is providing some timely support to household incomes. Overall, consumption spending seems likely to be restrained over coming quarters. In the business sector, real outlays for equipment and software were about flat in the first quarter of the year, and construction of nonresidential structures slowed appreciably. In the second quarter, the available data suggest that business fixed investment appears to have expanded moderately. Nevertheless, surveys of capital spending plans indicate that firms remain concerned about the economic and financial environment, including sharply rising costs of inputs and indications of tightening credit, and they are likely to be cautious with spending in the second half of the year. However, strong export growth continues to be a significant boon to many U.S. companies. In conjunction with the June FOMC meeting, Board members and Reserve Bank presidents prepared economic projections covering the years 2008 through 2010. On balance, most FOMC participants expected that, over the remainder of this year, output would expand at a pace appreciably below its trend rate, primarily because of continued weakness in housing markets, elevated energy prices, and tight credit conditions. Growth is projected to pick up gradually over the next 2 years as residential construction bottoms out and begins a slow recovery and as credit conditions gradually improve. However, FOMC participants indicated that considerable uncertainty surrounded their outlook for economic growth and viewed the risks to their forecasts as skewed to the downside. Inflation has remained high, running at nearly a 3\1/2\ percent annual rate over the first 5 months of this year as measured by the price index for personal consumption expenditures. And, with gasoline and other consumer energy prices rising in recent weeks, inflation seems likely to move temporarily higher in the near term. The elevated level of overall consumer inflation largely reflects a continued sharp run-up in the prices of many commodities, especially oil but also certain crops and metals. \2\ The spot price of West Texas intermediate crude oil soared about 60 percent in 2007 and, thus far this year, has climbed an additional 50 percent or so. The price of oil currently stands at about five times its level toward the beginning of this decade. Our best judgment is that this surge in prices has been driven predominantly by strong growth in underlying demand and tight supply conditions in global oil markets. Over the past several years, the world economy has expanded at its fastest pace in decades, leading to substantial increases in the demand for oil. Moreover, growth has been concentrated in developing and emerging market economies, where energy consumption has been further stimulated by rapid industrialization and by government subsidies that hold down the price of energy faced by ultimate users.--------------------------------------------------------------------------- \2\ The dominant role of commodity prices in driving the recent increase in inflation can be seen by contrasting the overall inflation rate with the so-called core measure of inflation, which excludes food and energy prices. Core inflation has been fairly steady this year at an annual rate of about 2 percent.--------------------------------------------------------------------------- On the supply side, despite sharp increases in prices, the production of oil has risen only slightly in the past few years. Much of the subdued supply response reflects inadequate investment and production shortfalls in politically volatile regions where large portions of the world's oil reserves are located. Additionally, many governments have been tightening their control over oil resources, impeding foreign investment and hindering efforts to boost capacity and production. Finally, sustainable rates of production in some of the more secure and accessible oil fields, such as those in the North Sea, have been declining. In view of these factors, estimates of long-term oil supplies have been marked down in recent months. Longdated oil futures prices have risen along with spot prices, suggesting that market participants also see oil supply conditions remaining tight for years to come. The decline in the foreign exchange value of the dollar has also contributed somewhat to the increase in oil prices. The precise size of this effect is difficult to ascertain, as the causal relationships between oil prices and the dollar are complex and run in both directions. However, the price of oil has risen significantly in terms of all major currencies, suggesting that factors other than the dollar, notably shifts in the underlying global demand for and supply of oil, have been the principal drivers of the increase in prices. Another concern that has been raised is that financial speculation has added markedly to upward pressures on oil prices. Certainly, investor interest in oil and other commodities has increased substantially of late. However, if financial speculation were pushing oil prices above the levels consistent with the fundamentals of supply and demand, we would expect inventories of crude oil and petroleum products to increase as supply rose and demand fell. But in fact, available data on oil inventories show notable declines over the past year. This is not to say that useful steps could not be taken to improve the transparency and functioning of futures markets, only that such steps are unlikely to substantially affect the prices of oil or other commodities in the longer term. Although the inflationary effect of rising oil and agricultural commodity prices is evident in the retail prices of energy and food, the extent to which the high prices of oil and other raw materials have been passed through to the prices of non-energy, non-food finished goods and services seems thus far to have been limited. But with businesses facing persistently higher input prices, they may attempt to pass through such costs into prices of final goods and services more aggressively than they have so far. Moreover, as the foreign exchange value of the dollar has declined, rises in import prices have put greater upward pressure on business costs and consumer prices. In their economic projections for the June FOMC meeting, monetary policymakers marked up their forecasts for inflation during 2008 as a whole. FOMC participants continue to expect inflation to moderate in 2009 and 2010, as slower global growth leads to a cooling of commodity markets, as pressures on resource utilization decline, and as longer-term inflation expectations remain reasonably well anchored. However, in light of the persistent escalation of commodity prices in recent quarters, FOMC participants viewed the inflation outlook as unusually uncertain and cited the possibility that commodity prices will continue to rise as an important risk to the inflation forecast. Moreover, the currently high level of inflation, if sustained, might lead the public to revise up its expectations for longer-term inflation. If that were to occur, and those revised expectations were to become embedded in the domestic wage- and price-setting process, we could see an unwelcome rise in actual inflation over the longer term. A critical responsibility of monetary policymakers is to prevent that process from taking hold. At present, accurately assessing and appropriately balancing the risks to the outlook for growth and inflation is a significant challenge for monetary policymakers. The possibility of higher energy prices, tighter credit conditions, and a still-deeper contraction in housing markets all represent significant downside risks to the outlook for growth. At the same time, upside risks to the inflation outlook have intensified lately, as the rising prices of energy and some other commodities have led to a sharp pickup in inflation and some measures of inflation expectations have moved higher. Given the high degree of uncertainty, monetary policymakers will need to carefully assess incoming information bearing on the outlook for both inflation and growth. In light of the increase in upside inflation risk, we must be particularly alert to any indications, such as an erosion of longer-term inflation expectations, that the inflationary impulses from commodity prices are becoming embedded in the domestic wage- and price-setting process. I would like to conclude my remarks by providing a brief update on some of the Federal Reserve's actions in the area of consumer protection. At the time of our report last February, I described the Board's proposal to adopt comprehensive new regulations to prohibit unfair or deceptive practices in the mortgage market, using our authority under the Home Ownership and Equity Protection Act of 1994. After reviewing the more than 4,500 comment letters we received on the proposed rules, the Board approved the final rules yesterday. The new rules apply to all types of mortgage lenders and will establish lending standards aimed at curbing abuses while preserving responsible subprime lending and sustainable homeownership. The final rules prohibit lenders from making higher-priced loans without due regard for consumers' ability to make the scheduled payments and require lenders to verify the income and assets on which they rely when making the credit decision. Also, for higher-priced loans, lenders now will be required to establish escrow accounts so that property taxes and insurance costs will be included in consumers' regular monthly payments. The final rules also prohibit prepayment penalties for higher-priced loans in cases in which the consumer's payment can increase during the first few years and restrict prepayment penalties on other higher-priced loans Other measures address the coercion of appraisers, servicer practices, and other issues. We believe the new rules will help to restore confidence in the mortgage market. In May, working jointly with the Office of Thrift Supervision and the National Credit Union Administration, the Board issued proposed rules under the Federal Trade Commission Act to address unfair or deceptive practices for credit card accounts and overdraft protection plans. Credit cards provide a convenient source of credit for many consumers, but the terms of credit card loans have become more complex, which has reduced transparency. Our consumer testing has persuaded us that disclosures alone cannot solve this problem. Thus, the Board's proposed rules would require card issuers to alter their practices in ways that will allow consumers to better understand how their own decisions and actions will affect their costs. Card issuers would be prohibited from increasing interest rates retroactively to cover prior purchases except under very limited circumstances. For accounts having multiple interest rates, when consumers seek to pay down their balance by paying more than the minimum, card issuers would be prohibited from maximizing interest charges by applying excess payments to the lowest rate balance first. The proposed rules dealing with bank overdraft services seek to give consumers greater control by ensuring that they have ample opportunity to opt out of automatic payments of overdrafts. The Board has already received more than 20,000 comment letters in response to the proposed rules. Thank you. I would be pleased to take your questions. CHRG-110shrg50409--8 Mr. Bernanke," Chairman Dodd, Senator Shelby, and Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. The U.S. economy and financial system has confronted some significant challenges thus far in 2008. The contraction in housing activity that began in 2006 and the associated deterioration in mortgage markets that became evident last year have led to sizable losses at financial institutions and a sharp tightening in overall credit conditions. The effects of the housing contraction and of the financial head winds on spending and economic activity have been compounded by rapid increases in the prices of energy and other commodities which have sapped household purchasing power even as they have boosted inflation. Against this backdrop, economic activity has advanced at a sluggish pace during the first half of this year while inflation has remained elevated. Following a significant reduction in its policy rate over the second half of 2007, the Federal Open Market Committee eased policy considerably further through the spring to counter actual and expected weakness in economic growth and to mitigate downside risk to economic activity. In addition, the Federal Reserve expanded some of the special liquidity programs that were established last year and implemented additional facilities to support the functioning of financial markets and foster financial stability. Although these policy actions have had positive effects, the economy continues to face numerous difficulties, including ongoing strains on financial markets, declining house prices, a softening labor market, and rising prices of oil, food, and some other commodities. Let me now turn to a more detailed discussion of some of these key issues. Developments in financial markets and their implications to the macroeconomic outlook have been a focus of monetary policymakers over the past year. In the second half of 2007, the deteriorating performance of subprime mortgages in the United States triggered turbulence in domestic and international financial markets as investors became markedly less willing to bear credit risks of any type. In the first quarter of 2008, reports of further losses and writedowns by financial institutions intensified investor concerns and resulted in further sharp reductions in market liquidity. By March, many dealers and other institutions, even those that had relied heavily on short-term secured financing, were facing much more stringent borrowing conditions. In mid-March, a major investment bank, the Bear Stearns Companies Incorporated, was pushed to the brink of failure after suddenly losing access to short-term financing markets. The Federal Reserve judged that a disorderly failure of Bear Stearns would pose a serious threat to overall financial stability and would most likely have significant adverse implications for the U.S. economy. After discussions with the Securities and Exchange Commission and in consultation with the Treasury, we invoked emergency authorities to provide special financing to facilitate the acquisition of Bear Stearns by JPMorgan Chase and Company. In addition, the Federal Reserve used emergency authorities to establish two new facilities to provide backstop liquidity to primary dealers, with the goals of stabilizing financial conditions and increasing the availability of credit to the broader economy. We have also taken additional steps to address liquidity pressures in the banking system, including a further easing of the terms for bank borrowing at the discount window and increases in the amount of credit made available to banks through the Term Auction Facility. The FOMC also authorized expansion of its currency swap arrangements with the European Central Bank and the Swiss National Bank to facilitate increased dollar lending by those institutions to banks in their jurisdictions. These steps to address liquidity pressures, coupled with monetary easing, seem to have been helpful in mitigating some market strains. During the second quarter, credit spreads generally narrowed, liquidity pressures ebbed, and a number of financial institutions raised new capital. However, as events in recent weeks have demonstrated, many financial markets and institutions remain under considerable stress, in part because the outlook for the economy and, thus, for credit quality remains uncertain. In recent days, investors became particularly concerned about the financial condition of the Government-sponsored enterprises Fannie Mae and Freddie Mac. In view of this development, and given the importance of these firms to the mortgage market, the Treasury announced the legislative proposal to bolster their capital, access to liquidity, and regulatory oversight. As a supplement to the Treasury's existing authority to lend to the GSEs, and as a bridge to the time when the Congress decides how to proceed on these matters, the Board of Governors authorized the Federal Reserve Bank of New York to lend to Fannie Mae and Freddie Mac should that become necessary. Any lending would be collateralized by U.S. Government and Federal agency securities. In general, healthy economic growth depends on well-functioning financial markets. Consequently, helping the financial markets to return to more normal functioning will continue to be a top priority of the Federal Reserve. I turn now to current economic developments and prospects. The economy has continued to expand, but at a subdued pace. In the labor market, private payroll employment has declined this year, falling at an average pace of 94,000 jobs per month through June. Employment in the construction and manufacturing sectors has been particularly hard hit, although employment declines in a number of other sectors are evident as well. The unemployment rate has risen and now stands at 5.5 percent. In the housing sector, activity continues to weaken. Although sales of existing homes have been unchanged this year, sales of new homes have continued to fall, and inventories of unsold new homes remain high. In response, home builders continue to scale back the pace of housing starts. Home prices are falling, particularly in regions that experienced the largest price increases earlier this decade. The declines in home prices have contributed to the rising tide of foreclosures. By adding to the stock of vacant homes for sale, these foreclosures have in turn intensified the downward pressure on home prices in some areas. Personal consumption expenditures have advanced at a modest pace so far this year, generally holding up somewhat better than might have been expected given the array of forces weighing on household finances and attitudes. In particular, with the labor market softening and consumer price inflation elevated, real earnings have been stagnant so far this year. Declining values and equities in house have taken their toll on household balance sheets, credit conditions have tightened, and indicators of consumer sentiment have fallen sharply. More positively, the fiscal stimulus package is providing some timely support to household incomes. Overall, consumption spending seems likely to be restrained over coming quarters. In the business sector, real outlays for equipment and software were about flat in the first quarter of the year, and construction of nonresidential structures slowed appreciably. In the second quarter, the available data suggests that business fixed investment appears to have expanded moderately. Nevertheless, surveys of capital spending plans indicate that firms remain concerned about the economic and financial environment, including sharply rising costs of inputs and indications of tightening credit, and they are likely to be cautious with spending in the second half of the year. However, strong export growth continues to be a significant boon to many U.S. companies. In conjunction with the June FOMC meeting, Board members and reserve bank presidents prepared economic projections covering the years 2008 through 2010. On balance, most FOMC participants expected that, over the remainder of this year, output would expand at a pace appreciably below its trend rate, primarily because of continued weakness in housing markets, elevated energy prices, and tight credit conditions. Growth is projected to pick up gradually over the next 2 years as residential construction bottoms out and begins a slow recovery and as credit conditions gradually improve. However, FOMC participants indicated that considerable uncertainty surrounded their outlook for economic growth, and they viewed the risks to their forecast as skewed to the downside. Inflation has remained high, running at nearly a 3.5-percent annual rate over the first 5 months of this year, as measured by the price index of personal consumption expenditures. And with gasoline and other consumer energy prices rising in recent weeks, inflation seems likely to move temporarily higher in the near term. The elevated level of overall consumer inflation largely reflects a continued sharp run-up in the prices of many commodities, especially oil, but also certain crops and metals. The spot price of West Texas intermediate crude oil soared about 60 percent in 2007 and thus far this year has climbed an additional 50 percent or so. The price of oil currently stands at about 5 times its level toward the beginning of this decade. Our best judgment is that this surge in prices has been driven predominantly by strong growth in underlying demand and tight supply conditions in global oil markets. Over the past several years, the world economy has expanded at its fastest pace in decades, leading to substantial increases in demand for oil. Moreover, growth has been concentrated in developed and emerging market economies, where energy consumption has been further stimulated by rapid industrialization and by government subsidies that hold down the price of energy faced by ultimate users. On the supply side, despite sharp increases in prices, the production of oil has risen only slightly in the past few years. Much of the subdued supply response reflects inadequate investment and production shortfalls in politically volatile regions where large portions of the world's oil reserves are located. Additionally, many governments have been tightening their control over oil resources, impeding foreign investment and hindering efforts to boost capacity and production. Finally, sustainable rates of production in some of the more secure and accessible oil fields, such as those in the North Sea, have been declining. In view of these factors, estimates of long-term oil supplies have been marked down in recent months. Long-dated oil future prices have risen along with spot prices, suggesting that market participants also see oil supply conditions remaining tight for years to come. The decline in the foreign exchange value of the dollar has also contributed somewhat to the increase in oil prices. The precise size of this effect is difficult to ascertain as the causal relationships between oil prices and the dollar are complex and run in both directions. However, the price of oil has risen significantly in terms of all major currencies, suggesting that factors other than the dollar--notably, shifts in the underlying global demand for and supply of oil--have been the principal drivers of these increases in prices. Another concern that has been raised is that financial speculation has added markedly to upward pressure on oil prices. Certainly, investor interest in oil and other commodities has increased substantially of late. However, if financial speculation is pushing oil prices above the levels consistent with the fundamentals of supply and demand, we would expect inventories of crude oil and petroleum products to increase as supply rose and demand fell. But, in fact, available data on oil inventories show notable declines over the past year. This is not to say that useful steps could not be taken to improve the transparency and functioning of futures markets, only that such steps are unlikely to substantially affect the prices of oil or other commodities in the longer term. Although the inflationary effect of rising oil and agricultural commodity prices is evident in the retail prices of energy and food, the extent to which the high prices of oil and other raw materials have passed through to the prices of non-energy, non-food finished goods and services seems thus far to have been limited. But with businesses facing persistently higher input prices, they may attempt to pass through such costs into prices of final goods and services more aggressively than they have done so far. Moreover, as the foreign exchange value of the dollar has declined, rises in import prices have put greater upward pressure on business costs and consumer prices. In their economic projections for the June FOMC meeting, monetary policymakers marked up their forecasts for inflation during 2008 as a whole. FOMC participants continue to expect inflation to moderate in 2009 and 2010 as slower global growth leads to a pooling of commodity markets, as pressures on resource utilization decline, and as longer-term inflation expectations remain reasonably well anchored. However, in light of persistent escalation of commodity prices in recent quarters, FOMC participants view the inflation outlook as unusually uncertain and cited the possibility that commodity prices will continue to rise as an important risk to the inflation forecast. Moreover, the currently high level of inflation, if sustained, might lead the public to revise up its expectations for longer-term inflation. If that were to occur and those revised expectations were to become embedded in the domestic wage- and price-setting process, we could see an unwelcome rise in actual inflation over the longer term. A critical responsibility of monetary policymakers is to prevent that process from taking hold. At present, accurately assessing and appropriately balancing the risks to the outlook for growth and inflation is a significant challenge for monetary policymakers. The possibility of higher energy prices, tighter credit conditions, and a still deeper contraction in housing markets all represent significant downside risks to the outlook for growth. At the same time, upside risks to the inflation outlook have intensified lately as the rising prices of energy and some other commodities have led to a sharp pick-up in inflation, and some measures of inflation expectations have moved higher. Given the high degree of uncertainty, monetary policymakers will need to carefully assess incoming information bearing on the outlook for both inflation and growth. In light of the increase in upside inflation risk, we must be particularly alert to any indications, such as erosion of longer-term inflation expectations, that the inflationary impulses from commodity prices are becoming embedded in the domestic wage- and price-setting process. I would like to conclude my remarks by providing a brief update on some of the Federal Reserve's actions in the area of consumer protection. At the time of our report last February, I described the Board's proposal to adopt comprehensive new regulations to prohibit unfair or deceptive practices in the mortgage market using our authority under the Home Ownership and Equity Protection Act of 1994. After reviewing more than 4,500 comment letters we received on these proposed rules, the Board approved the final rules yesterday. The new rules apply to all types of mortgage lenders and will establish lending standards aimed at curbing abuses while preserving responsible subprime lending and sustainable homeownership. The final rules prohibit lenders from making higher-priced loans without due regard for consumers' ability to make the scheduled payments and require lenders to verify the income and assets on which they rely when making the credit decision. Also, for higher-priced loans, lenders now will be required to establish escrow accounts so that property taxes and insurance costs will be included in consumers' regular monthly payments. The final rules also prohibit prepayment penalties for higher-priced loans in cases in which the consumer's payment could increase during the first few years and restrict prepayment penalties on other higher-priced loans. Other measures address the coercion of appraisers' service or practices and other issues. We believe the new rules will help to restore confidence in the mortgage market. In May, working jointly with the Office of Thrift Supervision and the National Credit Union Administration, the Board issued proposed rules under the Federal Trade Commission Act to address unfair or deceptive practices for credit card accounts and overdraft protection plans. Credit cards provide a convenient source of credit for many consumers, but as the terms of credit card loans have become more complex, transparency has been reduced. Our consumer testing has persuaded us that disclosures alone cannot solve this problem. Thus, the Board's proposed rules will require card issuers to alter their practices in ways that will allow consumers to better understand how their own decisions and actions will affect their costs. Card issuers would be prohibited from increasing interest rates retroactively to cover prior purchases, except under very limited circumstances. For accounts having multiple interest rates, when consumers seek to pay down their balance by paying more than the minimum, card issuers would be prohibited from maximizing interest charges by applying excess payments to the lowest-rate balance first. The proposed rules dealing with bank overdraft services seek to give consumers greater control by ensuring that they have ample opportunity to opt out of automatic payments of overdrafts. The Board has already received more than 20,000 comment letters in response to these proposed rules. Thank you very much. I would be pleased to take your questions. " FOMC20050503meeting--88 86,MR. HOENIG.," Mr. Chairman, I’ll start off by repeating the obvious: There have been a couple of surprises since our last FOMC meeting. The economy has lost momentum after the end of May 3, 2005 47 of 116 the first quarter has led me to join others in marking down my forecast for growth this year to about 3½ percent. I expect growth in the second half of this year to be about 3¾ percent and then slow perhaps back to 3½ percent next year. With trend growth of about 3¼ percent, the output gap and labor market slack should continue to diminish, as we’ve said before. I would agree with those who attribute much of the slowdown to the persistence of higher energy prices. This is especially the case for consumer spending and confidence, as we see it. Higher energy costs have also reduced growth in other countries, and I think that probably has contributed to some of the worsening in our trade balance. Obviously, we need a little more time and information to determine whether the recent economic performance reflects temporary factors or is likely to be more permanent. If it is temporary, then, as energy prices level off or perhaps decline somewhat, I would expect the fundamental forces of growth to take over—those being monetary policy that, in my opinion, remains accommodative and financial conditions that are, perhaps, highly accommodative. I’ll digress here by giving you just one anecdote. I talked recently to an executive of one of our major banks that lends across the nation in some of the hot markets. He described a condominium deal, a fairly large one, where the construction cost was about $100 million. The developers had $3 million of equity in the project. Those who lent $97 million lent those funds on a pro forma sale price that finished out at $140 million. So there is a lot of speculation, I think, in these markets. And that is something that we have to take into account. But I also see that the labor and capital markets that we talk about here are strengthening. So overall I think the evidence is that the economy will improve. And I would say, from a regional perspective, that the Tenth District mostly provides support for an improving outlook, though I May 3, 2005 48 of 116 including travel and tourism, rose solidly in March and early April, and most retailers said sales were up substantially from a year ago. In addition, housing activity turned up, following a pause in late 2004 and early 2005 in our region. Housing starts and permits rose solidly in March, and home sales were strong in most of our District’s cities. Still, preliminary data from our manufacturing survey suggest some evidence of a slowdown. In fact, in April the production and shipments indexes both fell. More worrisome, though, was the large decline in the six-month-ahead production, shipments, and new orders indexes. This bears watching, since it may suggest a more permanent slowdown than we currently expect. In addition, a number of contacts expressed concerns to us about higher energy prices. For example, in our April manufacturing survey, some firms said that they were delaying shipments in order to assure full truckloads and thus save on fuel costs. A few firms also said that they expect to cut back on production due to high energy costs. In addition, some retailers were worried that higher gasoline prices would eventually take a toll on their sales. Of course, for our region, higher energy prices are positive for some of our District’s states, particularly Oklahoma and Wyoming, where we see nearly boom conditions. Turning to the inflation outlook, I do expect to see further increases in core inflation, with core PCE inflation averaging almost 2 percent in 2005 and core CPI inflation averaging 2½ percent, similar to the Greenbook forecast. However, unlike the Greenbook, I expect core inflation to remain elevated in 2006 rather than to fall back. I take note of the fact that energy price increases may be a rock in the pond, but I think the substantially accommodative monetary policy we have had is more like a boulder. And it is carrying itself forward, which is what we need to be aware of and alert to. We continue to see increases in core inflation. Whether measured in 3-, 6-, or 12-month May 3, 2005 49 of 116 inflation is now higher than at any time since the second half of 2001. In my opinion it is above comfortable levels. Measured from six months ago, core CPI inflation is about 2½ percent and core PCE inflation is above 2 percent. Clearly, some of the increase represents temporary factors—such as the energy prices we keep talking about and the prices of some commodities—and may be reversed. However, I would take note that the pass-through of energy prices to core inflation is difficult to predict, as we talked about earlier, and may be greater than some suggest. I also believe that there is more to the inflation story than energy prices. Even if we exclude the two largest quarterly rates, core CPI inflation over the last four quarters was 2 percent, which is significantly higher than core inflation over the previous four quarters. I believe some of the increase is the result of our continued accommodative policy. We’ve seen inflation rise over the last year in the presence of sizable slack and a rising funds rate. I’m concerned that, with less slack in the economy, we will continue to see higher inflation going forward. In addition, maintaining an accommodative monetary policy poses an upside risk to inflation, with the federal funds rate currently below many estimates of the lower bound of the neutral rate. If we are slow in removing this accommodation, I would be concerned that the increase in core inflation also might be passed through to higher expected inflation. We’re also seeing some evidence of pricing power in the Tenth District, as manufacturers continue to raise their output prices to cover what they’ve referred to as rising costs of energy and other inputs. In addition, the share of our Beige Book retail contacts who reported to us that they were raising prices this time was the highest in the last five years. These are my concerns. The one other thing I would mention relates to our statement. I would agree with those who would like to abbreviate our statement today. Since people are, in fact, May 3, 2005 50 of 116" CHRG-111hhrg53245--19 Mr. Johnson," Thank you very much, Mr. Chairman. As you said at the beginning, the question, I think, is not controversial. The issue is to remove the possibility in the future that a large financial institution can come to the Executive Branch and say, ``Either you bail us out, or there will be an enormous collapse in the financial system of this country and potentially globally.'' And I think there are two broad responses to that, two ways of addressing that problem that are on the table. The first is what I would call relatively technocratic adjustments, changing the rules around regulation or changing the rules around bankruptcy procedure. I think there are some sensible ideas there, that are relatively small ideas. I don't believe they will fundamentally solve this problem. The second approach is to reduce the size of these banks, and what we have learned, I think, over the past 9 months is a considerable amount about how small financial institutions can fail, and can fail without causing major systemic problems, both through an FDIC-type process, or through a market type process, as seen with the CIT Group. Let me emphasize or underline the difference between these two approaches, and why making them smaller is both attractive and feasible. I think that the key problem is this financial sector has become very persuasive. It has convinced itself, it has convinced its regulator, it has convinced many other people that it knows how to manage risks, that it understands what are large risks for itself. And of course this is what Mr. Greenspan now concedes was a mistake in his assessment of the situation during the boom. He thought that the large firms that had a great deal to lose if things went badly understood these risks and would control them and manage them. And they didn't. It's a massive failure of risk management and I see no indication either that the banks have improved this kind of risk management in the largest institutions, or that regulators are better able to spot this. And while I agree with the idea we should have a systemic risk spotter of some kind, analytically and politically, it seems to me we're a long way from ever achieving that. And if I may mention the lobbying of Fannie and Freddie on the one hand, and private banks on the other hand, it was just fantastic. These people are the best in the business, by all accounts, at speaking with many people, both with regard to legislation and of course detailed rules. Again, I see no reason to think that if you tweak the technocratic structures, you will remove this power and this ability that these large financial institutions have brought to bear. And it's not just in the last 5 to 10 years; it's historically in the United States and in many other countries, or perhaps most other countries the financial system has this kind of lobbying power, this kind of too-connected-to-fail issue raised by Mr. Sherman. Now I think, Mr. Chairman, if you put it in those terms and if you look hard at the technocratic adjustments, the most promising solution is to adjust the capital requirements of the firms, as Mr. Wallison said, in such as fashion as it becomes less attractive and less profitable to become a big financial firm. I also agree and would emphasize what Ms. Rivlin said, which is thinking about how to target leverage and control leverage, again through something akin to a modern version of margin requirements is very appealing in this situation. It's about size. CIT Group was $80 billion in assets. Treasury and other--looked long and hard not at that before deciding not to bail it out. I think from what we see right now, that was a smart decision. I think the market can take care of it. The line they're drawing seems to be around $100 billion in assets. Financial institutions above $500 billion in assets right now clearly benefit from some sort of implicit government guarantee, going forward. And that's a problem, that distorts incentives, exactly as many members of the committee emphasized it at the beginning. So I think stronger capital requirements. You could also do this with a larger insurance premium for bigger banks. What have they cost? What has the failure of risk management at these major banks cost the United States? Well, I would estimate that our privately held government debt will rise from around 40 percent of GDP, where it was initially to around 80 percent of GDP as the result of all the measures, direct and indirect, taken to save the financial system and to prevent this from turning into another Great Depression. That's a huge cost, and at the end of the day, you actually have more concentrated economic power, a more concentrated political access influence--call it what you want--in the financial system. So for 40 percent of GDP, we bought ourselves nothing in terms of reducing the level of system risk that we know now was very high, 2005-2007. I think it's capital requirements and you can combine that with higher insurance premium, reflecting the system costs. That's a lot of money. And include a tax on leverage. Now I want to, in my remaining 2 minutes, emphasize some issues of implementation I think are very important. The first is in terms of timing. I think the capital requirements can be phased in over time. I think the advantage of an economy that's bottoming out and starting to recover, you don't have to do this right away. The firms will likely--not for sure--will likely not engage in the same kind of restless risk-taking in the next 2 to 3 years. So there is some time to get ahead of this. But you really don't want to run through anything like the kind of boom that we have seen before. And of course this will reduce the profitability in this sector. No question about it. And the industry will point this out. They will be very cross with you, and they will tell you that this undermines productivity growth, and job creation in the United States. I see no evidence that is the case. I see no evidence that having an overleveraged financial system with excessive risk-taking does anything at all for growth in the real non-financial part of the economy. Now I would emphasize, though, two important pieces of this that we should also consider and that are more tricky. The first is foreign banks. So if we reduce the size of our banks, relative to the size of foreign banks, I think that does not create a competitive disadvantage for our industry. But it does raise the question of, ``How should you treat foreign banks operating in the United States?'' For example, Deutsche Bank, or other big European banks, banks that are very big relative to the size of those economies in Europe, let alone the size of the banks that we may end up with. Those banks, to the extent they operate in the United States, should be treated in the same way as U.S. banks. The capital requirements have to be high based on where you operate. And if you want to operate in the U.S. financial markets, that will have to be a requirement. Otherwise, you get into a situation where the next bank that comes to the Treasury and says, you know, ``It's bailout or collapse,'' will be a foreign bank, and that will be even more of a disaster than what we have faced recently. The second transactional issue, and my final point is with regards to the resolutional authority, I think Congress is rightly considering very carefully the resolutional authority requested by the Treasury, and I think that broadly speaking, that's a good idea. But I would emphasize, it is not sufficient. It's not a global resolutional authority. If a major multi-national bank comes to you with a problem and you know, you would like to say to them, ``Go through bankruptcy,'' but then when you look at the details of that, you see it will be a complete mess, because of the cross-border dimensions of that business. The same thing is true for a bailout. If you bail them out under your resolutional authority, it's also going to be a disaster unless you have a global agreement at the level of the G-20. Thank you very much, Mr. Chairman. [The prepared statement of Mr. Johnson can be found on page 49 of the appendix.] " fcic_final_report_full--206 Ira Wagner, the head of Bear Stearns’s CDO Group in , told the FCIC that he rejected the deal when approached by Paulson representatives. When asked about Goldman’s contention that Paulson’s picking the collateral was immaterial because the collateral was disclosed and because Paulson was not well-known at that time, Wagner called the argument “ridiculous.” He said that the structure encouraged Paulson to pick the worst assets. While acknowledging the point that every synthetic deal neces- sarily had long and short investors, Wagner saw having the short investors select the referenced collateral as a serious conflict and for that reason declined to participate.  ACA executives told the FCIC they were not initially aware that the short investor was involved in choosing the collateral. CEO Alan Roseman said that he first heard of Paulson’s role when he reviewed the SEC’s complaint.  Laura Schwartz, who was re- sponsible for the deal at ACA, said she believed that Paulson’s firm was the investor taking the equity tranche and would therefore have an interest in the deal performing well. She said she would not have been surprised that Paulson would also have had a short position, because the correlation trade was common in the market, but added, “To be honest, [at that time,] until the SEC testimony I did not even know that Paul- son was only short.”  Paulson told the FCIC that any synthetic CDO would have to invest in “a pool that both a buyer and seller of protection could agree on.” He didn’t understand the objections: “Every [synthetic] CDO has a buyer and seller of protec- tion. So for anyone to say that they didn’t want to structure a CDO because someone was buying protection in that CDO, then you wouldn’t do any CDOs.”  In July , Goldman Sachs settled the case, paying a record  million fine. Goldman “acknowledge[d] that the marketing materials for the ABACUS -AC transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was ‘selected by’ ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the port- folio selection process and that Paulson’s economic interests were adverse to CDO investors.”  The new derivatives provided a golden opportunity for bearish investors to bet against the housing boom. Home prices in the hottest markets in California and Florida had blasted into the stratosphere; it was hard for skeptics to believe that their upward trajectory could continue. And if it did not, the landing would not be a soft one. Some spoke out publicly. Others bet the bubble would burst. Betting against CDOs was also, in some cases, a bet against the rating agencies and their models. Jamie Mai and Ben Hockett, principals at the small investment firm Cornwall Capi- tal, told the FCIC that they had warned the SEC in  that the agencies were dan- gerously overoptimistic in their assessment of mortgage-backed CDOs. Mai and Hockett saw the rating agencies as “the root of the mess,” because their ratings re- moved the need for buyers to study prices and perform due diligence, even as “there was a massive amount of gaming going on.”  Shorting CDOs was “pretty attractive” because the rating agencies had given too much credit for diversification, Sihan Shu of Paulson & Co. told the FCIC. Paulson established a fund in June  that initially focused only on shorting BBB-rated tranches. By the end of , Paulson & Co.’s Credit Opportunities fund, set up less than a year earlier to bet exclusively against the subprime housing market, was up . “Each MBS tranche typically would be  mortgages in California,  in Florida,  in New York, and when you aggregate  MBS positions you still have the same geographic diversification. To us, there was not much diversification in CDOs.” Shu’s research convinced him that if home prices were to stop appreciating, BBB-rated mortgage-backed securities would be at risk for downgrades. Should prices drop , CDO losses would increase -fold.  CHRG-110hhrg34673--5 Mr. Gutierrez," Thank you, Mr. Chairman. And thank you, Chairman Frank. Chairman Bernanke, I think it is safe to say that you and I have different backgrounds and that we bring disparate perspectives to the table when dealing with economic and monetary issues. But after taking over the chairmanship of the Monetary Policy Subcommittee, I am getting a sense of the significant and daunting task that you face. You should rest assured, however, that I will be here over the next 2 years, along with 443 Members of the House and 100 Members of the other body, to second-guess your every move. When it comes to economic and monetary policy, we are entering a very crucial and complex period, especially for the Federal Reserve and its mandate of maximum employment, stable prices, and moderate long-term interest rates. For example, the housing boom has taken a substantial downturn. Energy prices have climbed and we are facing some serious issues about our long term energy security. Some economists warn the threat of inflation is on the horizon. Yet others appear less worried about inflation than the rising mortgage delinquencies and foreclosures effecting a wider economy. The two major Asian currencies are undervalued, and the U.S. trade deficit is at record highs, while accusations of currency manipulations are frequently leveled against both China and Japan. And perhaps most important of all, we face a huge Federal deficit at a time when baby boomers are reaching retirement age and healthcare costs are at an all time high. While I am anxious to hear from you, Mr. Bernanke, what concerns me most is retirement insecurity. When it comes to kitchen table issues, retirement insecurity is the obstacle for many American families. The U.S. economy is now producing over $13 trillion a year. But many American families are struggling just to maintain their living standards and they are up against stagnating wages, diminishing healthcare, and retirement benefits that are just disappearing. More and more families are living paycheck-to-paycheck with very little in their bank accounts or none at all, and paying higher interest rates and more fees than they should. And hanging over their heads is retirement. I know, Chairman Bernanke, that you have publicly addressed the related issues of retirement insecurity, the budget deficit, and the looming retirement of 78 million baby boomers on several occasions. But from what I have heard and read, you have approached the problem only in terms of entitlement reform. Entitlement reform is needed. No question. But this is not just an issue of entitlement reform. The skyrocketing cost of healthcare are not just going to disappear if we reduce entitlement spending. The costs will just be shifted to already strapped family budgets. Many baby boomers are simply not financially ready for retirement. If we substantially cut healthcare, and Social Security spending for the baby boomer generation, many will face healthcare crises that will drive them into bankruptcy. The correlation between rising healthcare expenses and personal bankruptcy filings is well-documented. And merely moving these expenses from the public sector to the American families, in my opinion, is not good for long-term economic growth. We need more than entitlement reform to give Americans retirement security. I would like to hear your views on this today. Clearly, no single political party and no single body, the Fed, the Congress, or the Administration, has the answers to the problems we face. We must work together. And I look forward to an open frank dialogue with the Federal Reserve, my subcommittee counterpart, Dr. Paul, and the Treasury Department on all these issues. And I yield back the balance of my time. " FOMC20060808meeting--10 8,MR. POOLE.," I’d like to put a question to you, but I want to do it in the form of an observation that I’d like you to comment on. It has to do with the inflation situation. Obviously, we are not in a situation anything remotely like that of the 1970s, but I do believe that we have very generalized inflation across sectors and across regions of the world. Let me support that statement in the following way. In the overall numbers, the core PCE is at or above 2 percent— or was in ’04 and ’05 and is projected for ’06 and ’07. So this number is for a four-year period— it’s not a little flash in the pan. The inflation projections abroad have been shaded up. I think you commented explicitly to that effect. Import and export prices are being revised up a bit. The revisions are not huge, but they are all in the same direction. Dollar depreciation would tend to promote higher prices. I’ve looked at the disaggregated CPI for the twelve months ending in June of this year versus the twelve months ending in June 2005—so it’s a year-over-year comparison. When we look at the components—I won’t go through all of them—we know what’s happening to owners’ equivalent rent. We know what is happening to the energy part of it. Household furnishings and operations are up; apparel is up. The major things going down are actually new vehicles and used vehicles, which are tending to hold the CPI down. Public transportation is up; medical care commodities are up; and there is a very small decline in medical care services. Other goods and services, communications, and recreation are all up. Education is up just a bit. The upward revision is very generalized across almost all sectors of the CPI. Then, on the cost side, we’re going to have this big upward revision in unit labor costs. By the way, were the unit labor costs released this morning?" CHRG-110shrg46629--77 Chairman Bernanke," I have talked about in the past what I called the global saving glut, which is basically the idea that outside the United States there is a huge amount of funds looking for returns. That includes reserves of China and other countries that have accumulated lots of reserves. But it also includes the profits from oil and commodity sales. And that is a lot of where the sovereign wealth funds are based on revenues from, say, oil sales. So a lot of that capital is looking for return, is looking for a home, and a lot of it is flowing into the United States. On net, I think that is beneficial because it provides capital for our economy. It does drive real interest rates probably lower than they might otherwise be. In terms of risk taking, the sovereign wealth funds, for the most part, are pretty passive investors. They are not active in switching between types of assets. They may sometimes have components which are more return-seeking, such as the Chinese, for example, have a component of their reserves fund that is more return-seeking. But for the most part they are pretty passive suppliers of capital. Senator Allard. They are going after security more than anything; is that right? " CHRG-111hhrg52397--16 Mr. Lucas," Thank you, Mr. Chairman, and Ranking Member Garrett, for holding today's hearing. Serving on this committee, as well as being the current ranking member on the House Agriculture Committee, I have had the opportunity to examine the various issues surrounding the role derivatives have played in the current financial crisis and have worked to respond to the need for more effective regulation. While better transparency and disclosure are needed within the industry, we must make sure that we create responsible legislation that does not impede appropriate legislation and risk management within the marketplace. Additionally, I believe we must work to ensure that the CFTC plays a leading role in appropriately regulating the derivatives and commodities market. The House Agriculture Committee recently reported a comprehensive bill aimed at addressing these regulatory concerns. I am prepared to use that experience to influence the discussion and the actions of this committee. I look forward to striking the proper balance as we craft the legislation that gives us that regulatory balance we need. I yield back, Mr. Chairman. " CHRG-110hhrg38392--134 Mr. Royce," Thank you very much, Mr. Chairman. We discussed that since 2000, we have seen stagnant wages for low skilled workers. Well, supply and demand are a reality, and certain business interests on the right want low skilled labor because it will drive down wages. They want more low skilled labor in the country. On the other end of the spectrum, there are those who believe in open borders for the disadvantaged. But the result of the policy is that until we have enforcement against illegal immigration, wages will lag. They are going to lag if you have massive illegal immigration of low skilled wages in the United States. You can't expect anything else to happen if you have 20 million people here illegally other than to have the pressures of supply and demand force down wage rates. Indeed that has happened since--well, for the last decade. To encourage monetary inflation, shifting to that subject, is to encourage a return of the boom and bust in a business cycle and to abandon a stable monetary unit. That is what I think the effect would be if we move towards the direction that didn't attempt to really control inflation. Now, Chairman Bernanke, as you know, in the past decade we have also seen unprecedented growth in the mortgage industry. If you went back to the 1960's, there was very little movement back then in home ownership rates until the development of technology and tools such as risk based pricing, which allowed lending institutions to more accurately calculate the risk associated with potential borrowers. As a consequence of that, in 2004, the home ownership rate went up to just under 70 percent, hitting record highs. Much of this growth which we had not seen in the decades prior was in a sector of the population which was previously locked out from obtaining mortgages, therefore, they rented instead of owning homes. For the most part, they had blemished credit, and they benefited greatly from the transformation in the industry as a result. As you know, the subprime lending market has come under tremendous scrutiny. Some believe we should rush to legislate. I believe we should approach this topic with tremendous caution. While deceptive lending practices should be prevented, I believe effective disclosure is the proper anecdote. Expanding liability to include secondary market participants for abusive loan originations would be a misguided policy. My fear is that if we overlegislate, which we have been known to do, it will prompt a credit crunch for Americans. I believe that the availability of credit has been good for consumers, by and large. The economy has benefited as a result, and any potential solution to concerns that have arisen should be very closely scrutinized. So Chairman Bernanke, I would like to get your thoughts on this issue and whether you believe an ill-conceived legislative fix will have any potential unintended consequences. Lastly, as you know, the outflow of capital from our markets has been discussed at length over the last few months. Much of the debate is centered around two major burdens faced by our public companies. One is cumbersome regulation and the prevalence of securities class action lawsuits. The threat of overregulation and overlitigation has caused many companies to reconsider listing on our public markets. This has resulted in a growth in the amount of capital in a private equity and hedge fund industry. So my second question, Chairman, is if our private equity and hedge fund industries are subjected to a sharp increase in regulation and taxation, what do you believe will be the end result? Thank you. " FinancialCrisisReport--506 Even before this email, Goldman’s sales force had been vocal in its criticism of Goldman’s low marks which were making their sales job more difficult. On June 21, 2007, Mr. Sparks stated in an email: “sales is making significant noise about gs notable conservatism in marking and haircuts.” 2163 Mortgage Department personnel dismissed such criticisms out of hand. One managing director responded: “Would have tho[ugh]t that bsam event [failure of Bear Stearns Asset Management hedge funds] would provide reasonable explanation as to why our marking and haircuts r ok.” Mr. Sparks replied: “Kind of stunning – but we are hearing it.” Goldman generally declined to offer any written explanations of its marks to clients, and rarely offered any financial accommodation or compromise regarding the marks or related collateral calls. 2164 On one occasion, when a sales representative asked about providing information about the 2162 2163 2164 Id. 6/21/2007 email from Mr. Sparks to Lester Brafman, “Repo,” GS MBS-E-010847490. The Subcommittee did identify at least one instance of a mark change. Goldman ’s China sales representative contacted the ABS Desk to request an increase in a mark on an RMBS security: “[C]an we try our best to show ‘better ’ indicative prices for [client]? ... [C]lient is under pressure of being questioned that they bought something looks really bad. ... [W ]e showed a price of LBMLT 06 A A1 as of 95-00 . . . this is something hard for client to believe .... [W]e need them to think of GS as the best firm, and we need them to be our best client when next biz boom comes. ... W e would highly appreciate if a slightly aggressive price can be showed from trading desk. ” 5/21/2007 email from China sales representative to Edwin Chin and others, “Mark to market prices,” GS MBS-E- 011068490. Mr. Chin moved the mark in question from 95 to 98, and wrote: firm’s CDO marks to a customer, Mr. Lehman wrote: “We cannot put this on paper - It concerns me they want something specifically in writing.” 2165 When told that other dealers had provided the customer with marks and a written description of their CDO pricing methodologies, Mr. Lehman responded: “Our marking policy is a market price (bid and/or offer) – We do not have a written methodology for pricing and we should tell them that.” 2166 In another instance, when a client asked for marks for the two prior months related to a CDO it was considering buying, Mr. Lehman wrote: “Verbal only .... Want to give them our tho[ugh]ts on market levels, not ‘marks.’” 2167 In his 2007 performance self-evaluation, the head of the SPG Trading Desk, Michael Swenson, wrote: “I spent numerous hours on conference calls with clients discussing valuation methodologies for GS issued transactions in the subprime and second lien space .... I said ‘no’ to clients who demanded that GS should ‘support the GSAMP’ program [Goldman RMBS securities] as clients tried to gain leverage over us. Those were unpopular decisions but they saved the firm hundreds of millions of dollars.” 2168 FOMC20081007confcall--47 45,MR. PLOSSER.," Thank you, Mr. Chairman. I'd just like to make a couple of observations and perhaps ask a question and make maybe one observation about language. As a general proposition, I do not like intermeeting cuts. I think they signal more panic than they do stability. On the other hand, I think this is an opportunity, given what the other central banks are doing, that might prove to be an exception to that. So I am reluctantly or modestly comfortable with this, however you want to characterize it, because I don't think that anything that we do today--cutting the funds rate 50 basis points or whatever--is going to make the next couple of months in terms of the overall economy any less painful. They won't be felt in the real economy for some time to come. They may provide some solace to the markets. I hope that they will. I wouldn't bet the ranch on that, but I do think that the coordinated effort might be helpful. I like in the statement the stressing of the point that, as you put it, this is based on a deteriorating economic outlook, and I think it is very important that we continue to emphasize that point as opposed to just volatility in the financial markets. So I feel that's very helpful. I have one question. President Yellen alluded to this, and I would like your thoughts on this, Mr. Chairman. Obviously, as we have been experiencing over the last year, things have seemed to change very rapidly at times, sometimes in surprising ways and in ways that we couldn't anticipate. But I have stressed in past meetings the importance for us of thinking not just about a funds rate decision on any given day or at any given meeting but about what we think the path should look like. So rather than just considering our action today, we obviously have a scheduled meeting coming up in a few weeks. Do you think that this is the precursor, as President Yellen suggested, to perhaps additional cuts, and where do you think a likely path might take us going forward, given that this is an intermeeting cut? My last comment has to do with the language, and I'd just like to make an observation about the sentence on inflation. It reads, ""Inflation has been high, but the Committee believes that the decline in energy and other commodity prices and the weaker prospects for economic activity have materially reduced the upside risks to inflation."" I guess I would make two observations, Mr. Chairman. One, that seems to be a much stronger statement about the reduction in the prospects for inflation than actually you gave in your speech today, where you emphasized that it had been reduced but that there continues to be lots of uncertainty and inflation continues to need monitoring. I would put on the table for discussion that we change the phrase ""materially reduced"" to these things have ""mitigated near-term upside risks to inflation."" Clearly commodity and oil prices have both mitigated the expectational channel for inflation in the near term. But I'm not necessarily convinced--and it's very model dependent--as to what inflation might do in the latter part of '09 and so forth. So I think that we should emphasize that the inflation risks for the near term have been mitigated as our rationale there. Thank you, Mr. Chairman. " FOMC20050630meeting--289 287,VICE CHAIRMAN GEITHNER.," Let me just follow this conversation a little further. If I get this right, what is new in the forecast, based on this conversation today, is that you’re anticipating a little more persistence in what we view as the underlying rate of the core PCE deflator. And it ends the forecast period higher than we previously expected. Again, that is in the context of a forecast where you’re expecting both oil and commodity prices—and import prices, too, I think—not to be a source of negative pressure. They constitute a sort of positive factor on the inflation dynamic. And you’re expecting structural productivity growth to stay fairly high. What is interesting, I think, is that you haven’t changed your implied path for the fed funds rate significantly. I guess my question is: Why is that? It’s not that your growth forecast has come down and is significantly softer. It’s not as if you’re substantially more pessimistic on the outlook for growth relative to potential. So why wouldn’t that view on inflation, if it’s right, have induced June 29-30, 2005 97 of 234" CHRG-110shrg50409--13 Chairman Dodd," I have a last question for you dealing with gasoline prices, and, again, let me first of all commend you because you did something different than your predecessor. In the past, we have excluded in the consideration of inflation gasoline or energy pricing and food. And if you do not drive a car, heat your home, or put food on the table, I suppose that has some relevance here. And I understand the macroeconomic value of excluding energy and food. But for average Americans, excluding those two necessities hardly reflects real inflation. And so the fact that you are now adding those to real inflation is very welcome, and I thank you for it. I wonder if you might comment briefly on the notion, how is it--and I understand your points about demand in the country and around the world and supply issues. But it strikes many of us here in the speculation area, and you said the need to look at transparency issues and the like are warranted. But it seems to me in 1 year's time to go from $60 or $70 a barrel to this morning I think it is hovering around $150 a barrel has to be explained in terms other than just normal economic pressures that it created. Does it concern you at all about margin requirements, for instance, in the area of speculation where the margin requirements are somewhat different in the area of energy pricing than they are for other commodities that there should be some leveling of the playing field when it comes to margin requirements, as an example of what might come as a response? " FOMC20070509meeting--49 47,MS. YELLEN.," Thank you, Mr. Chairman. My assessment of the economic outlook and the risks to it is largely unchanged since our last meeting. The data since that meeting have been mixed. On the one hand, the very sluggish real GDP growth in the first quarter gives me pause concerning potential downside risks. Much of the first-quarter weakness, of course, was due to housing, and I really don’t see that sector starting to turn around at this point. My homebuilder and banking contacts report stricter underwriting standards for all mortgages, not just subprime ones, so residential investment could remain a significant drag on the economy over the near term as the Greenbook now envisions. Indeed, whereas the Greenbook assumes that national house prices are flat going forward, I am worried that they may actually fall. On the other hand, the improved picture of auto inventories along with some positive glimmers on manufacturing and business investment suggests that those sectors may prove to be less of a drag on the economy going forward. With respect to inflation, the recent news has also been somewhat mixed with lower-than- expected readings on core consumer prices and labor compensation offset by higher prices for energy, other commodities, and imports. Taking a longer view, I anticipate real GDP growth over the next two and a half years of about 2.6 percent, just a bit below my assessment of potential. My forecasts of both actual and potential growth are a tenth or two stronger than the Greenbook forecasts; but the basic story is very similar, and the underlying assumptions, including the path for the nominal funds rate, are essentially the same. I view the stance of monetary policy as remaining somewhat restrictive throughout the entire forecast period. The key factors shaping the longer-term outlook include continued fallout from the housing sector, with housing wealth projected to be roughly flat through 2008. Given the reduced impetus from housing wealth, household spending should advance at a more moderate pace going forward than over the past few years. This slowdown in consumption is reinforced by more-moderate gains in personal income, as the unemployment rate gradually rises, reaching 5 percent in 2009. Although I anticipate that the labor market will remain fairly tight over the next year, I do not expect faster compensation growth to exert significant upward pressure on prices. I expect it instead to restrain profits, given that labor’s share of income is now at an exceptionally low level. I also anticipate that various temporary factors that have been boosting inflation, such as the run-up in owners’ equivalent rent and the pass-through of energy prices, should dissipate, while inflation expectations remain well anchored. Overall, I’m more optimistic regarding inflation than the Greenbook and anticipate that core PCE price inflation will edge down below 2 percent after next year. One of the more interesting questions about the outlook, as David noted in the questions to him, is how to reconcile the strong labor market performance with the weak growth in output or, equivalently, how much of the recent slowdown in productivity growth is likely to persist. And that is something that we have been thinking about, too. Over the four quarters of 2006, nonfarm business productivity rose 1.6 percent, about half as fast as the average pace set from 2000 through 2005. Whether these recent lower numbers reflect a transitory drop in growth or a downshift in the trend rate is an important issue. A lot of excellent research has been done on this topic by staff at the Board and elsewhere in the System. My reading of the evidence at this point is that the recent decline in productivity growth does largely reflect cyclical factors. I think productivity growth has fallen significantly below trend because of labor hoarding and lags in the adjustment of employment to output. We have also been giving close scrutiny to the behavior of the residential construction sector and productivity in that sector. My staff has done some work on estimating what productivity growth has been over the past year or so in residential investment and in the nonfarm business sector outside residential investment. They estimate that essentially all of last year’s slowdown in labor productivity growth is due to the behavior of productivity in residential construction. We estimate that residential construction productivity dropped 10 to 15 percent in 2006, whereas productivity in the nonfarm business sector outside residential investment was well maintained. Exactly why those lags exist, again, is a mystery to me as well as to David and others. But going forward, it seems to us that, as the adjustment lags work themselves out, residential construction employment will likely post significant declines, and productivity in that sector and the economy as a whole will rebound. That said, the pace of structural productivity growth may also have declined slightly as the Greenbook hypothesizes. Relative to the second half of the 1990s, both the pace of productivity growth in the IT sector and the pace of investment in equipment and software have slowed, and these factors have probably depressed trend productivity growth slightly in recent years and are likely to continue depressing it somewhat going forward. But the hypothesis that the recent decline in productivity growth is mainly structural does not seem to me to square well with the broad range of available evidence. Recall that in the 1990s there was a whole constellation of evidence—including a booming stock market, robust consumption, and rapid business investment—that was consistent with a hypothesis of a lasting increase in the rate of productivity growth. In contrast, over the past year or so, business investment in equipment has been very sluggish and more so than seems warranted by the deceleration in business output. So such weakness could reflect lower assessments by companies of their ability to improve productivity through the installation of new capital, and that is, I think, consistent with the lower trend of productivity growth. But you would think that a marked slowdown in secular productivity growth would also result in downward revisions to the expected paths of future profits and real wages, weakening equity market valuations and crimping consumption growth. I have seen no signs over the past year that household perceptions of their future wealth accumulation have been downgraded. In sum, the data seem consistent with the view that the recent slowdown in nonfarm business productivity represents a temporary cyclical drop that is concentrated in residential construction combined with a modest decline in the trend. So I remain optimistic that the underlying productivity trend is at or only slightly below 2½ percent." fcic_final_report_full--536 In the Triggers memo, based on his research, Pinto estimated that Fannie and Freddie purchased about 50 percent of all CRA loans over the period from 2001 to 2007 and that, of the balance, about 10-15 percent were insured by FHA, 10-15 percent were sold to Wall Street, and the rest remain on the books of the banks that originated the loans. 159 Many of these loans are likely unsaleable in the secondary market because they were made at rates that did not compensate for risk or lacked mortgage insurance—again, the competition for these loans among the GSEs, FHA and the banks operating under CRA requirements inevitably raised their prices and thus underpriced their risk. To sell these loans, the banks holding them would have to take losses, which many are unwilling to do. What are the delinquency rates? Under the Home Mortgage Disclosure Act HMDA), banks are required to provide data to the Fed from which the delinquency rates on loans that have high interest rates can be calculated. It was assumed that these were the loans that might bear watching as potentially predatory. When Fannie and Freddie, FHA, Countrywide and other subprime lenders and banks under CRA are all seeking the same loans—roughly speaking, loans to borrowers at or below the AMI—it is likely that these loans when actually made will bear concessionary interest rates so that their rate spread is not be reportable under HMDA. It’s just supply and demand. Accordingly, the banks that made CRA loans pursuant to their commitments have no obligation to record and report their delinquency rates, and as noted above several of the large banks that made major commitments recorded by the NCRC told FCIC staff that they don’t keep records about the performance of CRA loans apart from other mortgages. However, in the past few years, Bank of America has been reporting the performance of CRA loans in its annual report to the SEC on form 10-K. For example, the bank’s 10-K for 2009 contained the following statement: “At December 31, 2009, our CRA portfolio comprised six percent of the total residential mortgage balances, but comprised 17 percent of nonperforming residential mortgage loans. This portfolio also comprised 20 percent of residential net charge-offs during 2009. While approximately 32 percent of our residential mortgage portfolio carries risk mitigation protection, only a small portion of our CRA portfolio is covered by this protection.” 160 This could be an approximation for the delinquency rate on the merger-related CRA loans that the four banks made in fulfilling their commitments, but without definitive information on the number of loans made and the banks’ current holdings it is impossible to make this estimate with any confidence. In a letter from its counsel, another bank reported serious delinquency rates on the loans made pursuant to its merger-related commitments ranging from 5 percent to 50 percent, with the largest sample showing a 25 percent delinquency rate. 158 “Fannie Mae Passes Halfway Point in $2 Trillion American Dream Commitment; Leads Market in Bringing Housing Boom to Underserved Families, Communities” http://findarticles.com/p/articles/ mi_m0EIN/is_2003_March_18/ai_98885990/pg_3/?tag=content;col1. 159 160 Triggers memo, p.47. Bank of America, 2009 10-K, p.57. CHRG-111hhrg51698--110 Mr. Damgard," I think you have to trust the CFTC. There are spec limits on speculative traders that are not there for the hedgers. The CFTC has a pretty admirable history in making sure that these markets have worked as well as they have. Random speculation, or outrageous speculation, is something that, in my judgment, is left to the decision of the people in the Surveillance Department of the CFTC, and to legislate hard and fast rules, particularly as these markets expand, is pretty dangerous. We want speculators in these markets. We want hedge funds in the markets. We want pension funds in the markets. Clearly, an awful lot of the money that was made in the rise in the price of oil was pension funds and endowment funds that had deserted the equity markets. The people that manage those endowments recognized that there was more opportunity in the commodity area. There have been a lot of adjustments in our market since the advent of electronic trading. It used to be that certain markets, particularly when it was floor-based, were kind of a club. With electronic trading, everybody that has access and money to an account with a clearing member has the opportunity to invest in whatever they want to invest in. " FOMC20080430meeting--190 188,MS. PIANALTO.," Thank you, Mr. Chairman. My concerns about the real economy are similar to those that I had in March. I continue to believe that residential real estate markets could deteriorate even further than what I have in my baseline projection and could exert even greater downward pressure on business activity. Financial markets in my view are still fragile, and larger or more-widespread liquidity pressures could quickly present us with an even weaker set of economic fundamentals. At the same time, I can't easily dismiss the ongoing escalation of energy and commodity prices. Although many of us, as we talked about yesterday, have expected these price pressures to abate for some time, they have not; and as I indicated yesterday, I do believe there is a risk that core inflation will not follow the downward path that I submitted as my projection for this meeting. So like others, I can see a case being made for alternative C. However, I think a modest reduction to our policy rate today as a precaution against further slippage in the real economy is prudent. But I also strongly support the language that indicates we're very close to, if not at, a pausing point in our easing cycle. So I support the policy recommendation and the language in alternative B. Thank you. " fcic_final_report_full--211 Citi did have “clawback” provisions: under narrowly specified circumstances, compensation would have to be returned to the firm. But despite Citigroup’s eventual large losses, no compensation was ever clawed back under this policy. The Corporate Library, which rates firms’ corporate governance, gave Citigroup a C. In early , the Corporate Library would downgrade Citigroup to a D, “reflecting a high degree of governance risk.” Among the issues cited: executive compensation practices that were poorly aligned with shareholder interests.  Where were Citigroup’s regulators while the company piled up tens of billions of dollars of risk in the CDO business? Citigroup had a complex corporate structure and, as a result, faced an array of supervisors. The Federal Reserve supervised the holding company but, as the Gramm-Leach-Bliley legislation directed, relied on oth- ers to monitor the most important subsidiaries: the Office of the Comptroller of the Currency (OCC) supervised the largest bank subsidiary, Citibank, and the SEC su- pervised the securities firm, Citigroup Global Markets. Moreover, Citigroup did not really align its various businesses with the legal entities. An individual working on the CDO desk on an intricate transaction could interact with various components of the firm in complicated ways. The SEC regularly examined the securities arm on a three-year examination cycle, although it would also sometimes conduct other examinations to target specific con- cerns. Unlike the Fed and OCC, which had risk management and safety and sound- ness rules, the SEC used these exams to look for general weaknesses in risk management. Unlike safety and soundness regulators, who concentrated on prevent- ing firms from failing, the SEC always kept its focus on protecting investors. Its most recent review of Citigroup’s securities arm preceding the crisis was in , and the examiners completed their report in June . In that exam, they told the FCIC, they saw nothing “earth shattering,” but they did note key weaknesses in risk man- agement practices that would prove relevant—weaknesses in internal pricing and valuation controls, for example, and a willingness to allow traders to exceed their risk limits.  Unlike the SEC, the Fed and OCC did maintain a continuous on-site presence. During the years that CDOs boomed, the OCC team regularly criticized the com- pany for its weaknesses in risk management, including specific problems in the CDO business. “Earnings and profitability growth have taken precedence over risk man- agement and internal control,” the OCC told the company in January .  An- other document from that year stated, “The findings of this examination are disappointing, in that the business grew far in excess of management’s underlying in- frastructure and control processes.”  In May , a review undertaken by peers at the other Federal Reserve banks was critical of the New York Fed—then headed by the current treasury secretary, Timothy Geithner—for its oversight of Citigroup. The review concluded that the Fed’s on-site Citigroup team appeared to have “insufficient resources to conduct continuous supervisory activities in a consistent manner. At Citi, much of the limited team’s energy is absorbed by topical supervisory issues that detract from the team’s continuous supervision objectives . . . the level of the staffing within the Citi team has not kept pace with the magnitude of supervisory issues that the institution has realized.”  That the Fed’s  examination of Citigroup did not raise the concerns expressed that same year by the OCC may illustrate these prob- lems. Four years later, the next peer review would again find substantial weaknesses in the New York Fed’s oversight of Citigroup.  FOMC20080805meeting--179 177,MR. KROSZNER.," Thank you. I support no change, alternative B. As I mentioned before, I don't want to put the commodity price decreases and energy price decreases in the bank and say we don't have any problems going forward. But we also can't ignore them, and I think that does take off a bit of the pressure. It also manifests itself in some of the survey numbers and some of the market-based numbers in terms of expectations. So I think it allows a little more time, as someone said earlier, to be patient, to make the determination, given that I still think there are some very real downside risks, as I've mentioned. I think this type of statement will be largely consistent with market expectations, although I do think, and Brian can correct me, that this is one of the first times that we have made a very clear statement such as ""inflation has been high."" I think that's a bit of a change from where we have been. That's a much stronger acknowledgement of the inflation situation, which I think is appropriate to be acknowledging. But I do think that it may send a relatively strong signal to the market, and it makes me feel more comfortable about no change today with the statement because it shows a lot of concern about the level of inflation in actually characterizing it as high. Thank you, Mr. Chairman. " CHRG-111hhrg51698--292 The Chairman," The Committee will come to order. We have Members wandering in, but we will get started. We have three panels today, 15 total witnesses. So good morning and welcome to our second day of hearings on derivative legislation. We have a lot to get to, so I will try to be brief here. Yesterday, we had a very spirited discussions between Members and witnesses about the issues being considered in the draft legislation. I think that is a good thing and what I intended. We need to have this debate, we need to have it now, and we need to have it out in the open. It is important that we understand the concerns of those who think we are going too far, and from those who think we are not going far enough. Despite the fact that some of our witnesses yesterday took issue with some sections of the draft bill, I believe the consensus is that we need to take real steps to improve transparency and oversight of derivative markets whether they are on exchanges or over-the-counter. Today, we will continue the debate with three panels of witness representing financial exchanges, commodity groups, industry groups and investment companies. Since we do have so many witnesses testifying here today, I will ask you all to be brief. Your full written statements will be made part of the record. I welcome you to the Committee and appreciate you taking your time to be with us. [The prepared statement of Mr. Peterson follows:] Prepared Statement of Hon. Collin C. Peterson, a Representative in Congress from Minnesota Good morning, and welcome to our second day of hearings on derivatives legislation. We have three panels and fifteen total witnesses today and a lot to get to, so I will be very brief. Yesterday, we had a very spirited discussion between Members and witnesses about the issues being considered in the draft legislation. I think that's a good thing. We need to have this debate, we need to have it now, and we need to have it out in the open. It is important that we understand the concerns of those who think we are going too far, and from those who think we are not going far enough. Despite the fact that some of our witnesses yesterday took issue with some sections of the draft bill, I believe the consensus is that we need to take real steps to improve transparency and oversight of derivatives markets, whether they are on exchanges or over-the-counter. Today we will continue the debate with three panels of witnesses representing financial exchanges, commodity groups, industry groups, and investment companies. Since we do have so many witnesses testifying here today, I will ask you all to be brief, and your full written statements will be made part of the record. And now, I will to yield to Ranking Member Lucas for any opening remarks he may have today. " FOMC20070628meeting--197 195,CHAIRMAN BERNANKE.," Thank you. Well, we appear to be in considerable agreement about the policy action. [Laughter] It is a good thing, I guess. Not only are we in agreement, but also the bond market is in agreement. [Laughter] I would just note that, in fact, the bond market is acting as an automatic stabilizer, responding to news, as we have discussed before. I think we are in a very good place, and our forecasting process has served us very well. In that respect, I think this might be an appropriate time to congratulate the staff, including Dave Stockton, Karen Johnson, Vincent Reinhart, and the research directors at the Reserve Banks who are here, for their tremendous contributions to this process, which has really been instrumental in helping us find the right level of policy and in building a lot of credibility in the market. So thank you very much for your outstanding work. With respect to the statement also, I didn’t hear a lot of dissent. First of all, let me say that I think Governor Kohn’s amendments in section 3 are very much to the point— so that would be “a sustained moderation in inflation pressures.” First, the word “pressures” dilutes to some extent the attention to the monthly numbers. Second, as a number of people have said, it is a broader concept, and it can be construed as including some of the headline issues and the oil, commodities, and so on prices that we are concerned about. So I think it is definitely an improvement, and so I would like to recommend it. On section 2, just a couple things. One is that I would hesitate to try to indicate growing strength in the second half, for a couple of reasons. First, at least in terms of the Greenbook, that acceleration is relatively modest—certainly not at all a definite uptick. By continuing to use the language of “moderate pace,” I think we signal that we are not going to take the second quarter as necessarily indicating a new reacceleration of growth. We think that the second quarter represents, at least partly, a transitory increase in the growth rate. Second, Professor Minehan [laughter] was correct about the quality of writing in the section. The last statement began with the term “economic growth.” I am kind of ambivalent about whether or not to do this, but we could say, “Economic growth appears to have been moderate during the first half of this year, despite the ongoing adjustment in the housing sector.”" FinancialCrisisReport--348 A similar view as to why the CDO business continued to operate despite increasing market risk was expressed by a former executive at the hedge fund Paulson & Co. in a January 2007 email exchange with another investor. The Paulson executive wrote: “It is true that the market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytic tools nor the institutional framework to take action before the losses that one could anticipate based [on] the ‘news’ available everywhere are actually realized.” 1331 At the end of September 2006, the head of Deutsche Bank’s sales force, Sean Whelan, wrote to Mr. Lippmann expressing concern that some CDO tranches were getting increasingly difficult to sell: “[T]he equity and the AAA were the parts we found difficult to place.” 1332 Mr. Lippmann told the Subcommittee that once firms could not sell an entire CDO to investors, it was a warning that the market was waning, and the investment banks should have stopped structuring new ones. 1333 Instead of getting out of the CDO business, however, he said, a new source of CDO demand was found – when new CDOs started buying old CDO securities to include in their assets. One media report explained how this worked: “As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created – and ultimately provided most of the money for – new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those.” 1334 Research conducted by Thetica Systems, at the request of ProPublica, found that in the last years before the financial crisis, CDOs had become the dominant purchaser of high risk CDO securities, largely replacing real money investors like pension funds, insurance companies, and hedge funds. The CDO market analysis found that, by 2007, 67% of the high risk mezzanine CDO securities had been purchased by other CDOs, up from 36% in 2004. 1335 1331 1/14/2007 email from Paolo Pellegrini at Paulson to Ananth Krishnamurthy at 3a Investors, PAULSON ABACUS 0234459. 1332 9/27/2006 email from Sean Whelan to Greg Lippmann, DBSI_PSI_EMAIL02255361-63. 1333 Subcommittee interview of Greg Lippmann (10/18/2010). Mr. Lippmann told the Subcommittee that he thought Mr. Lamont’s CDO Group at Deutsche Bank had too many CDOs in the pipeline in the spring of 2007, when it could not sell all of its CDO securities. He reported that he told Mr. Lamont that defaults would increase. 1334 “Banks’ Self-Dealing Super Charged Financial Crisis,” ProPublica , (8/26/2010), http://www.propublica.org/article/banks-self-dealing-super-charged-financial-crisis. 1335 Id. ProPublica even found that, from 2006 to 2007, nearly half of all the CDOs sponsored by Merrill Lynch bought significant portions of other Merrill CDOs. CHRG-111hhrg63105--17 Mr. Gensler," Good afternoon. Thank you, Chairman Boswell, Chairman Peterson, Ranking Member Moran, Ranking Member of the full Committee, Congressman Lucas. I thank you for inviting me here to testify on behalf of the CFTC and I am pleased to be testifying along with Commissioner Chilton. Commissioner Chilton has been a real advocate that the markets that CFTC oversees work for all Americans, and he has been a leader in ensuring that we reestablish position limits in the energy and metals market and that they be extended to the swaps markets. Before I mention things on position limits, just let me update you on our work on implementing Dodd-Frank. We have been consulting extensively with fellow regulators and the public. I think the CFTC staff and I have met now--we keep a running count internally--over 300 times with fellow regulators. That would be 60 times a month with the SEC, the Federal Reserve and other regulators. We also are soliciting broad public input. We have had 7 days of public roundtables, usually with the SEC joining us. Additionally, many individuals of course want to come in and see us. We post these on our website to have transparency, and as of Monday there have been 460 such meetings from the public coming in to talk to us about these things. Thus far the Commission has moved forward with 30 proposals, and including some final rules and interim final rules and advance notices, the total count is 37 that we have published. We look forward to comments from the public. No doubt we will get tens of thousands of comments as we sort through this and we look forward to that. We have our eighth public meeting tomorrow where we plan to have two additional meetings in January in other key areas. With regard to position limits, the Dodd-Frank Act did expand the scope of the Commission's mandate to set position limits to include swaps, and I anticipate that we will consider staff recommendations tomorrow. These will include recommendations to include agricultural, energy and metals commodities. I also anticipate the staff's recommendation will be for position limits both for the spot month--this is when contracts are moving into delivery--as well as single months and all-months-combined. That is what Congress had asked us to look at, all three. We have asked staff to try to do this within one rule. The spot month limits are currently set are set in markets for energy, metals, and agriculture. We will be taking a look at 28 individual contracts. I think there are currently set in 26 of these contracts. In terms of the single month and all-months-combined limits, we currently have contract limits for most agriculture, and the staff will have some recommendations with regard to energy and metals as well. It is only with the implementation and passage of the Dodd-Frank Act, though, that the Commission has broad authority to collect information on the swaps market, as many Members have indicated. To this date we have really had very limited authority to collect data on the swaps market. We approved a rule in October on position reporting for physical commodity swaps that would allow us for the first time to collect data, more detailed data, on the swaps market. The comment period for that closed early December. Staff is currently looking through all those comments before we can finalize a rule on swaps data collection. This is different than the swaps data repository we actually put out. You might be--sometimes people call it large trader reporting, but we did put that rule out, as I say. Before I close, I just want to thank everybody here for your support on resources. I know that the House of Representatives did pass a continuing resolution. The Senate still is going to be taking up resources. The President's request of $261 million of resources for this fiscal year is very important. We think an estimate will be 300 to 400 new applicants, swap dealers, swap execution facilities, data repositories and the like that will be knocking on our doors, probably come next summer, for us to move forward. We estimate overall we will probably need about 400 more people. We are currently at about 680 people. With that, I look forward to your questions. I also look forward to your oversight. I think it is a very important part of our American system. It is also a good way that we can get these rules done and look forward to your advice and counsel. [The prepared statement of Mr. Gensler follows:] Prepared Statement of Hon. Gary Gensler, Chairman, Commodity Futures Trading Commission, Washington, D.C. Good afternoon, Chairman Boswell, Ranking Member Moran and Members of the Subcommittee. I thank you for inviting me to today's hearing on behalf of the Commodity Futures Trading Commission (CFTC).\1\ I am pleased to testify alongside my fellow Commissioner, Bart Chilton.--------------------------------------------------------------------------- \1\ Commissioner Bart Chilton did not participate in the approval of this testimony.---------------------------------------------------------------------------Implementing the Dodd-Frank Act Before I discuss the CFTC's rule-writing process with regard to position limits, I will update the Subcommittee on the CFTC's implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act is very detailed, addressing all of the key policy issues regarding regulation of the swaps marketplace. This Subcommittee's work on the Act should be commended. The Act reduces risk while promoting transparency in the swaps markets. To implement the Dodd-Frank Act, we have organized our effort around 31 teams who have been actively at work. Two principles are guiding us throughout the rule-writing process. First is the statute itself. We intend to comply with the statute's provisions and Congressional intent to lower risk and bring transparency to these markets. Second, we are consulting extensively with both other regulators and the broader public. We are working very closely with the SEC, the Federal Reserve, other prudential regulators and international regulators. To date, we have had more than 304 meetings with other regulators at the staff or Chairman's level. We also are soliciting broad public input into the rules. This began the day the President signed the Dodd-Frank Act when we listed the rule-writing teams and set up mailboxes for the public to submit their views directly. We also have organized seven public roundtables to hear on particular subjects. Last week we held a joint roundtable with the SEC and prudential regulators on issues related to capital and margin requirements for swaps. Additionally, many individuals have asked for meetings with the CFTC to discuss swaps regulation. As of Monday morning, we have had more than 466 such meetings. Just as Congress brought transparency to the swaps markets, the CFTC has added additional transparency to our rule-writing efforts. We are now posting on our website a list of all of our meetings, as well as the participants, issues discussed and all materials given to us. We are in the process of publishing proposed rules, using open Commission meetings for this purpose. So far, we have had seven public meetings. We have another meeting scheduled tomorrow during which the Commission will consider rules related to position limits, swap execution facilities, derivatives clearing organizations and business conduct standards. Thus far the Commission has approved 30 proposed rules, one final rule, two interim final rules and four advanced notices of proposed rulemaking. That does not include the four proposed rulemakings that the Commission will consider tomorrow. The Dodd-Frank Act requires the CFTC and the SEC to write rules generally within 360 days after the date of enactment. This means we have 213 days left for the majority of the rulemakings. In the case of position limit mandates, Congress had directed a more ambitious schedule.Position Limits RulemakingLegislative and Regulatory History Since 1936, the Commodity Exchange Act has prescribed position limits to protect against the burdens of excessive speculation, including those caused by large concentrated positions. Between the CFTC and the futures exchanges, there are currently position limits in the spot month on physical delivery contracts in the agricultural, energy and metals markets. There also are position limits in a number of financial contracts. In addition to these spot month limits, between federally-set position limits and those set by exchanges, there also are a number of agricultural contracts that have single-month and all-months-combined position limits. The exchanges had set all-months-combined limits in energy markets until 2001 and in metals markets earlier, after which the limits were replaced with position accountability regimes. The debate on the position limits provisions included in the Dodd-Frank Act began with actions taken by the House Agriculture Committee in the summer of 2008. According to the Committee report, the Agriculture Committee and this Subcommittee held six hearings with 44 witnesses on issues related to position limits. The House later passed H.R. 6604 in September 2008. The CFTC itself held three public meetings in the summer of July 2009 to gather further input from the public and Members of Congress regarding position limits for energy markets. In January 2010, the Commission published a proposed rule to set position limits on four energy contracts. In response to the proposal, the CFTC received more than 8,200 comments from the public. The CFTC announced the withdrawal of that proposal in August with plans to re-propose pursuant to the Dodd-Frank requirements. To be properly informed during the current rule-writing process, the Commission and staff are reviewing the comments received in response to the January rulemaking. The CFTC is scheduled to consider a new position limits rulemaking tomorrow. In March 2010, the Commission held an additional public meeting to consider the appropriateness of position limits in the metals markets. The public's views from that meeting and the comments that were later submitted also will be helpful as the Commission considers a proposed rulemaking on position limits in the metals markets. The CFTC does not set or regulate prices. Rather, the Commission is directed to ensure that commodity markets are fair and orderly. The January position limits proposal was intended to meet Congress's mandate and to promote market integrity. The CFTC is directed by statute to act in this regard to protect the American public. When the CFTC set position limits in the past, the agency sought to ensure that the markets were made up of a broad group of market participants with a diversity of views. At the core of our obligations is promoting market integrity, which the agency has historically interpreted to include ensuring markets do not become too concentrated. Position limits help to protect the markets both in times of clear skies and when there is a storm on the horizon. In 1981, the Commission said that ``the capacity of any contract market to absorb the establishment and liquidation of large speculative positions in an orderly manner is related to the relative size of such positions, i.e., the capacity of the market is not unlimited.''Dodd-Frank Requirements The Dodd-Frank Act requires the CFTC to set position limits for the following classes of contracts: futures; options on futures; and swaps that are economically equivalent to such futures or options. The Dodd-Frank Act also directs the Commission to set aggregate position limits for the following: contracts listed for trading on designated contract markets, contracts traded on a foreign board of trade providing persons in the U.S. with direct access that settle against the price of one or more contracts traded on a futures exchange or swap execution facility; and any other swap contracts that perform or affect a significant price discovery function with respect to regulated entities. The Act requires that the CFTC set the first set of position limits within 180 days of enactment for exempt commodities and within 270 days for agricultural commodities. The Commission has some additional flexibility with respect to the timing of the rulemaking for the aggregate limits. The Commodity Exchange Act exempts positions that are held as bona fide hedges from position limits. The Dodd-Frank Act provided further detail on the types of positions that fall in that category. End users and other persons with physical holdings in the energy and metals markets will not be limited in the amount or size of their positions that are entered into to hedge their physical purchases, holdings or sales. In establishing the limits for energy and agricultural commodities, the CFTC is required to set spot-month, single month and all-months-combined position limits to achieve the following goals: 1. diminish, eliminate or prevent excessive speculation; 2. deter and prevent market manipulation, squeezes and corners; 3. ensure sufficient market liquidity for bona fide hedgers; and 4. ensure that the price discovery function of the underlying market is not disrupted.Data Requirements The Commission is working to meet each of the deadlines included in the Dodd-Frank Act. Setting position limits in the swaps markets poses a unique challenge because of the market's opacity. Prior to the Dodd-Frank Act, the Commission had only limited authority to obtain data regarding the swaps market. The Dodd-Frank Act includes essential provisions to bring transparency in the markets to both regulators and the public. At this point, however, the Commission does not have the same comprehensive data for the swaps markets, including economically equivalent swaps, as it has for the futures markets. The Commission also currently has limited access to data on linked contracts traded on FBOTs through direct access by U.S. participants. The Commission has collected some data from swaps dealers since 2008, using special call authority to do so. However, additional data is required on the swaps markets to determine the size of the overall market in particular commodities, as well as the nature of the positions in this market. In particular, the Commission lacks data that would identify the extent to which positions are held for hedging or speculative purposes. On October 19, the Commission approved a proposed rulemaking on large trader reporting for physical commodity swaps. The proposal would require position reports on economically equivalent swaps from clearing organizations, their members and swap dealers. This would enable the CFTC to receive such data until swap data repositories are in operation and capable of fulfilling the Commission's need for this information. The comment period on the proposed rulemaking closed on December 2. In addition, large trader reporting will allow the Commission to gather data that could be used to determine appropriate position limits. The rule builds on the Commission's ongoing special call for data from swap dealers.Options for Position Limits Rulemakings CFTC staff is considering options to phase in implementation of the position limits rules as the agency obtains the necessary data regarding the swaps market. Staff is examining whether certain elements of the rule for which the Commission has substantial data can proceed on a more expedited timeframe, while leaving those aspects of the rule that depend upon additional data for later implementation. Staff is considering whether it would be possible to implement spot month limits sooner than the single-month or all-months-combined limits. The Commission could consider proposing single-month and all-months-combined position limits based on the open interest for futures, options and economically equivalent swaps. This is similar to the approach taken in the rulemaking that the Commission proposed in January. Open interest is currently used to establish position limits in the futures markets. Staff is reviewing an option that use data regarding open interest in the swaps markets to set hard aggregate limits. This approach would allow the Commission to hear from the public on the appropriate methodology for setting position limits while also allowing the Commission to collect additional swaps data through the large trader reporting regime. The actual hard limits would be applied when sufficient data becomes available. Currently, spot month limits for physically-settled futures contracts are generally set as some percentage of deliverable supply to prevent someone with a large position from cornering or squeezing the market as contracts move to expiration. In contrast, single-month and all-months-combined position limits have historically been set as a function of the overall size of the markets to guard against the burdens of excessive speculation.Resources Before I close, I will briefly address the resource needs of the CFTC. The futures marketplace that the CFTC oversees is approximately $40 trillion in notional amount. The swaps market that the Dodd-Frank Act tasks the CFTC with regulating has a far larger notional amount as well as more complexity. Based upon figures compiled by the Office of the Comptroller of the Currency, the largest 25 bank holding companies currently have $277 trillion notional amount of swaps. The CFTC's current funding is far less than what is required to properly fulfill our significantly expanded role. The CFTC requires additional resources to enhance its surveillance program, prevent market disruptions similar to those experienced on May 6 and implement the Dodd-Frank Act. The President requested $261 million for the CFTC in his Fiscal Year 2011 budget. This included $216 million and 745 full-time employees for pre-Dodd-Frank authorities and $45 million to provide \1/2\ of the staff estimated at that time needed to implement Dodd-Frank. The House of Representatives matched the President's request in the continuing resolution it passed last week. We are currently operating under a continuing resolution that provides funding at an annualized level of $169 million. To fully implement the Dodd-Frank reforms, the Commission will require approximately 400 additional staff over the level needed to fulfill our pre-Dodd-Frank mission. I again thank you for inviting me to testify today. I look forward to your questions. " FOMC20080109confcall--24 22,MR. ROSENGREN.," Thank you, Mr. Chairman. My views are actually very consistent with your own. I would support lowering the fed funds rate 50 basis points, and, if it were up to me, I would support doing it right now. The employment report last Friday was weaker than I expected. In conjunction with the likelihood of several quarters of economic growth below potential, the risk that the economy is in, or could be going into, a recession is too high. Continued declines in housing prices and stock prices raise my concern that deteriorating household wealth will constrain consumption more than we anticipate. I am also worried that weaker labor markets are likely to exacerbate problems in the housing market. Should housing prices fall further and foreclosures rise more rapidly as a result of weak labor markets, financial markets may experience even more turmoil than we have experienced to date. Commodity and oil prices have risen, but I expect that the weakening in labor markets will be sufficient to restrain inflation. The downside risks to the economy are significant, and I think we should take aggressive action to mitigate that risk. Thank you. " CHRG-111shrg54789--188 RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD FROM EDWARD L. YINGLINGQ.1. In assessing the need for and scope of a new Consumer Financial Protection Agency (CFPA), the Committee must conduct an objective evaluation regarding the responsibility of various types of financial services providers for the lending problems that have occurred in recent years. In your written testimony, you identify nonbank lenders as the source for the vast majority of abusive mortgage lending in recent years. Specifically you write that `` . . . the Treasury's plan noted that 94 percent of high cost mortgages were made outside the traditional banking system.'' Your testimony also says that `` . . . it is likely that an even higher percent of the most abusive loans were made outside our sector.'' On the other hand, the Committee heard testimony from Professor McCoy of the University of Connecticut on March 3, 2009, that such an assertion, ``fails to mention that national banks moved aggressively into Alt-A low-documentation and no-documentation loans during the housing boom.'' Professor McCoy cites data indicating that national banks and thrifts issued mortgage loans from 2006-2008 with higher default rates than State-chartered thrifts and banks. Moreover, Assistant Secretary Barr testified on the panel prior to you that ``about one-half of the subprime originations in 2005 and 2006--the shoddy that set off the wave of foreclosures--were by banks and thrifts and their affiliates.'' Is it your view that national banks and thrifts did not play a significant role, either directly or through their subsidiaries, in offering abusive or unsustainable mortgage loans?A.1. Thank you for your question, Mr. Chairman. Certainly, some banks--both national and State chartered--were involved in subprime lending, but the fundamental fact remains that the vast majority of banks in the country never made a toxic subprime loan. These regulated banks did not cause the problem; rather, they are the solution to the economic problem we face. The comment by Professor McCoy you cite in your question is not directed at the Treasury's statistic we referenced, i.e., that a very high percentage of high cost loans were made outside the banking industry. In fact, Professor McCoy refers to a study by the OCC which finds that national banks only accounted for 10 percent of subprime lending in 2006--thus confirming the evidence that the heart of the problem is with nonbanks. Even though attempts have been made to increase Federal regulation of the nonbank sector, the fact remains that in the key areas of examination and enforcement, nonbanks still are not regulated as strictly or robustly as banks. In fact, the GAO recently released a study on Fair Lending (July 2009) which found that the independent mortgage lenders represented ``higher fair lending risks than depository institutions'' yet ``Federal reviews of their activities are limited.'' Furthermore, GAO found that ``[d]epository institution regulators also have established varying policies to help ensure that many lenders not identified through HMDA screening routinely undergo compliance examinations, which may include fair lending components.'' This increased focus on insured depository institutions occurs because the banking agencies ``have large examination staffs and other personnel to carry out fair lending oversight.'' Traditional banks are the survivors of this financial crisis, not the cause. The fly-by-night nonbank mortgage lenders have disappeared as fast as they appeared. As I mentioned in detail in my written statement, the focus of policymaking should be on the core cause of the problem--the unregulated nonbank financial sector--and not end up punishing the very institutions that are most likely to restart our economy. ------ CHRG-110hhrg44903--5 Mr. Kanjorski," Thank you very much, Mr. Chairman. Today we continue our review of a systemic risk in financial markets. Although we passed the housing reform package yesterday, tremendous economic anxiety and uncertainty remain. Finding an effective regulatory regime to keep pace with increasingly complex financial products and markets remains our goal. Striking an appropriate balance to enhance protection against systemic risk is also a difficult task. For just as the markets continually change and evolve, so must regulation. The explosive growth of complex financial instruments is well-documented. Credit default swaps and collateralized debt obligations are just two examples of comparatively new exotic products flooding our markets. Warren Buffett famously labeled credit derivatives as ``financial weapons of mass destruction.'' Some may view his characterization as extreme. But allowing these risky creations to thrive in a thinly regulated or unregulated market is a recipe for disaster. So, in order to better understand these instruments, I sent 2 days ago a request to the Government Accountability Office that it begin a study on structured financial products. This study will examine the nature of these instruments and the degree of transparency and market regulation surrounding them. From this study, we should obtain a clearer picture of how to improve regulation in the sector of our financial system. Another area of regulation we should consider is the consolidation of regulation of our securities and commodities markets. The Treasury's recommendation to merge the Securities Exchange Commission and the Commodity Futures Trading Commission is something that ought to be discussed today. Such a merger illustrates the kind of streamlined regulatory system to which we should aspire. Additionally, last week's emergency order on naked short selling has received much attention. This committee is due an explanation as to the reason for the order, the effect to date on the market, its possible extension, and whether it will be expanded to broader market segments. I dare say it is something that the Commission should be commended for. I have seen the results and they seem to be quite clear that they aid the free flow of the market. Even to those of us who view short selling as a necessary provider of liquidity and market efficiency, naked short selling is worthy of closer scrutiny. People enter into trades with the expectation to complete them. In closing, both the Commission and the New York Federal Reserve have played crucial roles throughout the current financial crisis. I very much appreciate Chairman Cox and Mr. Geithner being here today, and I look forward to their testimony. " CHRG-110hhrg46591--50 Mr. Seligman," I think there are two different fundamental needs. First, you need some mechanism for investigating the relevant facts. And a challenge you have is because so many of the financial regulators were involved in regulation which has been called somewhat into question, how to create an independent mechanism. In 1987, after the stock market crashed then there were a number of reports. Some came from Congress. There was a particularly good one in that case that came from the Department of the Treasury. But one of the first things you should do is see if through Congress or otherwise you want to stimulate some sort of special study on a timeline which will be able to present to you a comprehensive report on what has happened. Second, and the point I stressed in my testimony, select committees, I think, are important for a different reason. Different congressional committees have different jurisdiction. To give you an illustration, this committee has a very broad ambit but it does not, for example, have within its scope the Commodities Futures Trading Commission, which reports to a separate committee. Given the urgency with which you should address financial futures and credit derivatives which have been not clearly allocated in our current regulatory scheme, a select committee would be a mechanism to a more comprehensive review. You could have everybody at the table hearing the same evidence and hopefully get to the appropriate resolution. " CHRG-111hhrg48674--144 Mr. Bernanke," That is a very good question and one we take very, very seriously. In the near term, inflation looks to be very low. In fact, we are seeing disinflation, so we don't see inflation as anything like a near-term risk. However, it is certainly the case that when the economy turns around, which it will, and begins to grow again, that in order to avoid inflation, the Fed will need to undo its balance sheet expansion, need to bring down these programs, or use other methods to sterilize the effects of our programs on the money supply. We understand that. We will look at it very carefully. That is one of the chief things we look at at our FMOC meetings. We want to be sure that whatever actions we take, which under the current circumstances will not be inflationary given how slack the economy is and how commodity prices have come down and so on, we want to be sure that when the time comes, we will be able to tighten appropriately to make sure that inflation does not in fact become a problem. I am entirely persuaded that stable prices are critical for long-term economic health, and we at the Federal Reserve are absolutely committed to assuring that. " FOMC20061025meeting--146 144,MR. FISHER.," I was just listening to Bill, and I consider us neither hawks nor sparrows nor doves. I hope that we’re being owlish, and that was a very owlish approach. But I’d like to come around to what Bill said, maybe in a different way. It struck me, Mr. Chairman, when I reflected last night on what I heard at the table yesterday, that on balance we sustained a barrage of attacks on the inflationary front. They came from energy. They came from commodity prices. They also came from potential shifts in the pricing behavior among business producers. And we’ve come out whole. I attribute this to our actions and our comportment and to the continued ability of the private sector to adapt and of private-sector producers and consumers to mine resources worldwide and through cyberspace as they’ve done so effectively. I know we’re doing a lot of work on that. It struck me particularly yesterday that we are not hearing anything about pricing power at this table. That was our preoccupation for a while. Not one person at the table mentioned it in the way it had been mentioned in the past several conversations. We are, however, continuing to hear about the availability and the cost of labor, and some of those costs, incidentally—such as the welders and Governor Kroszner’s show-up premium—are not going to be reflected in the data. The bottom line is that I think we’ve made substantial progress. But I think we have to be very mindful, Mr. Chairman, about perception if we’re to influence what really counts, which is inflationary expectations, and about whether those expectations are measured accurately by TIPS spreads, which I personally doubt. One need look no further than this morning’s Financial Times editorial or Bill Gross’s recent client letter—I’ve known Gross for twenty years, and I know he’s an oddball. Actually, I’d like that word struck from the record. [Laughter]" CHRG-111hhrg51698--75 Mr. Buis," Well, thank you, Congressman. I was enthralled by the debate that was going on here, and certainly trying to follow along on those credit default swaps. Things on the farm are not good, and this deregulatory approach, or the lack of oversight by CFTC, has led to it. Farmers thought they were going to get good prices. They were precluded from the market, and Mr. Damgard is right, they ran up against their credit limits. But what they don't tell you is that those markets were going up, not because of market fundamentals, but because of the tremendous amount of Wall Street money that came into those markets. And everyone saw this as a great opportunity to make money. As a result, you gave false hopes to the grain farmers that they were going to get these prices. They were precluded. You gave false hopes or big scares to the livestock industry because they thought the prices were going to continue to go higher and higher, so they locked in feed costs. You gave false hope to the ethanol industry, the biodiesel industry, all the processors that, to hedge themselves, they paid higher prices because the big fear was that it was going to continue. And when the bubble burst, and when commodity prices collapsed, it has virtually impacted every aspect of agriculture. " FOMC20081216meeting--177 175,MR. STOCKTON.," My guess is that, if our baseline forecast evolves in the way we are expecting here, you are still going to be worried about the downside risk to inflation even if, in fact, we were in the process of bottoming out because there will still be a very substantial output gap. On the commodity price side, things are fairly stable, and at least in our forecast, inflation expectations are probably drifting down some. On the other hand, there are upside risks to that inflation forecast as well. I do actually think that our baseline forecast, on the assumptions that we have had to make in constructing it, is reasonably well balanced because another possibility is, in contrast to the gradual downtrend that we're expecting in inflation expectations, that inflation expectations will be stickier, you will be able to convey a greater sense that you wouldn't want inflation over the longer haul moving down below 1 percent, we won't get as much disinflation into inflation expectations or into labor costs, and you'll get greater stability there than we're expecting. So to my mind, looking ahead, monitoring how those inflation expectations evolve in the context of an economy where things are weakening will be very important. " FOMC20060328meeting--90 88,MS. YELLEN.," Okay. I guess my view is that it’s a risk, but at the moment, by various measures, we’re pretty close to, not beyond, full employment. The unemployment rate has declined unusually rapidly over the last year, but a simple Okun’s law calculation—and I think that the staff has commented on this in the past, if I’m not mistaken—would assess the decline we’ve seen in the unemployment rate during 2005 as especially large, given what output growth was. In that sense, the unemployment rate is now giving us a reading of less slack in the economy than we would get from other indicators. Our forecast is that the mysterious decline in the unemployment rate last year will be reversed so unemployment will hold steady, even with growth at the magnitude that the Greenbook is projecting (around 3¾ percent). That’s what the error-correction mechanism is about. So I’m optimistic about inflation because I see us ending 2006 at roughly full employment, with the unemployment rate in the vicinity of its current level. I’m also optimistic about inflation because we’ve been persuaded that since the 1980s we’ve seen very little pass-through of energy- price increases into core inflation. That has been a source of considerably more optimism on our part than on Greenbook’s part in that it continues to project pass-through of energy and commodity prices into core inflation through 2006." fcic_final_report_full--118 As the United States ran a large current account deficit, flows into the country were unprecedented. Over six years from  to , U.S. Treasury debt held by foreign official public entities rose from . trillion to . trillion; as a percentage of U.S. debt held by the public, these holdings increased from . to .. For- eigners also bought securities backed by Fannie and Freddie, which, with their im- plicit government guarantee, seemed nearly as safe as Treasuries. As the Asian financial crisis ended in , foreign holdings of GSE securities held steady at the level of almost  years earlier, about  billion. By —just two years later— foreigners owned  billion in GSE securities; by ,  billion. “You had a huge inflow of liquidity. A very unique kind of situation where poor countries like China were shipping money to advanced countries because their financial systems were so weak that they [were] better off shipping [money] to countries like the United States rather than keeping it in their own countries,” former Fed governor Frederic Mishkin told the FCIC. “The system was awash with liquidity, which helped lower long-term interest rates.”  Foreign investors sought other high-grade debt almost as safe as Treasuries and GSE securities but with a slightly higher return. They found the triple-A assets pour- ing from the Wall Street mortgage securitization machine. As overseas demand drove up prices for securitized debt, it “created an irresistible profit opportunity for the U.S. financial system: to engineer ‘quasi’ safe debt instruments by bundling riskier assets and selling the senior tranches,” Pierre-Olivier Gourinchas, an economist at the Uni- versity of California, Berkeley, told the FCIC.  Paul Krugman, an economist at Princeton University, told the FCIC, “It’s hard to envisage us having had this crisis without considering international monetary capital movements. The U.S. housing bubble was financed by large capital inflows. So were Spanish and Irish and Baltic bubbles. It’s a combination of, in the narrow sense, of a less regulated financial system and a world that was increasingly wide open for big international capital movements.”  It was an ocean of money. MORTGAGES: “A GOOD LOAN ” The refinancing boom was over, but originators still needed mortgages to sell to the Street. They needed new products that, as prices kept rising, could make expensive homes more affordable to still-eager borrowers. The solution was riskier, more ag- gressive, mortgage products that brought higher yields for investors but correspond- ingly greater risks for borrowers. “Holding a subprime loan has become something of a high-stakes wager,” the Center for Responsible Lending warned in .  Subprime mortgages rose from  of mortgage originations in  to  in .  About  of subprime borrowers used hybrid adjustable-rate mortgages (ARMs) such as /s and /s—mortgages whose low “teaser” rate lasts for the first two or three years, and then adjusts periodically thereafter.  Prime borrowers also used more alternative mortgages. The dollar volume of Alt-A securitization rose almost  from  to .  In general, these loans made borrowers’ monthly mortgage payments on ever more expensive homes affordable—at least initially. Pop- ular Alt-A products included interest-only mortgages and payment-option ARMs. Option ARMs let borrowers pick their payment each month, including payments that actually increased the principal—any shortfall on the interest payment was added to the principal, something called negative amortization. If the balance got large enough, the loan would convert to a fixed-rate mortgage, increasing the monthly payment—perhaps dramatically. Option ARMs rose from  of mortgages in  to  in .  CHRG-111hhrg51698--2 The Chairman," The Committee will come to order. We have Members coming in. We don't have votes until 6:30, so I appreciate the Members making an effort to come back. I think we will have more Members joining us. Good afternoon to everybody, and welcome to today's hearing on derivatives legislation. For those on the Committee who were here in the 110th Congress, today's hearing will cover many of the issues and topics considered during the nine hearings held last year on this subject. The effort to strengthen oversight and improve transparency in derivatives markets, whether regulated or unregulated, whether they are physically based commodities or financial commodities has been a top priority of this Committee. For those of you who are new to the Committee, welcome to the fire. Members and staff have been working hard on this issue since the last Congress adjourned, and it is my intent to move expeditiously this month; because every day we delay is another day where markets operate without the oversight or transparency they desperately need. Last year, we began our journey with extensive public hearings on the issue of speculation, lack of convergence, lack of effective oversight, and increased transparency of derivative markets. The result of those hearings was a strong bipartisan bill that had more than \2/3\ majority when it passed the House last September. We will continue this effort in the 111th Congress, but this time with new provisions resulting from the hearings we held late last year on the role of credit derivatives in the economy after the collapse of large financial institutions that were heavily engaged in the over-the-counter derivatives transactions and market. The language that I circulated last week, and that this Committee will be discussing, contains provisions similar to last year's bipartisan bill. It will strengthen confidence and trader position limits on all futures markets as a way to prevent potential price distortions caused by extensive speculative trading. It would close the so-called London loophole by requiring foreign boards of trade to share trading data and adopt position limits on contracts that trade U.S. commodities linked to U.S.-regulated exchanges. It would direct the CFTC to get a clearer picture of the over-the-counter markets, and it calls for a new full-time CFTC staff to improve enforcement, prevent manipulation, and prosecute fraud. This proposal would bring a sense of order to the over-the-counter market by requiring transparent central clearing for all OTC derivatives. The legislation contemplates multiple entities, whether regulated by the CFTC, the SEC, or the Federal Reserve, offering clearing services for the market. In that sense, it is modeled after the current law. However, the bill requires these clearing entities to follow the same set of core principles in their operations as a means of avoiding regulatory arbitrage. The failures of AIG, Lehman, Bear Stearns, and other institutions have shown us that it is time for some transparency in the market for credit derivatives. The way for us to identify and reduce the risk out there is to facilitate clearing it. The draft bill provides the CFTC with authority to exempt some derivatives from clearing in recognition of the fact that not every OTC trade is suitable for clearing. However, those seeking to remain in the derivatives business without clearing will have to report their actions and demonstrate their financial soundness. In the debate over credit derivatives, there has been much discussion about choosing the proper regulator, whether it is the CFTC, the SEC, or the Fed. I have made it clear that I believe the CFTC is the agency that has the knowledge and the expertise in these markets. I am flat-out opposed to the Fed having a role in clearing or overseeing these products. If I could have my way, the Fed would not be involved. However, that is probably not a political reality of today, and the draft legislation reflects that. The Federal Reserve is an independent banking system, not a police officer of derivatives transactions. I share the concerns of those who think the Fed controls too much already. They are an unelected body that sets monetary policy, oversees its state member banks, oversees holding companies, and now they are printing money for the bailout. I am not surprised that the large banks are clamoring for the Fed to regulate derivative activity, given their cozy relationship with Fed members. Plus, they probably think it is a good idea to have a regulator with resources to bail them out if things go wrong. I am also strongly opposed to allowing the SEC to have primary authority over these contracts. The SEC uses a rules-based system that is behind the curve of today's modern, complex financial products and in my opinion is just not workable. They are not just trying to solve yesterday's problems or last week's problems; they are still trying to solve the last decade's problems. As a result, they have done a poor job. How much confidence can we have in an agency that repeatedly ignored calls even from within its own agency to examine the investment advisory business of Bernard Madoff, which turned out to be the biggest Ponzi scheme in history? They gave them a road map as to what was going on; and they missed it. They even missed the red flags in their oversight of Bear Stearns, as was detailed in a report by the SEC Inspector General. Other people are trying to use the problems of credit default swaps as an argument to create a super financial regulator. However, in my opinion, taking something that is working, like the CFTC oversight of the futures market, and moving it to another place where things are not working is, frankly, crazy. To name a financial czar or a single super-regulator over the whole thing is an even worse idea and has the potential to create financial markets' version of the Department of Homeland Security, which a lot of us don't want to see happen. So I don't want to even imagine the problems that we would create if we would go down that avenue. So as this Committee moves forward on this matter, we will continue to work on a bipartisan basis on this bill. We will do our work out in the open, and we will listen to any and all who want to comment. That is what we did with the farm bill, with the reauthorization of the Commodity Exchange Act and with our examination of speculation. The result of that approach was passage of strong bipartisan legislation last Congress that had the support of the Ranking Member at the time, Mr. Goodlatte, and it received \2/3\ of the vote in the House. This is must-pass legislation, in my view, which is why we need to move quickly; and that is why I have circulated this language, and why we are holding these hearings today and over the next couple of weeks. So I welcome all of today's witnesses and the Members to the hearing. I look forward to their testimony. [The prepared statement of Mr. Peterson follows:] Prepared Statement of Hon. Collin C. Peterson, a Representative in Congress From Minnesota Good afternoon and welcome to today's hearing on derivatives legislation. For those on the Committee who were here in the 110th Congress, today's hearing will cover many of the issues and topics considered during the nine hearings held last year on this subject. The effort to strengthen oversight and improve transparency in derivative markets, whether regulated or unregulated; whether they are physically based commodities or financial commodities has been a top priority of this Committee. For those of you who are new to the Committee, welcome to the fire. Members and staff have been working hard on this issue since the last Congress adjourned and it is my intent to move expeditiously this month because every day we delay is another day where markets operate without the oversight or transparency they desperately need. Last year, we began our journey with extensive public hearings on the issue of speculation, lack of convergence, lack of effective oversight, and increased transparency of derivatives markets. The result of those hearings was a strong, bipartisan bill that had more than a \2/3\ majority when it passed the House last September. We will continue this effort in the 111th Congress, but this time with new provisions resulting from the hearings we held late last year on the role of credit derivatives in the economy after the collapse of large financial institutions that were heavily engaged in OTC derivative transactions. The language that I circulated last week and that this Committee will be discussing contains provisions similar to last year's bipartisan bill. It would strengthen confidence in trader position limits on all futures markets as a way to prevent potential price distortions caused by excessive speculative trading. It would close the so-called London Loophole by requiring foreign boards of trade to share trading data and adopt position limits on contracts that trade U.S. commodities linked to U.S.-regulated exchanges. It would direct the CFTC to get a clearer picture of the over-the-counter markets, and it calls for new full-time CFTC staff to improve enforcement, prevent manipulation, and prosecute fraud. This proposal would bring a sense of order to the over-the-counter market by requiring transparent, central clearing for all OTC derivatives. The legislation contemplates multiple entities, whether regulated by the CFTC, the SEC, or the Federal Reserve, offering clearing services for market. In that sense, it is modeled after current law. However, the bill requires these clearing entities to follow the same set of core principles in their operations, as a means to avoid regulatory arbitrage. The failures of AIG, Lehman, Bear Stearns, and other institutions have shown us that it is time for some transparency in the market for credit derivatives. The way for us to identify and reduce the risk out there is to facilitate clearing it. The draft bill provides the CFTC with authority to exempt some derivatives from clearing, in recognition of the fact that not every OTC trade is suitable for clearing. However, those seeking to remain in the derivatives business without clearing will have to report their actions and demonstrate their financial soundness. In the debate over credit derivatives, there has been much discussion about choosing the proper regulator; whether it is the CFTC, the SEC, or the Fed. I have made it clear that the CFTC is the agency that has the knowledge and expertise in these markets. I am flat opposed to the Fed having a role in clearing or overseeing these products. If I could have my way, the Fed would not be involved; however that is not the political reality of today, and the draft legislation reflects that. The Federal Reserve is an independent banking system, not a police officer of derivatives transactions. I share the concerns of those who think the Fed controls too much already. They are an unelected body that sets monetary policy, oversees its state member banks, oversees holding companies, and now they are printing money for the bailout. I am not surprised that the large banks are clamoring for the Fed to regulate derivative activity, given their cozy relationship with Fed members. Plus, they probably think it is a good idea to have a regulator with the resources to bail them out when things go south. I am also strongly opposed to allowing the SEC to have primary authority over these contracts. The SEC uses a rules-based system that is behind the curve of today's modern, complex financial products and is just not workable. They are not just trying to solve yesterday's problem or last week's problem; they are still trying to solve last decade's problem. As a result, they have done a poor job. How much confidence can we have in an agency that repeatedly ignored calls, even from within its own agency, to examine the investment advisory business of Bernard Madoff, which turned out to be the biggest Ponzi scheme in history, having cheated an untold number of investors, charities, and foundations out of billions; or that missed the red flags in its oversight of Bear Stearns, as was detailed by a report from the SEC Inspector General? Other people are trying to use the problems with credit default swaps as an argument for creating a super financial regulator. However, in my opinion, taking something that is working, like CFTC oversight of the futures markets, and moving it to another place where things are not working is just crazy. To name a financial czar or single super regulator over the whole thing is an even worse idea that has the potential to create a financial markets version of the Department of Homeland Security. I don't want to even imagine the kind of mess that would create. As this Committee moves forward on this matter, we will continue to work on a bipartisan basis on this bill, and we will do our work out in the open and listen to any and all who want to comment. That is what we did with the farm bill, with reauthorization of the Commodity Exchange Act, and with our examination of speculation. The result of that approach was passage of strong bipartisan legislation last Congress that had the support of the Ranking Member at the time, Mr. Goodlatte, and achieved \2/3\ votes in the House. This is must-pass legislation, in my view, which is why we need to move quickly. That is why I have circulated this language and why we will be holding hearings over the next 2 weeks. I welcome today's witnesses and I look forward to their testimony. At this time I would like to yield to Ranking Member Lucas for an opening statement. " FOMC20060328meeting--247 245,MS. YELLEN.," Thank you, Mr. Chairman. I think overall we are in a good position at this point with the economy essentially at full employment and growth homing in on potential, which will, I hope, hold unemployment roughly steady. Core inflation is pretty steady although, at least by several measures and particularly the core PCE, it is in the top half of the range that I would like to see. But I agree with Governor Kohn that this is a matter that we should consider. What index, and where it is relative to what we would like, bears further thinking about. If you take inflation to be in the top half of a comfort range as opposed to the middle, an optimal policy setting would place the funds rate toward the upper end of a neutral range or would be minimally restrictive. I say “minimally” because we are at most a little above the middle of the so-called comfort range and also because the various rules presented in chart 7 of the Bluebook suggest that the appropriate response of policy to a deviation of inflation from the middle of the range is actually quite small. If inflation were to decline, say, 50 basis points, from 2 percent to 1½ percent, the response, according to most of the rules in the table, of the fed funds rate to that deviation is on the order of 25 or 30 basis points. So it is sort of a one-policy-move difference. At this point, it seems to me, policy is pretty close to appropriately positioned. In terms of risk assessments, I share Governor Kohn’s concern about the possibility that growth won’t actually slow to a sustainable pace and so the economy may overheat. But I am also concerned about overshooting, in part because the delayed effect of our policy actions may show up especially in the housing sector with greater force than we expect and we are a little uncertain— David mentioned this yesterday—about just what the spillovers might be to consumer spending via balance sheet effects or wealth effects. I think we do need to be sensitive to the possibility of overshooting, and here I would endorse President Hoenig’s comments on that. So I can certainly support a 25 basis point tightening today coupled with some slight policy inclination for further firming. But I would not like to do anything to boost the market’s perceptions of the likely ending point of the cycle. I’m not sure what the best way is to accomplish that. I had first found myself having some preference for using the alternative language suggested for B that would say that some modest additional policy firming may be needed. But I am not sure that is the right way to go. As I look forward, I share the concern that a number of you have expressed—that as we get to the May meeting we are going to find not only that markets expect us to go another 25 but also that an additional 25 will be priced into the market. And it seems to me that the construction of our statement raises the likelihood that markets are going to continue to build in expectations for moves beyond 5 percent. Let me explain in part what I’m worried about. I am worried about the way in which line 3 of alternative B characterizes our concerns about energy and commodity prices. As I looked at the new Bluebook handout that Vince just gave us, I liked the change that has been made in line 2 where it says that the economic growth has rebounded but in effect then adds, “But look, in our Committee forecast, we wanted to let you know we’re expecting really strong numbers for Q1, but we think it is then going to moderate to a more-sustainable pace.” Now, we might have tried to do the same thing in line 3, but unfortunately we didn’t. We don’t state what our forecast is to give markets a reasonable way to judge incoming data. Let me get a bit more specific about what I mean. Consider the Greenbook forecast for core PCE inflation for the remainder of this year. I’m more optimistic than the Greenbook is, but the Greenbook forecast is that, for the remainder of this year, core PCE inflation is going to come in at 2.2 percent, which is certainly above the top end of the comfort range that I or anyone else who has opined on this has suggested. So what will the market response be if the Greenbook forecast actually materializes? It seems to me that the Greenbook projects that the uptick would be temporary, so we needn’t respond. But the statement in B essentially says, “Look. The run-up in energy prices has had only a modest effect on core inflation.” In effect, it says we continue to think that that will be the way the world transpires, and in the end I think it says that we regard it as an upside risk to our forecast that elevated prices of energy and other commodities have the potential to add to inflation pressure. So if, in point of fact, the Greenbook is right and we start seeing 2.2 for core PCE, what will markets conclude? “Yes, this is what they’re worried about. They’re really worried that an upside risk to their inflation forecast is that inflation is going to come in this high. What are we to conclude other than that this is a negative surprise to the Committee, and therefore they are going to go above 5 percent?” So we have told market participants in line 2, “Don’t be surprised if you see a very strong growth number in Q1. We think that’s temporary. It’s going to abate.” What we haven’t told markets is the comparable thing, namely, that we may well see a boost in core PCE inflation for the next couple of quarters, but we think it is temporary. One thing that we could do would be to change the phrasing and say in line 3 that the elevated prices of energy and other commodities may boost core inflation modestly for a time. That would distinguish this from the case of rising inflation due to resource utilization, which we do see as an upside risk to our forecast. But generally whether or not we make this change, I am concerned that we are going to see more increases priced into fed funds futures, and I would cheerfully endorse the kind of move that has been made in this draft of alternative B, in which the Committee’s forecast for growth has been clearly enunciated. And moving in that direction for our baseline forecast for inflation would be a useful way to go as well. If I could just spend one more second, I would like to propose a bit more wordsmithing in alternative B. A principle, or a practice, that I learned at the Council of Economic Advisers that I think would be a good one for us is that you never make a statement that purports to be a statement of fact unless it can be fact-checked. [Laughter] This process is rigorous there. I would say the first statement in line 3—“as yet the run-up in the prices of energy and other commodities has had only a modest effect on core inflation”—is not fact-checkable. I believe that’s the case. I think most of you believe that’s the case. I wouldn’t want to have to fact-check it. I don’t know how you would do it. I would add something like “has apparently had only a modest effect on core inflation.” The point about the fact that productivity gains have held the growth of unit labor costs in check, I don’t personally mind that at all. I agree with that. I simply think that it is not the only thing—arithmetically modest compensation gains have done the same thing. So I do not mind listing it, but I would say “have helped.”" FOMC20080430meeting--121 119,CHAIRMAN BERNANKE.," Thank you, and thank you all for very helpful comments. As usual, let me briefly summarize what I heard today and then make a few comments of my own. Again, in summary, data since the March meeting have been soft, and economic activity is weak. But the recent news has not generally been worse than expected. There was disagreement over whether we are technically in a recession. Most saw improved economic growth in the second half of 2008 with further improvement in 2009, although some saw more-protracted weakness. The housing sector remains weak, though there were reports of improvement. Starts and the demand for new houses continue to decline. Prices are falling. Inventories of unsold homes remain very high. Housing demand is affected by restrictive conditions in mortgage markets, fears that house prices have much further to fall, and weakening economic conditions. Retail sales, sentiment, and consumer spending have generally been soft, reflecting a long list of headwinds, including tightening credit, weaker house prices, and higher energy prices. Payrolls are falling, although there are some pockets of strength. Unemployment is likely to keep rising. It may remain somewhat high into 2010. We will soon see whether the fiscal stimulus package affects either the consumer or business investment plans. Possibly, liquidity-constrained consumers may respond more strongly than normally. Business sentiment is also relatively weak, reflecting in part credit conditions but also the uncertain prospects for the economy and continued cost pressures. Investment has softened somewhat, including declines in commercial real estate investment. Strength in foreign markets is helping support U.S. production and profits, especially manufacturing, although foreign economies may slow in the coming quarters. The energy and agricultural sectors are strong. Financial conditions have improved in the past month, with financing conditions better, credit risk spreads coming in a bit, and both equities and real interest rates up since the last meeting. Decent earnings, a sense on the part of some that the bulk of the write-downs in the banking sector have been taken, the ability of financial institutions to raise capital, and possibly Fed actions, including liquidity provision and the actions regarding Bear Stearns, have contributed to the improvement. On the other hand, many markets remain fragile, including the key interbank market and other short-term funding markets. Some expressed the view that moresignificant write-downs and financial stress lie ahead, as house prices continue to fall and the slowing economy weakens credit quality, and that the full impact of tighter credit has not yet been felt in the nonfinancial economy. Others, however, were less concerned about the real effects of the financial conditions. Financial conditions and the housing market probably remained the most important downside risks to growth, although energy prices were also cited. Readings on core inflation were moderate in the intermeeting period, although some of the reasons for improvement may be transitory. Oil prices have continued to move up, contributing to higher headline inflation. Other commodity prices have also begun to rise again. Many firms noted these strong cost pressures and indicated some ability to pass those costs along to consumers. Inflation breakevens showed improvement at some horizons since the March meeting, possibly reflecting lower risk premiums, though survey inflation expectations were higher. The dollar appreciated during the intermeeting period, but longer-term depreciation and rising import prices remain another source of pressure on inflation. Nominal wage gains remain moderate, however, and markups are high. Uncertainty about the course of oil and other commodity prices adds to overall inflation uncertainty and perhaps to inflation risks that are now somewhat more to the upside. Many participants expressed concerns about these upside risks, about inflation expectations, and about the maintenance of the Fed's inflation-fighting credibility. Any comments? Let me just add a few thoughts to what has already been said. On the real side, I think that I am probably somewhat more pessimistic than the median view that I heard around the table. First of all, I am reasonably confident that we are in a recession. We don't see these dynamic patterns of employment, sentiment, and so on without a recession being eventually called by the NBER. That fact, I believe, raises the risks of more-rapid declines in employment and consumer spending in the months ahead because there seem to be somewhat more-adverse dynamics in a recession scenario. Second, I remain concerned about housing, which is not showing really any significant signs of stabilization. Mortgage markets are still dysfunctional, and the only source of mortgage credit essentially is the GSEs, which are doing their best to raise fees and profit from the situation. Sales of new homes remain weak. Inventories of unsold homes are down in absolute terms, but they still are very high relative to sales. We heard this morning of yet even faster price declines for housing. As I've said several times at this table, until there is some sense of a bottoming in the housing market and in housing prices, I think that we are not going to see really broad stabilization, either in the economy or in financial markets. Now, there are some positives--exports, for example--which have kept manufacturing and other industries from declining as much as usual during a recession. Interestingly, this could be a mirror image of the 2001 recession. In 2001, the business sector was weak, and consumption and housing were strong. We could have the mirror image this time. In financial markets, there certainly have been improvements, and that is certainly encouraging. I agree with people about that. But we have heard a few people in the market say that credit losses and write-downs are in the ninth inning. As a baseball fan, I think we are probably closer to the third inning. Let me explain why I think that. The IMF recently projected aggregate credit losses on U.S.-based assets of about $945 billion worldwide, with about a quarter of those coming in the U.S. banks and thrifts. The Board staff has a somewhat lower number, around $700 billion to $800 billion, but they have a higher fraction in U.S. banks and thrifts. So the basic numbers are pretty similar in that respect. The staff projection for credit losses for U.S. commercial banks and thrifts, excluding investment banks, is about $215 billion for this year and next year and $300 billion if the recession is more severe. In addition, the staff projects about $60 billion in write-downs of CDOs and other types of traded assets. Now, most of those $60 billion write-downs have been taken. They are mostly held by the top banks, and they have mostly been already written off. However, of the $215 billion to $300 billion in projected credit losses, so far U.S. banks and thrifts have acknowledged only about $60 billion. So if you put together those numbers, you find that we are about one-third of the way through total losses. Now, there are, in fact, obviously some countervailing factors. Banks and thrifts have already raised about $115 billion in capital since the middle of last year, which essentially covers the losses announced so far. But that said, there is still a lot of deleveraging to go. There is going to be a long process of selling assets, reducing extensions of credit, and building capital ratios. This may not yet be fully felt in the real economy, but it will eventually be there. So I do think that we are going to see continued pressure from financial markets and credit markets, even if we don't have any serious relapses into financial stress. So, again, I am somewhat more skeptical about a near-term improvement in economic growth, although I do acknowledge that the fiscal package and other factors that the Greenbook mentions will be helpful. The question has been raised about whether monetary policy is helpful and what the stance of monetary policy is. I agree with the comment that the real federal funds rate is not necessarily the best measure of the stance of monetary policy right now. Let me take an example that was given in the New York Fed's daily financial report a couple of days ago, which was about the all-in cost of asset-backed securities backed by auto loans. According to this report, in February of '07, the three-year swap rate was about 5 percent, and the spread on AAA tranches of auto-backed ABS was about 10 basis points. The all-in cost was 5.07 percent for this particular asset. In February of '08, the three-year swap rate was 3.15 percent, almost 2 percentage points lower, but the spread on AAA tranches was 195 basis points. Therefore, the overall all-in cost of auto loan ABS was 5.36 percent. So the net effect is--well, is monetary policy doing anything? Absolutely. We have reduced the safe rate. We have brought down the cost of funds. But the spreads have obviously offset that. So what we have really done is essentially offset the effects of the credit crisis. Obviously, if we had not responded to the situation, those costs would be much higher, and the extent of restriction would be a lot greater. For these reasons, I really do believe that we need to take a much more sophisticated look at what the appropriate interest rate is. The Taylor rules, in particular, are just not appropriate for the current situation because the equilibrium real interest rate of 2 percent that is built into them is not necessarily appropriate. Let me turn to inflation, which a lot of people talked about today. First, let me just say that I certainly have significant concerns on the nominal side. In particular, I have a lot of anxiety about the dollar. Foreign exchange rates in general are not well tied down, and they are very subject to sentiment and swings in views. Therefore, although I think that the depreciation of the dollar so far is a mixed bag--obviously, it has effects on different parts of the economy--I do think that there is a risk of a sharper fall with possibly adverse implications, in the short run, for U.S. assets and, in the long run, perhaps implications for our position as a reserve currency and so on. So I think that is an issue to be concerned about. For that reason and for other reasons as well, I am very sympathetic to the view I hear around the table that we are now very, very close to where we ought to be, that it is time to take a rest, to see the effects of our work, and to pay equal attention to the nominal side of our mandate. I agree with all of that. So I am hopeful that in our policy discussion tomorrow we will be fairly close around the table. That being said, I do want to take a little exception to some of the discussion about inflation. There is an obvious and very elementary distinction between relative price changes and overall inflation. Let me ask you to do the following thought experiment. Imagine you are speaking to your board. Last year, as a first approximation, headline inflation was 4 percent, labor compensation grew at 4 percent, and oil prices rose 60 percent. Let's imagine that we had been so farsighted and so effective that we managed to keep headline inflation last year at 2 percent. The implications would have been, assuming that relative price changes were the same, that wages would have grown at 2 percent and that oil prices would have risen at 57 percent. In the conversation with your board, your board would say, ""This inflation is killing us. These costs are killing us. We have to pass them through."" They would, and they would be right. When there are big changes in relative prices, that is a real phenomenon, and it has to be accommodated somehow by nominal price shifts. So to the extent that the changes in food and oil prices reflect real supply-and-demand conditions, obviously they are very distressing and bad for the economy and create a lot of pain, but they are not in themselves necessarily under the control of monetary policy. If we give the impression that gasoline prices are the Fed's responsibility, we are looking for trouble because we cannot control gasoline prices. That said, of course we need to address the overall inflation rate. We need to address inflation expectations. All of that is very important. But, again, we need to make a distinction between relative price changes and overall inflation. Now, a more sophisticated response to that is, ""Well, maybe monetary policy is contributing to these relative price changes as well""; and I think that is a very serious issue. Certainly the dollar has some effects on oil prices. But keep in mind that a lot of the depreciation of the dollar is a decline in real exchange rates, which is essential in any case for balancing our external accounts. So, yes, the depreciation of the dollar, through our policies, has contributed somewhat to commodity prices. But compared with the overall shifts in relative prices that we have seen, I think it is not that large. There are other hypotheses suggesting that we have been stimulating speculation in a bubble, suggesting that low real interest rates contribute to commodity price booms. I don't want to take more time, but the evidence for those things is very limited. In particular, the fact that we have not seen any buildups in hoarding or inventories is a very strong argument against the idea that inflation expectations, hoarding, or speculation is a major factor in energy price increases. So, yes, the nominal side is very important. We need to address that. I agree with that. But we should try to help our audiences understand the very important distinction between real and nominal changes. I think I will stop there. If I can ask for your patience, we could do the briefing on the alternatives today and give ourselves more time tomorrow. Around the table, does that seem okay? I'll call on Bill English. " fcic_final_report_full--103 New Century and Ameriquest were especially aggressive. New Century’s “Focus ” plan concentrated on “originating loans with characteristics for which whole loan buyers will pay a high premium.”  Those “whole loan buyers” were the firms on Wall Street that purchased loans and, most often, bundled them into mortgage- backed securities. They were eager customers. In , New Century sold . bil- lion in whole loans, up from . billion three years before,  launching the firm from tenth to second place among subprime originators. Three-quarters went to two secu- ritizing firms—Morgan Stanley and Credit Suisse—but New Century reassured its investors that there were “many more prospective buyers.”  Ameriquest, in particular, pursued volume. According to the company’s public statements, it paid its account executives less per mortgage than the competition, but it encouraged them to make up the difference by underwriting more loans. “Our people make more volume per employee than the rest of the industry,” Aseem Mital, CEO of Ameriquest, said in . The company cut costs elsewhere in the origina- tion process, too. The back office for the firm’s retail division operated in assembly- line fashion, Mital told a reporter for American Banker; the work was divided into specialized tasks, including data entry, underwriting, customer service, account management, and funding. Ameriquest used its savings to undercut by as much as . what competing originators charged securitizing firms, according to an indus- try analyst’s estimate. Between  and , Ameriquest loan origination rose from an estimated  billion to  billion annually. That vaulted the firm from eleventh to first place among subprime originators. “They are clearly the aggressor,” Countrywide CEO Angelo Mozilo told his investors in .  By , Countrywide was third on the list. The subprime players followed diverse strategies. Lehman and Countrywide pur- sued a “vertically integrated” model, involving them in every link of the mortgage chain: originating and funding the loans, packaging them into securities, and finally selling the securities to investors. Others concentrated on niches: New Century, for example, mainly originated mortgages for immediate sale to other firms in the chain. When originators made loans to hold through maturity—an approach known as originate-to-hold —they had a clear incentive to underwrite carefully and consider the risks. However, when they originated mortgages to sell, for securitization or other- wise—known as originate-to-distribute —they no longer risked losses if the loan de- faulted. As long as they made accurate representations and warranties, the only risk was to their reputations if a lot of their loans went bad—but during the boom, loans were not going bad. In total, this originate-to-distribute pipeline carried more than half of all mortgages before the crisis, and a much larger piece of subprime mortgages. For decades, a version of the originate-to-distribute model produced safe mort- gages. Fannie and Freddie had been buying prime, conforming mortgages since the s, protected by strict underwriting standards. But some saw that the model now had problems. “If you look at how many people are playing, from the real estate agent all the way through to the guy who is issuing the security and the underwriter and the underwriting group and blah, blah, blah, then nobody in this entire chain is re- sponsible to anybody,” Lewis Ranieri, an early leader in securitization, told the FCIC, not the outcome he and other investment bankers had expected. “None of us wrote and said, ‘Oh, by the way, you have to be responsible for your actions,’” Ranieri said. “It was pretty self-evident.”  CHRG-111hhrg51698--537 Mr. Kaswell," Thank you, Mr. Chairman. Mr. Chairman, Ranking Member Lucas, and Members of the Committee, I am Stuart Kaswell, Executive Vice President and General Counsel, Managed Funds Association. MFA appreciates the opportunity to testify before you today. MFA represents the majority of the world's largest hedge funds and is the primary advocate for sound business practices and industry growth for professionals in hedge funds, funds of funds, and managed funds, as well as the industry service providers. MFA appreciates the opportunity to share its views with the Committee regarding the proposed Derivatives Markets Transparency and Accountability Act of 2009. As participants in our nation's markets, MFA's members share your concerns regarding the challenges in those markets and the difficulties facing our economy. We commend this Committee for considering measures which, in seeking to strengthen the regulatory framework, can help restore stability and confidence in our markets and the economy they serve. The DMTAA has a number of provisions that MFA generally supports. These provisions would strengthen and codify the information that the CFTC receives to ensure that its decisions are well informed. For example, we support section 4, which would improve reporting of positions of index funds and require the CFTC to issue a rule defining and classifying index traders and swap dealers for data reporting. We also view sections 9 and 10 of the legislation as useful provisions which should provide the Committee and regulators with greater information about the OTC derivatives markets and international energy commodity markets. Our members also support the provisions included in section 3, which would codify the CFTC's authority to set conditions on the access of foreign boards of trade to the United States. While we support these provisions and the Committee's commitment to promoting greater transparency and a more sound regulatory structure, we are concerned about certain other aspects of the legislation. Section 6 would direct the CFTC to set position limits for all commodities. We believe this provision is unnecessary. The exchanges currently perform this important function and are in a better position to establish and enforce position limits. Moreover, we believe that position limits are more appropriate for the spot month of physical delivered commodities than for the back months of such contracts. We also view the language in section 11 as problematic, as it; first, effectively mandates that the CFTC set position limits on OTC derivatives; and second, is premature given the lack of understanding about this market. As the Committee knows, section 9 of the bill seeks more detailed information about this market, which we believe is an important predicate before Congress takes further action. Finally, we believe that section 16, which seeks to eliminate the so-called naked credit default swap transactions, would significantly damage the liquidity and price discovery process in the CDS market. Such an outcome would not only undermine the efficiency of this market, but would also have a negative impact on the real economy as it would increase the cost of capital, and potentially cause the cost of projects and business development to rise substantially. With respect to section 13, MFA strongly supports moving to a clearing system and a central counterparty for OTC products. In fact, we believe that the credit review and margin requirements attendant to central clearing would address many of the concerns that may have been the motivation for the section 16 language. While we strongly support central clearing, which has proven to help reduce risks in other commodity and financial markets, we believe that Congress should not mandate this requirement in the OTC market until such platform is fairly mature. Moreover, we believe that over time many OTC products should be standardized and centrally cleared. It would be inadvisable to require all OTC transactions to be centrally settled and cleared since customized products are an important risk management tool. Mr. Chairman, Ranking Member, although we have outlined certain concerns, MFA and our members are grateful for the opportunity to testify and we appreciate the bipartisan approach you have taken in fashioning this legislation. We appreciate your willingness to consider the views of all interested parties. We welcome the opportunity to work with you. I do have one request. I would like to add to the record a letter that MFA sent to the Federal Reserve Bank of New York, the SEC and the CFTC to supplement my written statement. [The prepared statement of Mr. Kaswell follows:] Prepared Statement of Stuart J. Kaswell, Executive Vice President and General Counsel, Managed Funds Association, Washington, D.C. Managed Funds Association (``MFA'') is pleased to provide this statement in connection with the House Committee on Agriculture's hearing on the ``Derivatives Markets Transparency and Accountability Act of 2009'' (the ``Derivatives Act'') to be held February 2, 2009. MFA represents the majority of the world's largest hedge funds and is the primary advocate for sound business practices and industry growth for professionals in hedge funds, funds of funds and managed futures, as well as industry service providers. MFA's members manage a substantial portion of the approximately $1.5 trillion invested in absolute return strategies around the world. MFA appreciates the opportunity to express its view on the Derivatives Act and the important issues that it raises. MFA members are active participants in the commodities and over-the-counter (``OTC'') derivatives markets and have a strong interest in promoting the integrity of these markets. MFA consistently supports coordination between policy makers and market participants in developing solutions to improve the operational infrastructure and efficiency of the OTC credit derivatives markets. We are supportive of the Committee's goals to: (1) enhance transparency and reduce systemic risk; (2) promote a greater understanding of the OTC markets and their interaction with exchange-traded and cleared markets; (3) ensure equivalent regulatory oversight in the international regulatory regime for energy commodities and derivatives and provide for greater information sharing and cooperation among international regulators; and (4) provide additional resources to the Commodity Futures Trading Commission (``CFTC''). Nevertheless, we have significant concerns with several provisions of the Derivatives Act, including, in chronological order, Section 6 ``Trading Limits to Prevent Excessive Speculation'', Section 11 ``Over-the-Counter Authority'', Section 12 ``Expedited Process'', Section 13 ``Clearing of Over-the-Counter Transactions'', and Section 16 ``Limitation on Eligibility to Purchase a Credit Default Swap''. We believe these provisions would have the effect of reducing market participants' hedging and risk management tools, and negatively impact our economy by raising the cost of capital and reducing market transparency and efficiency in capital markets. We would like to work with the Committee in addressing these issues. We respectfully offer our suggestions in that regard.Trading Limits To Prevent Excessive Speculation As a general matter, greater market liquidity translates into more effective price discovery and risk mitigation, especially in physically-settled contracts. We are concerned that Section 6 ``Trading Limits to Prevent Excessive Speculation'' will impose upon the CFTC a new obligation that historically has been left to the exchanges in deference to their greater expertise respecting the various factors that affect liquidity in these markets. We are concerned that section 6 implements an overly rigid structure for establishing speculative position limits. We urge that the markets are best served by placing the CFTC in an oversight role. Currently, the exchanges, as part of their self-regulatory obligations, are involved daily in monitoring the activities of market participants. They frequently engage in soliciting the views of speculators and hedgers in their markets. Also, they are more closely engaged in watching deliverable supply. Because position limits may have an impact on price, we believe speculative position limits are best determined by a regulatory authority, rather than market participants through position limit advisory groups. For these reasons, we believe that the exchanges, subject to their regulatory obligations under the Commodity Exchange Act (``CEA''), should propose the size of the speculative position limits following the processes they now employ with their energy and other markets. Section 6 would require the CFTC to convene a Position Limit Agricultural Advisory Group and a Position Limit Energy Group, consisting of industry representatives, exchanges and electronic trading facilities, to provide the CFTC with position limit recommendations. While, as stated, we believe the exchanges, subject to the CFTC's oversight, should determine and administer speculative position limits, we are concerned that the make-up of these advisory groups is not well-balanced and therefore does not provide a mechanism for obtaining the views of all parties active in these markets. For example, noncommercial participants add vital liquidity to these markets through investment capital and are necessary to the success of a market. Thus, we believe that each advisory Committee should have the same number of noncommercial participants as there are short and long hedgers. We support the setting of speculative limits in spot months for physically-delivered energy and agriculture commodities for two reasons. First, physically-delivered futures contracts are more vulnerable to market manipulation in the spot month, because the deliverable supply of the commodity is limited and, thus, more susceptible to price fluctuations caused by abnormally large positions or disorderly trading practices. Second, the commodity is likely delivered by the contract owner during the spot month and has a closer nexus to the end-price received by consumers. On the other hand, we believe that requiring speculative position limits for all months and for aggregate positions in the energy markets, in particular, has the capacity to distort prices. Commercial hedgers often enter into long-dated energy futures (for example, a contract with an expiration date 7 years into the future) to hedge specific projects. Speculators typically take the other side of these contracts. The markets for contracts in these distant (or back) months are less liquid as there are fewer buyers and sellers for long-dated contracts. We are concerned that by setting position limits for all months, including the less liquid, back months, the speculative position limit will reduce liquidity in these distant months and distort the market price for these contracts. We note that the CFTC already has at its disposal several tools, including position reporting and accountability levels, which serve effectively in ensuring market integrity without the inflexibility of speculative position limits. Cash-settled commodities do not raise the same market manipulation concerns as do physically-delivered commodities in that the ability to impact the futures price by controlling deliverable supply is absent. Cash-settled commodities (particularly financial futures) tend to have deep and liquid markets, are primarily used for hedging and risk mitigation by commercials, do not contribute to price discovery which is usually set in the cash markets and therefore have little or no impact on consumers. The CEA, as amended by the CFTC Reauthorization Act of 2008, provides that any contract that has a significant price discovery function on an exempt commercial market, is subject to greater CFTC regulation and oversight. We are concerned that imposing speculative position limits on cash-settled commodities will have the effect of depressing liquidity and thereby increase the cost of using these back months. It would appear that Congress has already addressed this issue in section 4a of the CEA which grants to the CFTC broad authority to impose limits on trading and to curb excessive speculation. In MFA's view it would be advisable for all interested parties to work together to address concerns about excessive speculation, rather than having Congress mandate a process that could result in negative consequences. As market participants, we have a strong interest in promoting fair and orderly markets. To this end, we believe the CFTC should be afforded regulatory flexibility, which the current framework provides, in addressing excessive speculation and policing the markets.Over-the-Counter Authority and Central Clearing MFA supports the requirement in Section 9 ``Review of Over-the-Counter Markets'' that the CFTC study and analyze the effects of OTC trading and aggregate limits across the OTC markets, designated contract markets and derivative transaction execution facilities. We applaud this effort in conjunction with the additional authority Congress seeks to provide to the CFTC through Section 4 ``Detailed Reporting and Disaggregation of Market Data'' and Section 5 ``Transparency and Recordkeeping Authorities''. We believe these provisions will provide the CFTC with better information to understand the OTC markets and how best to regulate these markets. However, we believe that the CFTC should be authorized to determine position limits under Section 11 ``Over-the-Counter Authority'' only after the study has defined the existence of risks that are appropriately controlled by the imposition of such limits. In other words, the results of such study should be the predicate for taking further legislative or regulatory action. We are concerned that section 11 creates a test that can only result in the CFTC concluding that all fungible OTC agreements must be subject to position limits. Section 11 requires the CFTC to determine whether fungible OTC agreements have the potential to disrupt market liquidity and price discovery functions, cause severe market disturbance, or prevent prices from reflecting supply and demand. It would be extremely difficult for the CFTC to find that OTC agreements have absolutely no potential for disruption under any circumstances, whether currently known or unknown. Thus, section 11 may be interpreted to automatically provide the CFTC with the authority to impose and enforce position limits for anyone trading in fungible significant price discovery agreements. We recognize that the bill would leave to the CFTC the discretion to use its authority as to the size of the position limits it imposes. Nonetheless, we think the grant of authority is too broad. With regard to Section 13 ``Clearing of Over-the-Counter Transactions'', we strongly support the concept of central clearing and believe that it offers many potential market benefits. We greatly appreciate the urgent attention of Federal regulators and Congress in addressing this important matter. The private sector, working in conjunction with the Federal Reserve Bank of New York (``NY Fed''), has made strong progress in standardizing credit default swap (``CDS'') contracts and establishing a central clearing house for these contracts. There is also a private sector initiative to develop exchange trading for CDS contracts. As investors in the OTC derivatives markets, we would like to see greater contract standardization and a move toward central clearing for other OTC derivatives instruments, including interest rate, foreign exchange, equity and commodity derivatives. MFA shares Congress' desire to expedite the establishment of central clearing platforms covering a broad range of OTC derivative instruments. We believe a central clearing platform, if properly established, could provide a number of market benefits, including: (1) the mitigation of systemic risk; (2) the mitigation of counterparty risk and protection of customer collateral; (3) market transparency and operational efficiency; (4) greater liquidity; and (5) clear processes for the determination of a credit event (for CDS). In fact, MFA and its members have been actively involved in the establishment of CDS central clearing platforms. Congress, regulators, and the private sector should promote central clearing of OTC derivative products. However, while we urge Congress and regulators to stay engaged in the process and development of establishing central clearing platforms for OTC derivatives products, we do not believe that Congress should mandate clearing for all OTC derivatives by a certain date. As a step in this direction, Congress should simplify regulatory procedures and remove obstacles to prompt approval of central clearing for OTC products. For example, in view of the support shown by many spokespeople for different sectors of the agricultural industry, we believe Congress should allow agricultural swaps to be centrally cleared without the need to first obtain an exemption from the CFTC. Our concern with section 13 mandating central clearing of all OTC derivatives transactions is twofold. First, as central clearing platforms for financial derivatives are still in development, there remain many undetermined and unresolved operational factors that could limit the value of central clearing. Among the operational factors are: most importantly, protection of customer collateral; central counterparty governance and dispute resolution; the most appropriate formats for clearing; and the optimum fee structure. To the point on protection of customer collateral, we are especially concerned that early discussions on central clearing operations will not protect customer assets through segregated accounts. As noted in our December 23, 2008 letter to the NY Fed, the Securities and Exchange Commission (``SEC'') and the CFTC (attached hereto), the current collateral management mechanism used by banks do not adequately protect a participant's pledged collateral, and as such, contributes to systemic risk. For example, because pledged collateral at Lehman Brothers was not segregated, once the company was placed in bankruptcy, pledgors became general creditors of the company. With respect to central counterparty governance, we believe a central counterparty should be an established independent body led by a board reflecting balanced representation of all market participants. Similarly, a central counterparty should have an independent, fair and efficient dispute resolution process. Second, central clearing is not readily attainable for the majority of OTC derivatives because these products are not standardized. We appreciate the Committee's attempt to address the issue of non-standardized, highly unique (individually-negotiated or bespoke) contracts by providing the CFTC with the authority to exempt a transaction from the section 13 clearing requirement. We note that as part of a regulatory framework that maximizes the ability of market participants to mitigate risk and encourage product innovation, it is important to provide market participants with the ability to engage in non-standardized, highly unique contracts. However, in view of the number of OTC derivative contracts that would have to rely on an exemption and the delays that occur when an agency must staff a new mandate, we are concerned that the implementation of section 13 would be highly disruptive to the marketplace. In contrast to other OTC derivatives, the CDS market has quickly become more standardized for various reasons. When the CDS markets began to develop in 1997, only a few of the major derivatives dealers traded these products. Since these dealers were similarly positioned in the market and traded these contracts as both buyers and sellers, they were able to negotiate and develop standardized templates for CDS contracts. These template contracts, with some modifications, have remained relatively unchanged and are currently used by all market participants that trade CDS. This standardization is a major reason why CDS contracts are highly liquid and attractive products. Conversely, derivatives dealers are generally the sellers of other OTC derivatives and will negotiate and structure different terms with each counterparty. As a result, other OTC derivatives are not as fungible or liquid as CDS. The fungibility and liquidity of CDS contracts have caused them to reach a certain level of standardization and efficiency, which have made them ripe for centralized clearing. The same can be said for certain interest rate, energy and agricultural commodity derivatives. By way of comparison, the majority of OTC derivatives markets, including those trading interest rate, foreign exchange, and equity derivatives, are nowhere near the level of standardization of the CDS markets. The CDS markets account for roughly 8% to 9% of the notional volume of the OTC derivatives market. As stated above, these other OTC derivative instruments are not interchangeable between buyers and sellers, and are generally sold by banks or dealers to market participants other than banks or dealers. MFA fully supports collaborative industry-wide efforts and partnerships with regulators, like the NY Fed, SEC and CFTC to develop solutions to promote sound practices and to strengthen the operational infrastructure and efficiency in OTC derivatives trading. MFA is an active participant in the Operations Management Group (the ``OMG''), an industry group working towards improving the operational infrastructure and efficiency of the OTC derivatives markets. The goals of the OMG are: Full global use of central counterparty processing and clearing to significantly reduce counterparty credit risk and outstanding net notional positions; Continued elimination of economically redundant trades through trade compression; Electronic processing of eligible trades to enhance T+0 confirmation issuance and execution; Elimination of material confirmation backlogs; Risk mitigation for paper trades; Streamlined trade lifecycle management to process events (e.g., Credit Events, Succession Events) between upstream trading and confirmation platforms and downstream settlement and clearing systems; and Central settlement for eligible transactions to reduce manual payment processing and reconciliation. In recent years, the OMG and other industry-led initiatives have made notable progress in the OTC derivatives space. Some of the more recent market improvements and systemic risk mitigants have included: (1) the reduction by 80% of backlogs of outstanding CDS confirmations since 2005; (2) the establishment of electronic processes to approve and confirm CDS novations; (3) the establishment of a trade information repository to document and record confirmed CDS trades; (4) the establishment of a successful auction-based mechanism actively employed in 14 credit events including Fannie Mae, Freddie Mac and Lehman Brothers, allowing for cash settlement; and (5) the reduction of 74% of backlogs of outstanding equity derivative confirmations since 2006 and 53% of backlogs in interest rate derivative confirmations since 2006. MFA supports the principles behind section 13, but, as discussed, has concerns with how these principles will be implemented. Although central clearing is not appropriate for all OTC derivative contracts, we firmly believe that greater standardization of OTC derivative contracts and central clearing of these more standardized products would bring significant market benefits. Indeed, we believe that central clearing offers substantially greater opportunity to address concerns about systemic risk, than other alternatives, such as section 16 of the legislation. To this end, MFA is committed to continuing its collaboration with the major derivatives dealers and service providers to prioritize future standardization efforts across OTC derivatives and other financial products. MFA also understands Congress's desire to have greater oversight of these markets and believes there is an important role for the NY Fed, CFTC and SEC to play in monitoring and guiding industry-led OTC derivatives solutions. We believe it would be more appropriate at this stage to require the applicable regulatory authorities to work with market participants towards the principles espoused in section 13 and to provide the Committee with frequent progress reports.Expedited Process Section 12 ``Expedited Process'' provides the CFTC with the authority to use emergency and expedited procedures. While we do not object to this authority, we strongly urge Congress and the CFTC to use the notice and comment process whenever possible. We believe the notice and comment process is more likely to protect the public interest, minimize market disruptions and unintended consequences, and result in better regulation.Limitation on Eligibility To Purchase a Credit Default Swap Credit derivatives are an important risk transfer and management tool. Market participants use credit derivatives for hedging and investment purposes. We believe both are legitimate uses of the instrument and are equally important components of a liquid and well-functioning market. Section 16 would make it a violation of the CEA for a market participant to enter into a CDS unless it has a direct exposure to financial loss should the referenced credit event occur. We appreciate that it is the goal of the provision to add stability to the CDS market by reducing excess speculation. Nonetheless, this provision would severely cripple the CDS market by making investment capital illegal and removing liquidity providers. Without investment capital in the market, market participants wishing to hedge their position through a CDS would find few, if any, market participants to take the other side of the contract. As a result, the CDS market could cease functioning for lack of matching buyers and sellers. Market participants that risk their own capital provide depth and liquidity to any market, and the market for CDS is no exception. Because the provision would eliminate such market participants, the CDS market would have much less price transparency and continuity. This outcome is particularly troubling given the benefits the CDS markets provide to the capital markets and to the overall economy. CDS contracts have improved our capital markets by enhancing risk transparency, price discovery and risk transferal, with the effect of reducing the cost of borrowing. Market participants use the CDS market as a metric for evaluating real-time, market-based estimates of a company's credit risk and financial health; and it is in this way that the CDS markets provide risk transparency and price discovery. Market participants find that CDS market indicators are a superior alternative to relying on credit rating agency scores. CDS contracts also provide banks, dealers and other market participants with a tool to mitigate or manage risk by dispersing credit risk and reducing systemic risk associated with credit concentrations in major institutions. Take the following scenario, which section 16 would prohibit, for example: Bank A owns a $1 billion loan to Company X. Bank B owns a $1 billion loan to Company Y. Both banks would be better off from a risk management perspective, assuming that Companies X and Y have comparable credit worthiness, if they each had a $500 million Company X loan and a $500 million Company Y loan. The loans, however, are not transferable. Through CDS contracts, Bank A is able to buy Company X protection and sell Company Y protection, and Bank B is able to do the opposite. In this way, market participants use CDS contracts to manage risk. Financial markets benefit overall from the reduction in systemic risk. Accordingly, these products reduce an issuer's cost of borrowing from banks, dealers and other market participants by enabling these entities to relay existing risk and/or purchase risk insurance against a particular issuer. Simply put, CDS markets facilitate greater lending and support corporate and public finance projects. By reducing the depth and liquidity of the CDS market, the cost of capital would rise. As a consequence, new investment in manufacturing facilities and other private sector projects and public works efforts would be more expensive. If market participants could not hedge their market risk through CDS contracts, the risk premium on debt would increase significantly. We do not believe this is advisable, especially in light of the troubled state of the U.S. economy and the Congress' current stimulus package deliberations. To our knowledge, Congress has never before imposed a trading restriction such as is proposed in section 16 on any type of commodity or financial instrument, and for good reason. Congress has previously recognized in section 3 of the CEA that we have a national public interest in providing a means for managing and assuming price risks, discovering prices or disseminating price information. Shutting out investors from the CDS market would be contrary to the public policy interests enumerated in the Act. As noted below, we believe that there are more effective alternatives for addressing concerns about the CDS markets.All Commodities Are Not Equal Finally, we are concerned with the expansion of the bill to all commodities. Physically-delivered, cash-settled and OTC commodities each trade in distinct markets and have different characteristics. We believe the rationale behind certain requirements, such as spot month speculative limits and aggregate position limits, are not applicable to financial futures or their OTC derivatives. Legislation that attempts to regulate all commodity and financial markets in an identical manner will fail to take into consideration the different needs of these markets and important functions they serve. Specifically, we refer to sections 6, 11 and 13, which we believe attempts to uniformly regulate these distinct markets. Moreover, such legislation will risk affecting liquidity and the opportunity for innovation that have made these markets so widely used and integral to the economy.Conclusion As Congress, including this Committee, considers ways to restore stability and confidence to our markets and to address the recent economic downturn, we believe it is important to recognize the important role the OTC derivatives markets have played. These products allow market participants to contribute vital market liquidity, mitigate risk, support lending and project finance, and facilitate economic growth. In considering ways to promote enhanced risk management and greater transparency in the marketplace, we urge you to resist any efforts which, while well-intended, could prove harmful to these important markets and our broader economy. These markets have played a pivotal role with respect to the development of our financial markets and the growth of our nation's economy. This success is attributable to the innovation and sophistication of our financial markets and the participants of these markets. It is also a testament to the competency of the underlying regulatory framework. MFA would like to thank the Committee for allowing us the opportunity to share our views on these important issues. MFA, and our members, are committed to working constructively with this Committee, the Congress, and the Administration over the coming weeks and months as this legislation and the broader dialogue regarding financial regulatory reform progresses. Thank you. AttachmentDecember 23, 2008Timothy F. Geithner,President,Federal Reserve Bank of New York;Hon. Christopher Cox,Chairman,U.S. Securities and Exchange Commission;Hon. Walter Lukken,Acting Chairman,U.S. Commodity Futures Trading Commission. Dear President Geithner, Chairman Cox and Chairman Lukken: Recently, Managed Funds Association (``MFA'') \1\ and its members met with the Federal Reserve Bank of New York (the ``NYFRB'') to discuss and provide comments regarding the state of the credit default swap (``CDS'') market, including our feedback on current proposals to establish a central clearing counterparty for the CDS market. As part of our ongoing commitment to proactively work with regulators on topics that pose significant market or systemic risk concerns, we wish to direct your attention to the protection and safeguarding of customers' initial margin that they deposit with dealer financial institutions in connection with the trading of all over-the-counter (``OTC'') derivatives.--------------------------------------------------------------------------- \1\ MFA is the voice of the global alternative investment industry. Its members are professionals in hedge funds, funds of funds and managed futures funds, as well as industry service providers. Established in 1991, MFA is the primary source of information for policy makers and the media and the leading advocate for sound business practices and industry growth. MFA members include the vast majority of the largest hedge fund groups in the world who manage a substantial portion of the approximately $1.5 trillion invested in absolute return strategies. MFA is headquartered in Washington, D.C., with an office in New York. For more information, please visit: www.managedfunds.org.---------------------------------------------------------------------------Effects of Current Collateral Management Practices By way of background, the default of Lehman Brothers, a major OTC derivatives counterparty, and the resulting market concerns about the viability of other major dealers, has caused significant volatility in the capital markets. These concerns demonstrate that current mechanisms for collateral management, outside of the context of broker-dealer accounts covered by Exchange Act Rule 15c3-3, do not adequately protect the pledgors of collateral and can contribute to systemic risk in several important respects: The purpose of initial margin is to provide dealers with a cushion against the potential counterparty risk they assume when entering into an OTC derivatives contract with a customer. However, since such margin is not typically segregated from the dealers' other unsecured assets, what is supposed to be a credit mitigant for the dealer instead subjects the customer to actual credit risk on the posted amounts. If a dealer becomes insolvent, initial margin posted by customers that is not so segregated is treated in bankruptcy as a general unsecured claim of the customer. As a result, customers who are counterparties to that dealer stand to incur significant losses, regardless of the current value of their derivatives contracts. Investment managers have fiduciary duties to their investors. When a dealer experiences difficulties, the risk to initial margin may cause managers to seek to hedge counterparty exposure to such dealer (either through the CDS market or by trying to close-out or assign derivatives trades away from such dealer). These hedging actions can have a further destabilizing impact on such dealer and the market generally, thereby increasing systemic risk. In addition, given that dealers are able to freely use posted collateral, they have come to rely on initial margin, a fluctuating source of cash, to fund their business activities. As trades are closed-out or assigned, dealers are required to return initial margin to their customers. The return of margin constricts dealers' liquidity and, as recent events demonstrate, the inability of the dealers to access cash has potentially severe market consequences. We highlight that the aforementioned counterparty risks related to customer initial margin have been greatly exacerbated over the last few months as dealers as a whole have significantly increased their demands for initial margin. These risks are in turn further compounded by the general weakening of the financial sector as a whole.Enhanced Customer Segregated Accounts As you are aware, the segregation of initial margin is a key component of the central clearingparty initiatives for the CDS market, and we understand that the NYFRB, SEC and CFfC have stipulated this condition to be a prerequisite for regulatory approval. We agree that segregation of initial margin is crucial to the success of these clearing initiatives, but also believe that the protection of customer initial margin should be implemented more broadly for all OTC derivatives, irrespective of the launch of any CDS central counterparty because it is critical in order to promote broader market stability and to mitigate counterparty risk. Protection of customer initial margin with respect to all bilaterally negotiated OTC derivatives could be incorporated into the existing transaction structure through dealer use of a segregated account, in the name of, and held for the benefit of, the customer (e.g., at a U.S. depository institution or a regulated U.S. broker-dealer), whereby the dealer would not be permitted to rehypothecate the initial margin held in such an account. This would promote broader market stability and mitigate counterparty risk. Given that dealers will be required to provide initial margin segregation as part of the clearing initiatives, they should be capable of offering this to customers on a broader basis. However, to date the dealer community, as a whole, has been resistant to such efforts by MFA's members and other investment managers. * * * * * We recognize the efforts of regulators to collaborate on mitigating risk and promoting market stability. We appreciate the constructive working relationship fostered by each of you as well as the opportunity to share the views of our members on this important topic. We welcome the opportunity to discuss this issue further with each of your staffs. If we can provide further information on this topic, or be of further assistance, please do not hesitate to contact us at [Redacted]. Yours Sincerely,[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Richard H. Baker,President and Chief Executive Officer.cc:Hon. Ben Bernanke,Chairman,Board of Governors, Federal Reserve System;Patrick M. Parkinson,Deputy Director,Division of Research and Statistics, Board of the Federal Reserve System;Ananda Radhakrishnan,Director,Division of Clearing and Intermediary Oversight, Commodity Futures Trading Commission;Theodore Lubke,Senior Vice President,Bank Supervision Group, Federal Reserve Bank of New York;Erik R. Sirri,Director,Division of Trading and Markets, U.S. Securities and Exchange Commission. " FOMC20060920meeting--146 144,MR. WARSH.," Thank you, Mr. Chairman. I’d like to make four points, a couple of which have been stated by my colleagues this morning, and then spend a little time on each of them. First, like many of you, I am more concerned about the upside risks to inflation than downside risks to output and employment. Second, the markets responded quite positively to the last FOMC, so they’ve been going in the right direction. The stock market has been up, the bond market has been up, energy and commodities are down, and TIPS inflation compensation measures are down. Six months ago I would have taken some comfort from that; now, six months into being a central banker, I’m worried. [Laughter] So I join the ranks of Jack and the rest of you who have been here a bit longer than I have. Third, for the first time since I’ve been here, I’m a little less sanguine about the supply side of the economy in looking at the business base, the cap-ex base, and the manufacturing base. But I find myself today probably more comfortable, or at least as comfortable as I’ve been, with the strength and resilience of consumer demand. The fourth point I would like to spend a couple of minutes on is that I think we are at the beginning of a major test of market liquidity that’s happening in real time in the fixed-income markets. So let me take each of those in turn. First, on the consumer side, consumer spending appears to be strong and resilient. As was noted at the outset, there was a strong July PCE reading, on par with the strongest gains of the year, suggesting to me that consumer demand may actually be accelerating from the second quarter into the third quarter. The Greenbook estimate of 3 percent PCE for the third quarter and 2.75 percent PCE for the fourth quarter may actually be understating the strength of the consumer, particularly with falling gas prices. I’m also comforted by income growth and labor market conditions, which I see as likely to be far more important to consumer spending than housing wealth. Consumer income gains appear to be rising. I’ve made note previously of very strong tax receipts. Although they’ve tapered off somewhat, they continue to be robust. Tax receipts for the year are up about 12.4 percent. The past couple of months would suggest they are in the high single digits, and though there is some noise in those data, I do take some comfort from them. Other recent corroboration of labor income, with the revised NIPA data and other measures, suggests that real wage and salary income again may be accelerating. It has been noted this morning that stock options and bonus payments may have had an effect in the first quarter, creating a bit of noise in those data. However, they should also remind us of the wealth effect of equity gains, which may partially offset the negative wealth effect from housing, particularly with 100 million members of the investor class. I think that’s something that needs to be considered in our thinking about the strength of the consumer during the forecast period. Finally, as I think Governor Bies noted, the labor markets remain reasonably tight. Despite the softness in housing, unemployment insurance claims and unemployment rates remain quite encouraging. Turning for a moment to business, about which I am perhaps a little less optimistic than I’ve been before, industrial production is still reasonably strong but, perhaps disappointingly, has flattened for August, even though the July numbers appeared to be on an upward trend. When I looked back over the past 24 monthly readings for 2004 and 2005, both of IP and retail sales, I found that each declined about six times, so I’m not sure that we’re seeing a new trend here. My own sense of where IP is in September is that it’s remarkably strong, but, again, I have some caution that I didn’t have before. One other note—unlike the Greenbook, I sense that exports are likely to make a real, meaningful contribution to GDP during the forecast period. In terms of capital expenditure growth rates, another survey I’d like to mention is the Business Roundtable survey that came out a couple of days ago. It was more negative on capital expenditures than it has ever been. I would say that the group has a mixed record in calling inflection points, but the survey results, nonetheless, suggest that only a little less than 40 percent expect increased cap-ex in the next six months, whereas about half said that cap-ex would remain constant over that period. Perhaps that’s an effort to protect margins with higher costs that could be only partially passed through. As I’ve noted before, earnings growth continues to meet or beat expectations, certainly through the second and third quarters, and my own sense is that fourth-quarter earnings will also be fine, probably still at the double-digit rates of about 10 or 11 percent. Perhaps that explains some of the taking the foot off the accelerator in terms of capital expenditures. In terms of housing, to add a bit to the previous discussion, my own sense is that the residential sector may have, in fact, crowded out some nonresidential loans during the most recent boom and that nonresidential construction was marked up sharply in the second quarter, to an annual growth rate of 22 percent. My sense is also that the market’s capital allocation function is working well. C&I loans are growing about 15 percent or more, perhaps the highest rate in the past 20 or 25 years, and we’ll probably see a little more capital allocation to this nonresidential sector. Whereas the Greenbook assumes a significant deceleration in this group, I think that there’s reason for some upside surprise. As a result, I expect stronger GDP for the second half of ’06 than the Greenbook does. Turning to inflation, I think that inflation risks have not materially receded, though we’ve probably seen acceleration stopping. That is, we’ve seen the top, but the new direction is not clear. One measure that I’ll look to over the next six weeks is what’s going on in the capital markets. Since we last met, ten-year yields have probably moved down about 15 basis points, and the Greenbook reports that there should be a slowdown in business debt financing. That statement of the Greenbook is probably reflected in the data that we’ve seen in July and August in terms of the capital markets. But the test of liquidity to which I referred will be a big supply/demand test over the course of the next six or seven weeks. Perhaps $150 billion in funding is coming to market from the bank loan market, the leveraged loan market, high yield and investment grade. Admittedly, in that $150 billion number, which stacks up as a big number even compared with only a couple of years ago, when we would see financings over a year of $175 billion, there are some elephant deals, and they are probably distorting that number a bit. HCA is coming to market with a $20 billion deal, as well as a couple of other major leveraged buyouts. The liquidity in those capital markets appears to be incredibly robust at this moment; there are massive pipelines. You hear words like “euphoria.” I would say that the capital markets are probably more profitable and more robust at this moment, or at least going into the six-week opportunity, than they have perhaps ever been. A significant variety of participants are playing. This is a function of huge sovereign debt inflows and of significant liability management by issuers—some of the CFOs to whom Governor Bies was speaking. Investors at this moment appear to have very little leverage in terms of the pricing of these deals or in terms of some of the covenant protections that were referenced at an earlier meeting. Previously, I had said that, particularly in the investment-grade market, we were seeing issuers hesitate to come to market because they didn’t want to negotiate their covenants away. In the event that they were to be taken out by a leveraged-buyout player, they wouldn’t want to have a change-of-control premium. Now that these markets are as robust as they are, those same brand-name issuers are coming back to the market, and at this point it seems as though they will likely get their pricing done. So, I do not yet have a final determination of what this pipeline looks like; but if all goes through, it will suggest to me that there has been rather massive liquidity during this period. Other measures of liquidity appear to be somewhat more encouraging from my perspective. The commodities markets have been mentioned. They’ve probably had some hot money come out of them, with a lot of retail investors, both directly and through pension funds, coming in too late and maybe exiting for good, as well as some very encouraging news about the TIPS markets, which were referenced previously. In sum, I would say that the markets seem to be very impressed by our letting the economy develop, particularly in the next couple of quarters, and I’m impressed by the market’s confidence in us. I think that it puts a significant responsibility on us and is probably the only way I can reconcile the rather robust gains in the equity markets and in the debt markets over this period. That is, the markets believe that somehow we’re going to manage to thread the needle and nail the perfect landing. There is, I think, increasingly a one-way bet in the bond markets in that they believe that there is a degree of accommodation and they have built in a degree of loosening in the forecast period, which we don’t have a proper understanding of. Only a couple of months ago we were describing, and the Chairman described, an economy in transition and the very wide tails around that. We still have the wide tails, but the markets seem to think that we’re going to nail this landing. I think the minutes from the last meeting faithfully captured our concerns about the appreciable upside risks remaining. Either the markets didn’t buy that description, or they were convinced that we were going to act with an incredibly deft touch to stop that inflation. All in all, I would say that in the markets there is less dispersion of views than is probably healthy and less dispersion of views over these different scenarios than we found ourselves discussing some time ago. So with that, I think we’ll have a more robust discussion in the next round. Thank you, Mr. Chairman." CHRG-111hhrg63105--24 Mr. Chilton," Thank you, Mr. Chairman. I can say I just want to thank and congratulate Senator-elect Moran. It has been a pleasure working with you over the years, sir, and I look forward to continuing that. I look forward to the scrutiny we will get from Chairman Lucas in the future. I did want to say a special thanks to Chairman Peterson. You guys passed back in 2008 legislation dealing with speculation. You may have passed it twice in a bipartisan way. I know you brought it up on the floor twice in 2008. So I appreciate your foresight and your oversight of this agency over the years. I also want to thank my friend, Chairman Gensler, for being so helpful. His expertise of the markets and of finance has really helped us. The other Commissioners are pretty much folks that came from here, came from the Hill and we have ag backgrounds and we have some other backgrounds, too, but having Chairman Gensler there has made us better Commissioners and a better Commission. So I thank him. If you look back at just the last 10 years, the futures industry around the world has increased three-fold. Yet in the U.S. it increased five-fold. So a lot was going on. Between 2005 and 2008, we saw roughly $200 billion of speculative money, index money, hedge funds, pension funds; $200 billion came into these markets. Now, that happened to coincide with this commodity bubble. Wheat is around $7\1/2\-$8 now. It was at $24 then. Gasoline is--crude is like $87, $90 now. It went up to $147.27 in June 2008. As we all know and your constituents told you, they had concerns because gasoline was over $4. Whether or not that increase in the speculative interest, that $200 billion, caused that bubble is a point that obviously can be debated. Some people say, move along folks, nothing here. Some people say it drove the prices. I come out sort of in the middle and say that--agree with MIT and Oxford and Rice and Princeton and even Lincoln University in Missouri. They all say that it had some impact. So, how much you can debate. The increase in speculative limits since that time, if it was a concern in 2008 with the amount of speculation in the market, if it was a concern when Congress passed the law in July, it is even more of a concern now. Now, before I give you some new statistics, don't get me wrong: We don't have speculators, we don't have a market. They are critical. Full stop. We have to have them. But if you look at what is going on between June of 2008 and where we are today or where we were in October, we see more speculative positions in the futures markets than at any time in history, $149 billion. That is an increase in the energy complex of 47 percent since 2008, an increase in the metals complex of 20 percent, and an increase in the agriculture complex by 18 percent. So there has been this large influx. Now, the Chairman talked about all the rules and a number of Members have talked about the rules. There has been a flurry of activity. We have been going gangbusters. And the staff at the CFTC has been real inspirational. We all sort of talk about it every time we meet. At the same time, by and large, while these rules have been sort of trains that are on time, position limits have sort of derailed. And the reason is exactly what Congressman Moran alluded to, whether or not we have this data on swaps in order to meet the deadline of January. And there are a couple of points; first, I am not sure we do have the authority to delay. And this as appropriate language, Congressman Moran, I appreciate your point but to say that as appropriate is expansive enough of a definition to render the provision moot and meaningless, I think begs the question a little bit. I think we are required to implement it. I see no authority for us to delay, no legal authority. I asked the attorneys why we would delay. Second, I think it is needed now more than ever, because of those statistics I just cited to you. And third, there are ways that we can do this. There are things that we can do as Chairman-elect Lucas said in a deliberate fashion, not ad hoc and not hasty, sir, that we can do to start doing what Congress set as our goals in January. It may not be the full Committee but there are things that we can do now. I agree we don't want something hasty. We don't want to mess up markets. There are ways to go about this. So far what we have been talking about is how we just go ahead and wait, and we are talking about a delay, we are talking about not getting this data until next September or October. So I am just trying to do what Congress told us to do. You can have different interpretations. I have mine, and I am trying to do the best, I don't think we are--as I said, we are going to have a meeting tomorrow, we are not quite back on the track, but we can get there. Thank you Mr. Chairman. [The prepared statement of Mr. Chilton follows:] Prepared Statement of Hon. Bart Chilton, Commissioner, Commodity Futures Trading Commission, Washington, D.C. Mr. Chairman, Ranking Member Moran, Members of the Subcommittee, thank you for the opportunity to be with you today. In the last decade, we saw the U.S. futures industry grow five-fold when the rest of the world grew three-fold. In several years we saw over $200 billion come into regulated U.S. futures markets. This new money was primarily from speculators, much of which was held by speculators I call ``massive passives,'' those with a known, fairly price-insensitive trading strategy. Then, in 2008, we saw a huge commodity bubble. Wheat was at $24. Today it is around $8. Crude oil spiked to $147.27 and gas was at $4 per gallon. Then the economy and commodity prices all fell off a cliff. Did the new speculators, including the massive passives, contribute to that price volatility-volatility that had farmers and ranchers, small and large agribusinesses and other businesses alike all paying higher prices than they should? Researchers at Oxford, MIT, Princeton and Rice all say speculative interests had an impact on prices. Some have said the speculators drove prices. In fairness, some on the other side of the issue say there was no impact whatsoever. My take is somewhere in the middle. Speculators didn't drive prices, but they tagged along and helped to push them to levels, high and then low, that we would not have seen without them. Futures prices should, by and large, be based upon the fundamentals of supply and demand. We saw delinked commodity prices in 2008, and some of us are concerned that we see that taking place this year. Congress passed the Wall Street Reform and Consumer Protection Act in July. With more than 40 rules to be promulgated by our agency, Congress gave us expedited implementation dates for only nine regulations. For example, speculative position limits for energy and metals are to be implemented within 180 days and for the agricultural complex within 270 days. As someone who has been calling for these limits, and who appreciates the work of the Committee in this regard since 2008, the early implementation deadline is important. Large and small agribusinesses and other commercial businesses rely upon these markets to hedge their risks. They are having an increasingly difficult time doing so, in part I believe, because of large position concentrations of speculators. Don't get me wrong, without speculators there isn't a market. We need them. We want them. Too much concentration, however, can be problematic and has the possibility of contorting markets. Now today, we see even larger speculative positions than in 2008. In total, there is $149 billion in speculative money in these markets, representing an increase since June of 2008 of 47% in the energy complex, where we have seen a single trader with positions as high as 20%. In the metals markets, we've witnessed an increase in speculative contracts of 20% and one silver trader with roughly 40% of the market earlier this year. In the agricultural complex, speculative interests grew by 18% since June of 2008. All of this makes the implementation of position limits as Congress mandated important. Some have suggested, however, that we not implement the limits on time because we don't have all the swaps data we need. There is a point there. Congress didn't require that we promulgate the swaps data rule until next July, so how do we come up with a reasonable limit, particularly an aggregate limit, without that data? While this is a worthy point, there are ways to address it. I'd be pleased to explain several options. Some, however, inside and outside the agency have suggested we simply find a way around the law's implementation deadline. They suggest, for example, that we ``implement'' the position limit rule, but not make it ``effective'' until sometime much later. First, we have no such legal authority to do so. Second, that is exactly the type of dancing on the head of a legal pin Washington-speak that folks in the country are all too tired of--and they should be. We shouldn't be about getting around the law. We should be about working to do what we were instructed to do, to protect markets and help consumers. Congress passed the new law. We must implement it in a thoughtful manner. End of story in my book. Thank you for the opportunity to be with you. I'd be pleased to try to answer any questions. " CHRG-111hhrg51698--468 Mr. Cicio," Good afternoon, Mr. Chairman, Ranking Member Lucas, and Members of the Committee. My name is Paul Cicio. I am the President of the Industrial Energy Consumers of America, thank you for the opportunity to testify here. IECA member companies are exclusively from the manufacturing sector and unique, in that our competitiveness is dependent upon the cost of energy. Mr. Chairman, we are very grateful for the attention this Committee is giving to this incredibly important issue. And this legislation is an excellent start to addressing excessive speculation in commodity markets. Specifically, excessive speculation in the first half of 2008 cost consumers $40.4 billion, and that is just for natural gas. IECA supports most of the draft as it is currently written, so, with your permission, I will just address those areas where we have some recommendations or concerns. Point number one: section 6 creates an energy and agriculture position limit advisory group. It is essential that the advisory group be numerically weighted in favor of physical producers and consumers who are bona fide hedgers, and that its governance favor the consumer to ensure the best interests of those who are paying the bill, the consumer. Point number two: We strongly encourage the legislation to require aggregate position limits. Your draft bill proposes Federal speculation limits on the regulated markets and eliminates the swap loophole by limiting hedging exemptions to bona fide hedgers who would have physical risk. However, Mr. Chairman, the draft bill only calls for studying speculative position limits on the over-the-counter market. In order to prevent speculators from moving between markets to evade speculation limits, speculative position limits need to be aggregated to cover designated contract markets, the exempt commercial markets, foreign boards of trade, and over-the-counter markets. Over-the-counter trading is not insulated from the cash markets. It impacts cash prices in two ways: first, through arbitrage between the OTC swap market and the cash market; and, second, through arbitrage between the swaps market and the futures market. Futures prices, in turn, are used as the reference price for most cash transactions. Swap dealers can also shift their risk to other trading platforms, such as the IntercontinentalExchange, and foreign boards of trade, such as ICE Futures. Mr. Chairman, unless there is an umbrella which covers all of these venues, particularly with respect to commodities for U.S. delivery such as natural gas, speculators will circumvent the regulated venues in favor of unregulated venues. For that reason, we urge to you require the CFTC to provide aggregate position limits across all exchanges in order to control excessive speculation in energy commodities. Point number three: section 13 requires clearing of all over-the-counter transactions. We do not support requiring bona fide commercial hedgers, such as ourselves, to clear. The problem of excessive market speculation is not caused by commercial hedgers, and our volumes are too small to manipulate the market. For example, in natural gas, our volumes are well under five percent of the market. Requiring us to clear our transactions will significantly increase transaction costs to the extent that it could become a disincentive for industrial consumers to manage risk. Clearing transactions would require us to post significant sums of margin capital, which is very difficult to do even under good economic times. Point number four: Consumers need assurances that this legislation deals appropriately with index funds and other passive, long-only, short-only investment instruments that have a significant negative impact on the market, and will do so again unless these instruments are limited in volume or banned. The draft legislation only requires reporting, which is not sufficient. Number five, and our final comment: Regarding treatment of carbon allowances and offsets, we have deep concerns about including this provision. U.S. manufacturing companies who have been studying cap and trade and our colleagues in Europe believe that carbon trading could very well be the next subprime crisis. Our written testimony includes an article from The Guardian, a U.K. newspaper, dated January 30, 2009, entitled ``Carbon Trading: The Next Sub-prime.'' Trading and offsets are very susceptible to fraud and manipulation. Cap and trade is only one of several policy approaches to regulating carbon, and the alternatives would not require carbon trading and creation of other high-risk derivative trading markets. Including carbon emissions as a tradeable commodity is premature to Federal policy decision making, and Congress should not limit the debate to trading. Thank you. [The prepared statement of Mr. Cicio follows:] Prepared Statement of Paul N. Cicio, President, Industrial Energy Consumers of America, Washington, D.C. Mr. Chairman, Ranking Member Lucas, and Members of the Committee, my name is Paul N. Cicio. I am President of the Industrial Energy Consumers of America (IECA). Thank you for the opportunity to testify before you on the draft legislation entitled ``Derivatives Markets Transparency and Accountability Act of 2009''. IECA is a 501(c)(6) national nonprofit non-partisan cross-industry trade association whose membership is exclusively from the manufacturing sector. IECA promotes the interests of manufacturing companies for which the availability, use and cost of energy, power or feedstock play a significant role in their ability to compete in domestic and world markets. IECA membership represents a diverse set of industries including: fertilizer, steel, plastics, cement, paper, food processing, aluminum, chemicals, brick, rubber, insulation, glass, industrial gases, pharmaceutical, construction products, foundry resins, automotive products, and brewing. For those on Wall Street who still do not acknowledge that excessive speculation is a problem, let me briefly describe what happened to natural gas prices in the time period of January to August of 2008. During the first half of 2008, excessive speculation drove the NYMEX price of natural gas from $7.17/mm Btu in January to a high of $13.60/mm Btu in July before prices began to recede. During that same time period, the Energy Information Administration reports that domestic production increased by 8.6 percent; demand was essentially unchanged from the previous year and that national inventories were in the normal 5 year average range for that time of the year. These facts prove that the price spike was not driven by supply versus demand fundamentals. Unfortunately for homeowners, farmers and manufacturers, the net increase in the price of natural gas cost consumers over $40.4 billion from January to August 2008 when compared to the same time period in 2007. It is also important to highlight to the Committee that natural gas was specifically targeted by traders for manipulation more than any other commodity during that same time period by a significant margin. This information comes from the Commodity Futures Trading Commission (CFTC) September, 2008 report entitled ``Staff Report on Commodity Swap Dealers & Index Traders with Commission Recommendations.'' The report highlights that more noncommercial traders exceeded the speculative limit or exchange accountability levels for trading natural gas than any other commodity and by a very high margin. The below paragraph is from the report. Exceeding Position Limits or Accountability Levels: On June 30, 2008, of the 550 clients identified in the more than 30 markets analyzed, the survey data shows 18 noncommercial traders in 13 markets who appeared to have an aggregate position (all on-exchange futures positions plus all OTC equivalent futures combined) that would have been above a speculative limit or an exchange accountability level if all the positions were on-exchange. These 18 noncommercial traders were responsible for 35 instances that would have exceeded either a speculative limit or an exchange accountability level through their aggregate on-exchange and OTC trading that day. Of these instances: eight were above the NYMEX accountability levels in the natural gas market; six were above the NYMEX accountability levels in the crude oil market; six were above the speculative limit on the CBOT wheat market; three were above the speculative limit on the CBOT soybean market; and 12 were in the remaining nine markets. Mr. Chairman, we are very grateful for the attention this Committee is giving this incredibly important issue and this legislation is an excellent start to addressing excessive speculation in commodity markets. IECA strongly supports: section 3 that establishes speculative limits and transparency of offshore trading; section 4 that requires increased transparency through detailed reporting and disaggregation of market data that includes index funds and other passive, long-only and short-only investors in all regulated markets and data on speculative positions; section 5 that increases transparency and record-keeping to the CFTC and includes over-the-counter (OTC) contracts; section 6 that establishes trading limits to prevent excessive speculation and creates a Energy and Agriculture Position Limit Advisory Group that would provide recommendations on setting position limits; section 7 that provides for at least 200 additional full-time CFTC employees; section 8 that ensures that prior CFTC actions are consistent with this Act. IECA areas of concern and recommended improvements are as follows:More Transparency in CFTC Processes We encourage the legislation to reflect a change in culture at CFTC to one that has more transparency and public input into their decision making processes. We prefer the Federal Energy Regulatory Commission (FERC) model. The FERC frequently have rule making processes that allow for public comment and organize sessions that are similar to your Congressional hearings in which entities are solicited for comment. At FERC, there are ample opportunities for written public input as well.Section 13: Clearing of Over-the-Counter Transactions We do not support requiring commercial hedgers such as ourselves to be required to clear their transactions. The problem of market speculation is not caused by commercial hedgers and they are a relatively small portion of the market. The problem is non-hedgers or speculators. For this reason, only speculator bilateral OTC transactions should be cleared. We believe that requiring commercial hedgers to clear their transactions will potentially decrease our competitiveness through increased complexity and cost creating a disincentive for industrial users to manage risk. We also urge the Chairman to add provisions to section 13 that will increase transparency to the CFTC decision making process and with a public comment period.Section 6: Trading Limits to Prevent Excessive Speculation-- Establishment of Advisory Groups We strongly support the establishment of a Position Limit Advisory Group for both agricultural and energy commodities. However, we recommend an additional step in the process by requiring that a public comment period be added to further increase transparency of the process. We further recommend that the governance of this advisory group favor the consumer perspective to ensure the best interest of those paying the bills.Section 14: Treatment of Emission Allowances and Offset Credits We have concerns including this provision. Including carbon emissions as a tradable commodity in this legislation is premature to Federal policy making. The Congress has not decided how it will regulate greenhouse gas emissions and we are concerned that this legislation would preempt that decision. U.S. manufacturing companies that have been studying cap and trade and our colleagues in Europe believe that carbon trading will be the next Sub-Prime Crisis. Attached is a copy of a recent article from The Guardian, a UK newspaper dated January 30, 2009 entitled ``Carbon Trading: The Next Sub-Prime.'' We encourage the Committee to read it. (Attachment A) Carbon cap and trade is only one of several policy approaches to regulating carbon and alternatives would not require trading carbon. Other alternatives include a carbon tax, sector approaches (example: CAFE); energy efficiency or GHG intensity mandates for the manufacturing sector or setting energy efficiency standards on every major energy consuming device thereby reducing energy consumption (example: appliance standards) and building codes for homes and commercial buildings. In general, manufacturers have raised serious concerns regarding cap and trade because it is not transparent; offsets are easily subject to manipulation; it cannot be effectively border adjusted which means importers who are not burdened with equivalent higher costs will take business away from domestic producers and will result in lost jobs; it raises energy costs that manufacturers cannot pass-on because of international competition. The Industrial Energy Consumers of America welcomes the opportunity to work with the Committee on Agriculture as it moves forward with this legislation.Paul N. Cicio,[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]President,February 4, 2009. Attachment ACarbon Trading: The Next Sub-PrimeJanuary 30, 2009The Guardian, Friday 30 January 2009By Terry Macalister Climate and Capitalism has long argued that carbon trading is a scam to boost profits without reducing emissions. Here's confirmation from an unexpected source: the CEO of a major European energy company. The row over the working of the European Union's emissions trading scheme intensified last night when EDF Energy warned that speculators risked turning carbon into a new category of sub-prime investment. Vincent de Rivaz, the chief executive of the UK arm of the French-owned gas and electricity group, said politicians and regulators needed to revisit the way the ETS was working and whether it was bringing the results they wanted. ``We like certainty about a carbon price,'' he said. ``[But] the carbon price has to become simple and not become a new type of sub-prime tool which will be diverted from what is its initial purpose: to encourage real investment in real low-carbon technology.'' Green campaigners have long been critical of the way the emissions trading scheme was set up, but it is unusual for a leading industry figure to cast doubt on it, as power companies lobbied hard for a market mechanism to deal with global warming. ``We are at the tipping point where we . . . should wonder if we have in place the right balance between government policy, regulator responsibility and the market mechanism which will deliver the carbon price,'' said de Rivaz. De Rivaz's comments came as Tony Hayward, chief executive of BP, emphasised that a predictable global carbon price was important because it would make ``vast numbers of alternative energy sources competitive''. He told the World Economic Forum in Davos that certainty over carbon emissions would help ``solve the world's energy problems''. Their comments came days after the Guardian revealed that steelmakers and hedge funds were cashing in ETS carbon credits obtained for free, causing the price of carbon to plunge. The price of carbon has slumped from =30 a tonne to below =12, leading to a tail-off in clean-technology offset projects in the developing world. The EU's emissions trading scheme was set up as a market solution to cut greenhouse gas pollution from industry. Polluters were issued with permits that can be traded between companies and countries as a way of encouraging an overall reduction in carbon output. However, companies are now cashing them in. Up to =1bn-worth of permits are said to have been sold off in recent months as companies see an opportunity to bring in funds at a time when their carbon output is expected to fall due to lower production. De Rivaz said an over-reliance on markets without tougher safeguards was responsible for the financial turmoil that has sent banks into administration or forced sale. He believed there had been a ``lost sense of values'' and he was anxious that this should not extend into the energy sector, but was not prepared yet to call for a carbon tax to replace the ETS. Point Carbon, an information provider and consultancy, claims the sell-offs are only one of a number of factors influencing carbon prices and argues it is ``rational'' for them to be selling off credits. ``Recession in Europe is bringing a slowdown in manufacturing, meaning less production and less emissions,'' said Henrik Hasselknippe, global head of carbon at Point Carbon. ``Companies are doing exactly the rational thing in these circumstances, which is to sell if they are long on credits. If they are emitting less then they do not need the credits so much and the price of carbon will fall.'' However, Bryony Worthington, an expert on climate change and founder of sandbag.org.uk, said: ``What should have been a way to kick-start investment in much needed low-carbon, efficient technologies is now a cash redistribution exercise.'' A study commissioned by the WWF environmental organisation from Point Carbon, published in March last year, estimated that ``windfall profits'' of between =23bn and =71bn (20.9bn-64.4bn) would be made under the ETS between 2008 and 2012, on the basis that the price of carbon would be between =21 and =32. Up to =15bn could be made by British companies that were given credits they did not need. " CHRG-111hhrg51698--123 Mr. Cota," Congressman, first with regard to your comments on the CFTC in that they didn't have enough information in order to determine whether or not there was speculation having an impact, that is because they don't have jurisdiction over large chunks of the market through various--closing the Enron bill does take part of that, but those administrative rules are not in place yet, and it still exempts the lending loophole in all of those. So until you start counting the whole pie, it doesn't make any sense. The case of Amaranth, which was a hedge fund that went bad, they only got caught because they did some of their trades upon a regulated exchange, a subsidiary of the Chicago Merc, the New York Mercantile Exchange, where they were cornering--it was perceived that their positions were too large for the February contract. In retrospect, after an investigation, it turned out that they had 80 percent of the U.S. total natural gas production for the February contract, just for their position. So until you see what these aggregate position limits are of these large entities, and you keep track of it, that is the only time you can bring it to the light of day. I like to have exchanges do most of this, because you put all of the players together in the same room, and they know what is going on. When they see somebody is going to put them at risk, they are going to be much more diligent and make sure that person doesn't. As to what started the whole process, we started when the subprime market went bad, so people needed to put their money as they sold out of that. The banks that lost money on that initially lost because they had loaned money to people to buy these subprimes, and then they decided it went as high as possible, so I had better short it. So they shorted it. People they loaned money to went bad. People needed to move money out quickly. Any pyramid collapses faster than it went up, and then they went into their remaining items. The remaining investments were equities at that point, so in 2007 you saw a bump in equities. As that started to come apart, it moved into currencies and commodities. It was the only thing that was cash. As people became afraid of everything else, a stock may go to zero, Lehman may go to zero, a commodity will never go to zero. It may go to 2 cents on the dollar, but it won't go to zero. So the investing world was so afraid of any sort of investment. The banks didn't trust one another so that they went into the few things that they thought were left. That, to me, underscores the issue that you need to have sensible regulation. The world looks to the United States to have the most coherent regulation of financial markets in an open and free market--so that you can trust your money is going to be worth something. The other markets around the world don't have that. I am a kind of a contrarian to some of the conversations here--if you do have a well-regulated market in the United States, the money will flood back in because they can trust this market. They may not be able to trust the others. That is my analysis of what occurred. " FOMC20071211meeting--102 100,MR. PLOSSER.," Thank you, Mr. Chairman. There has been little change in the economic conditions in our District since the October meeting. Except for housing activity, manufacturing and other businesses are expanding at a modest pace, somewhat below trend. Our business contacts are a little less optimistic about growth in the near term than they were earlier in the fall primarily because of uncertainty surrounding the outlook rather than any immediate change in their business activity. I’ll begin by reporting on what our contacts say about credit conditions. Business contacts as well as our board of directors have told me that credit activity has changed very little. Creditworthy borrowers, as far as they were concerned, have had no problem accessing credit. Banks have reported some tightening of lending standards, but mostly that has occurred for real estate developers and in residential mortgages. Some loan demand has dropped because of businesses’ uncertainty about the future, as I suggested earlier. That is, businesses seem to be a bit more cautious. But banks do not appear to be conserving capital. In fact, they’re actively seeking good credits. To quote one of my directors, “The crunch on Wall Street has not hit Main Street.” A couple of bankers I spoke to, one representing a very large regional bank and another a very large community bank, expressed the view that they were actively seeking to regain market share from the larger banks because they did not engage in the same off-balance-sheet financing of riskier debt that the large banks did and so they were not facing either capital or funding constraints. Some bankers acknowledge that consumer credit quality seems to have deteriorated slightly, but they reminded me that this was from very good levels. So the defaults and delinquencies remain well within historical norms. Turning to the economy, payroll employment continues to expand at a somewhat slow pace in our three states, yet the unemployment rate is still 0.4 percentage point below that of the nation. Retail sales picked up in November. Moreover, retailers generally said they met their expectations for the Thanksgiving weekend. However, these sales seem to have been boosted by fairly heavy discounting, according to them; and despite the reasonable showing to date, retailers are wary and uncertain for the holiday season. Housing construction and sales continue to decline, but the pace of that decline is in line with the expectations at the time of our last meeting. Nonresidential real estate markets remain firm in our District. Office vacancy rates continue to decline, and commercial rents are rising. New contracts for commercial real estate have declined, however; but with the decline in vacancy rates and with rising rents, the outlook of many developers is not as negative as the current level of spending would suggest. According to our Business Outlook Survey, manufacturing activity in the District has been increasing at a modest pace for the past few months. The index of general activity moved up slightly, to 8.2 in November from 6.8 in October. This is actually about the same average level that the outlook survey has maintained over the past two years. Shipments and new orders moved up slightly. However, optimism regarding the outlook over the next six months declined. It’s a common theme of many of our business contacts that their businesses have not changed much, but they seem to be reacting to the steady stream of negative news, and it is affecting their outlook. Indeed, the CEOs of several very large industrial firms in our District report business to be very strong both domestically and overseas, and the CEOs have seen little effect of the turmoil on Wall Street on their ability to obtain credit. Now, last time I said that there had been little change in the District’s inflation picture. However, we have started to see evidence of increased price pressures. The Business Outlook Survey’s prices-paid index has risen considerably since the beginning of the year and has doubled since August. The index for prices received has also more than doubled since August, rising sharply in both October and November. Also retailers have noted spreading price increases for imported goods, and a wide range of industries are reporting increases in energy and transportation costs. Firms continue to report higher health care costs, and at the same time, wages continue to be moderate, they say. In summary, economic conditions have changed little since our last meeting. The business activity in the region is advancing at a moderate pace. Credit constraints experienced by the large money center banks have not appreciably affected the banks in our District or their lending practices. In general, firms in the District remain cautiously optimistic about their businesses six months from now but not so much as they were last month. Price pressures have increased on the input side related to energy and commodity costs; more generally, many firms are now prepared to raise their own prices and are looking to do so in the near future, and the financial conditions of our banks remain good. Turning to the nation, financial market conditions, especially those associated with the big money center banks, have clearly deteriorated in recent weeks. Until the end of October, spreads were gradually declining. It seems that the potential for a serious meltdown was monotonically declining. However, since early November, as we all pointed to, a number of financial institutions, subprime mortgages, jumbo mortgages, asset-backed commercial paper, below-investment-grade bonds, and LIBOR have experienced increased spreads. Volatility has risen as well. Clearly, risk premiums have risen for certain classes of assets, and investors have fresh concerns about the way credit market conditions are evolving. Overall, the recent financial developments suggest that it will take longer before conditions are “back to normal” in all segments of the market. As I’ve said before, I continue to believe that price discovery still plagues many of these markets. It now looks as though it will take a little longer before these markets can sort things out and return to normal. Financial institutions continue to write off some of the investments and take losses. I view these write-downs as a necessary and healthy part of the process toward stabilization. Infusions of capital in some financial institutions, I think, are encouraging and helpful to the process. This does not mean that the ultimate agreed-upon market prices for some of these assets will bear any resemblance to what they did before August. Indeed, they probably won’t. But that’s not necessarily a bad sign, nor is it a cause for concern. In general, it may be a very healthy development. The news on economic activity has softened somewhat since our last meeting. Among the negatives, of course, the housing market and residential investment continue to decline. Foreclosures have continued to grow at unprecedented rates. Firms have become a little more cautious in their investment plans. Consumer spending has softened slightly, and real disposable personal income declined in October. Oil prices have moved higher. On the brighter side so far, there is some evidence of spillovers from the financial and housing markets to the broader economy, but I believe it is limited. Net exports and business fixed investment have been surprises on the upside. Finally, and most important, the labor market still looks pretty solid. Foreclosures and consumer weaknesses appear to be heavily concentrated in those states where the housing boom and thus the housing price declines have been most pronounced—especially California, Nevada, and Florida—and in those states, such as Ohio and Michigan, that are feeling the effects of the decline in automobile manufacturing. As President Poole indicated, credit card delinquencies were up but highly concentrated in California, Nevada, and Florida. Thus, based on such observations and the news that I hear from my District, I sense that the stresses in the economy vary significantly by region, and we must be mindful that the weaknesses on Wall Street are in those states that have exaggerated housing volatility and may not be representative of the rest of the economy. To be sure, we must be wary of continued deterioration and spillovers, but at this point my assessment is that they remain concentrated in a few regions and are not as widespread as some of the aggregate data might suggest. It’s important to note that, for a good part of the forecast for the fourth-quarter GDP, it’s payback for strong inventories and net export numbers in the third quarter. I note that, absent payback and despite the worsening news, economic growth would be on the order of 2 percent higher. To put this differently, the news since the last meeting has not altered the overall GDP forecast for the second half of 2007. It’s about the same. The news has clearly altered the Greenbook’s forecast for 2008, especially for the first half of the year but also extending into the second half of 2008. The forecast calls for explicit spillovers from financial markets and the housing sector to the broader economy, to consumption, to fixed investment, and so forth. I should note, however, that most private sector forecasters are significantly less pessimistic than the Greenbook. The Blue Chip survey, our just-released Livingston Survey, our Survey of Professional Forecasters, and several of the major forecasting firms that have issued forecasts in the last couple of weeks see weakness extending into the first and maybe the second quarter of 2008 but a much more rapid bounceback in the second half of 2008 than is suggested in the Greenbook. These private sector forecasts are more in line with my own view. While the news on growth is somewhat on the downside, the news on inflation is on the upside. Readings on core inflation have been stable over the last few months, but headline inflation rates have risen sharply, with increases in energy and commodity prices. The broader scope of these commodity price increases and their breadth suggest that perhaps there are more-generalized inflationary pressures out there rather than these isolated relative price shocks. I will note that the core PCE inflation rate for March to June was 1½ percent; and in every three-month window subsequently, the inflation rate has risen monotonically, now reaching 2.26 percent for the latest three-month period from August to October. This comes after fairly steady declines in core rates during the first half of the year. In my comments on the Third District, I noted the greater prospects for price increases indicated by our manufacturing firms. I also am going to cite another statistic from the same survey that President Evans referred to—Duke University’s CFO Magazine survey. The survey to which he referred was a survey conducted in late November and early December of more than 600 CFOs. In the survey, the average price increase that these CFOs were estimating for their own products in the coming year was 2.8 percent, and that was up from just 2 percent in the previous quarter. Thus, it appears that firms are beginning to be more interested in increasing prices and are more able to do so than they were just a few months ago, even though the same CFOs were more pessimistic about the economy than they were in the last quarter. Another piece of news on inflation expectations comes from the Livingston Survey, which was just released yesterday. There the forecast of the average annual change for the CPI for 2007 to 2008 moved up from 2.3 percent to 3 percent. This, of course, partially reflects the behavior of oil prices during the past several months. The December-to-December forecast, on the other hand, also rose, but only slightly. Thus, overall, the economy is weak but only slightly more so than I anticipated. Volatility in the financial markets continues, and the repricing of risk has not progressed as smoothly as I would like to see. Nevertheless, the spillovers from the financial turmoil seem geographically concentrated, and broader spillovers appear limited to date. I view inflation expectations as fragile and see evidence that price pressures are growing and that more and more firms feel that price increases are coming and are supportable. I think we will have to be very careful not to presume that just because price expectations and prices have remained contained that they will continue to be so, independent of our actions. Thank you." CHRG-111hhrg63105--39 Mr. Gensler," I am sure. I don't think that the Commodity Exchange Act or Congress has said that the CFTC is an agency to regulate prices. What we have as our mission is to ensure fair and orderly markets, that the price discovery function is transparent, and that there is an integrity of the markets, and that the position limit regime that has been in place since the 1930s is to ensure that there is a diversity of points of view. It doesn't limit hedgers, it limits the number of contracts a speculator can hold, and speculators and hedgers, importantly, must meet in a marketplace, but that there may be burdens that come from excessive speculation. I will use an extreme case: If somebody had half a market, for instance, and then they were to liquidate that position it would be a burden on the market. Maybe if it is only ten percent of the market, to liquidate that market, it would be a burden. So, over the decades what we did is we put in place limits in the agricultural markets. There were limits through the exchanges in the metals and energy markets in the 1980s and 1990s. In fact energy markets had limits all the way through the summer of 2001, for these all-months-combined. And it was to prevent, prospectively as much as anything, the burdens that may come from large positions and the concentration of those positions in a marketplace. " CHRG-111shrg54589--100 Mr. Pickel," All right. I would say that in the derivatives space--and this has been around for 25 years--a lot of the developments were on market risk--interest rates, currencies, equities, commodities, where you are managing a market risk. Credit risk is a new, a relatively new derivative, and I would say that we are still understanding some of the implications of that. And I think that Professor Hu's work has been very interesting in that regard. I would say that, regarding that empty creditor issue, the fact is that every time somebody is going to into the market and buying protection, which is he suggested somebody is doing, they are sending signals to that company: Your business plan is not working; your business plan is not working. The yellow light is getting brighter and brighter and brighter. And so when it comes to the end and somebody says, ``Time is up; I am not going to continue to lend to you,'' I think that is a natural evolution of this market, but let us certainly understand that. I would also just mention that credit default swap spreads are becoming embedded in various ways. They are being used for pricing loans. It was done with the rollback of Scotland extension of credit by the U.K. Government, and just today in the Wall Street Journal, it was mentioned that S&P has developed an additional means of providing information on credit exposure to the marketplace that incorporates a credit default swap spread. So we see continuing evolution here, and I think it ought to be encouraged, but, understood, certainly. " FinancialServicesCommittee--69 Mr. G ARRETT . Yes. That is a good point about overseas trades. I was going to bring that up before, but— Mr. D UFFY . That is exactly where it will go, sir. Mr. G ARRETT . —thank you, Mr. Chairman. Mr. S COTT . Thank you, Mr. Garrett. I want to thank each of you—Mr. Leibowitz, Mr. Noll, Mr. Duffy, and also Chairman Schapiro and Chairman Gensler—for your ex- cellent, superb, and well-presented testimony today on this very critical issue as we move to make sure we maintain the strongest investor confidence in our financial markets and in our investor trading. Thank you again, very, very much, for coming before our committee and helping us with this. The Chair notes that some members may have additional ques- tions for this panel which they may wish to submit in writing. Without objection, the hearing record will remain open for 30 days for members to submit written questions to these witnesses and to place their responses in the record. Before we adjourn, the following will be made part of the record of this hearing: the written statement of Commissioner Bart Chilton, Commodities Future Trading Commission. Without objec- tion, it is so ordered. The panel is dismissed, and this hearing is adjourned. [Whereupon, at 6:32 p.m., the hearing was adjourned.] fcic_final_report_full--146 The CDO investors, like investors in mortgage-backed securities, focused on dif- ferent tranches based on their preference for risk and return. CDO underwriters such as Citigroup, Merrill Lynch, and UBS often retained the super-senior triple-A tranches for reasons we will see later. They also sold them to commercial paper pro- grams that invested in CDOs and other highly rated assets. Hedge funds often bought the equity tranches.  Eventually, other CDOs became the most important class of investor for the mez- zanine tranches of CDOs. By , CDO underwriters were selling most of the mez- zanine tranches—including those rated A—and, especially, those rated BBB, the lowest and riskiest investment-grade rating—to other CDO managers, to be pack- aged into other CDOs.  It was common for CDOs to be structured with  or  of their cash invested in other CDOs; CDOs with as much as  to  of their cash invested in other CDOs were typically known as “CDOs squared.” Finally, the issuers of over-the-counter derivatives called credit default swaps, most notably AIG, played a central role by issuing swaps to investors in CDO tranches, promising to reimburse them for any losses on the tranches in exchange for a stream of premium-like payments. This credit default swap protection made the CDOs much more attractive to potential investors because they appeared to be virtu- ally risk free, but it created huge exposures for the credit default swap issuers if signif- icant losses did occur. Profit from the creation of CDOs, as is customary on Wall Street, was reflected in employee bonuses. And, as demand for all types of financial products soared during the liquidity boom at the beginning of the st century, pretax profit for the five largest investment banks doubled between  and , from  billion to  billion; total compensation at these investment banks for their employees across the world rose from  billion to  billion.  A part of the growth could be credited to mortgage-backed securities, CDOs, and various derivatives, and thus employees in those areas could be expected to be compensated accordingly. “Credit derivatives traders as well as mortgage and asset-backed securities salespeople should especially enjoy bonus season,” a firm that compiles compensation figures for investment banks reported in .  To see in more detail how the CDO pipeline worked, we revisit our illustrative Citigroup mortgage-backed security, CMLTI -NC. Earlier, we described how most of the below-triple-A bonds issued in this deal went into CDOs. One such CDO was Kleros Real Estate Funding III, which was underwritten by UBS, a Swiss bank.  The CDO manager was Strategos Capital Management, a subsidiary of Cohen & Company; that investment company was headed by Chris Ricciardi, who had earlier built Merrill’s CDO business.  Kleros III, launched in , purchased and held . million in securities from the A-rated M tranche of Citigroup’s security, along with  junior tranches of other mortgage-backed securities. In total, it owned  mil- lion of mortgage-related securities, of which  were rated BBB or lower,  A, and the rest higher than A. To fund those purchases, Kleros III issued  billion of bonds to investors. As was typical for this type of CDO at the time, roughly  of the Kleros III bonds were triple-A-rated. At least half of the below-triple-A tranches issued by Kleros III went into other CDOs.  “Mother’s milk to the . . . market” CHRG-111shrg55117--81 Mr. Bernanke," Yes. Those are useful because for very short-term derivative and other positions, the netting provisions that allow you to deal with those before the whole bankruptcy process takes place, I think is actually constructive given our existing bankruptcy law. But this would intervene prior to the standard bankruptcy and would allow the Government to intervene and to unwind all different kinds of transactions. That would be an appropriate time to think about how you would deal with these short-term derivative positions and other types of obligations going forward. Senator Warner. I differ from the administration and perhaps your views in terms of where the responsibility ought to be on systemic risk oversight. I believe an independent council with an independent chair, including obviously on that council the Fed. But regardless of where the policy makers end up, in the interim period, are you comfortable, whether it is as Senator Menendez mentioned in terms of kind of getting ahead of the--potentially getting ahead on the CMBS issue, are you comfortable that the Fed is the de facto systemic risk overseer at this point? Is aggregating enough information upstream from all the day-to-day prudential regulators, not just on the banking side but from securities, commodities, and others, that this aggregation of information is taking place? " CHRG-111hhrg53021--63 Mr. Goodlatte," That is a good answer. And I would convey to both Chairmen my hope that they will make this an open and bipartisan process and assure us that, once the legislation is in writing, that we won't rush to mark it up without having the opportunity for the millions of Americans who are very much affected by it as well as their Representatives having the opportunity to ask the questions that need to be asked. In particular, I would note that you had indicated you hope that the Members of the Committee would write legislation that would establish broad principles upon which, then, the various agencies would write the particularity in the regulations. But we don't even, at this point, have those broad principles in front of us to know how we think that process would work. But let me ask you specifically about one area that is of considerable concern to me and many others. You told us that the SEC and the CFTC are still working on how best to divide up the jurisdiction over the OTC derivatives markets and dealers. When this division of jurisdiction and responsibility is finalized, does the Administration intend that each agency would exercise exclusive regulatory jurisdiction over their assigned area? The exclusive jurisdiction provision of the Commodity Exchange Act has worked well to avoid regulatory duplication and conflict. And I would hope that it would be built into the legislation on OTC derivatives, as well. Can you confirm to me that it will be? " CHRG-111hhrg53021Oth--63 Mr. Goodlatte," That is a good answer. And I would convey to both Chairmen my hope that they will make this an open and bipartisan process and assure us that, once the legislation is in writing, that we won't rush to mark it up without having the opportunity for the millions of Americans who are very much affected by it as well as their Representatives having the opportunity to ask the questions that need to be asked. In particular, I would note that you had indicated you hope that the Members of the Committee would write legislation that would establish broad principles upon which, then, the various agencies would write the particularity in the regulations. But we don't even, at this point, have those broad principles in front of us to know how we think that process would work. But let me ask you specifically about one area that is of considerable concern to me and many others. You told us that the SEC and the CFTC are still working on how best to divide up the jurisdiction over the OTC derivatives markets and dealers. When this division of jurisdiction and responsibility is finalized, does the Administration intend that each agency would exercise exclusive regulatory jurisdiction over their assigned area? The exclusive jurisdiction provision of the Commodity Exchange Act has worked well to avoid regulatory duplication and conflict. And I would hope that it would be built into the legislation on OTC derivatives, as well. Can you confirm to me that it will be? " CHRG-110hhrg44901--11 Mr. Bernanke," Thank you, Chairman Frank, Ranking Member Bachus, and members of the committee. I am pleased to present the Federal Reserve's Monetary Report to the Congress. The U.S. economy and financial system have confronted some significant challenges thus far in 2008. The contraction in housing activity that began in 2006 and the associated deterioration in mortgage markets that became evident last year have led to sizable losses at financial institutions and a sharp tightening in overall credit conditions. The effects of the housing contraction and of the financial headwinds on spending and economic activity have been compounded by rapid increases in the price of energy and other commodities, which have zapped household purchasing power even as they have boosted inflation. Against this backdrop, economic activity has advanced at a sluggish pace during the first half of this year, while inflation has remained elevated. Following a significant reduction in its policy rate over the second half of 2007, the Federal Open Market Committee eased policy considerably further through the spring to counter actual and expected weakness in economic growth and to mitigate downside risks to economic activity. In addition, the Federal Reserve expanded some of the special liquidity programs that were established last year and implemented additional facilities to support the functioning of financial markets and foster financial stability. Although these policy actions have had positive effects, the economy continues to face numerous difficulties, including ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil, food, and some other commodities. Let me now turn to a more detailed discussion of some of these issues. Developments in financial markets and their implications to the macroeconomic outlook have been a focus of monetary policymakers over the past year. In the second half of 2007, the deteriorating performance of subprime mortgages in the United States triggered turbulence in domestic and international financial markets as investors became markedly less willing to bear credit risk of any type. In the first quarter of 2008, reports of further losses and write-downs in financial institutions intensified investor concerns and resulted in further sharp reductions in market liquidity. By March, many dealers and other institutions, even those that had relied heavily on short-term secured financing, were facing much more stringent borrowing conditions. In mid-March, a major investment bank, The Bear Stearns Companies, Inc., was pushed to the brink of failure after suddenly losing access to short-term financing markets. The Federal Reserve judged that a disorderly failure of Bear Stearns would pose a serious threat to overall financial stability and would most likely have significant adverse implications for the U.S. economy. After discussions with the Securities and Exchange Commission, and in consultation with the Treasury, we invoked emergency authorities to provide special financing to facilitate the acquisition of Bear Stearns by JPMorgan Chase & Company. In addition, the Federal Reserve used emergency authorities to establish two new facilities to provide backstop liquidity to primary dealers, with the goals of stabilizing financial conditions and increasing the availability of credit to the broader economy. We have also taken additional steps to address liquidity pressures in the banking system, including a further easing of the terms for bank borrowing at the discount window and increases in the amount of credit made available to banks through the Term Auction Facility. The FOMC also authorized expansion of its currency swap arrangements with the European Central Bank and the Swiss National Bank to facilitate increased dollar lending by those institutions to banks in their jurisdictions. These steps to address liquidity pressures, coupled with monetary easing, seem to have been helpful in mitigating some market strains. During the second quarter, credit spreads generally narrowed, liquidity pressures ebbed, and a number of new financial institutions raised new capital. However, as events in recent weeks have demonstrated, many financial markets and institutions remain under considerable stress in part because of the outlook for the economy and thus for credit quality, which remains uncertain. In recent days, investors became particularly concerned about the financial condition of the Government-Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac. In view of this development, and given the importance of these firms to the mortgage market, the Treasury announced a legislative proposal to bolster their capital, access to liquidity, and regulatory oversight. As a supplemental to the Treasury's existing authority to lend to the GSEs, and as a bridge to the time when Congress decides how to proceed on these matters, the Board of Governors authorized the Federal Reserve Bank of New York to lend to Fannie Mae and Freddie Mac, should that become necessary. Any lending would be collateralized by U.S. Government and Federal agency securities. In general, healthy economic growth depends on well-functioning financial markets. Consequently, helping the financial markets to return to more normal functioning will continue to be a top priority of the Federal Reserve. I turn now to current economic developments and prospects. The economy has continued to expand, but at a subdued pace. In the labor market, private payroll employment has declined, falling at an average pace of 94,000 jobs per month through June. Employment in the construction and manufacturing sectors has been particularly hard hit, although employment declines in a number of other sectors are evident as well. The unemployment rate has risen and now stands at 5\1/2\ percent. In the housing sector, activity continues to weaken. Although sales of existing homes have been about unchanged this year, sales of new homes have continued to fall, and inventories of unsold new homes remain high. In response, homebuilders continue to scale back the pace of housing starts. Home prices are falling, particularly in regions that experienced the largest price increases earlier this decade. The declines in home prices have contributed to the rising tide of foreclosures. By adding to the stock of vacant homes for sale, these foreclosures have in turn intensified the downward pressure on home prices in some areas. Personal consumption expenditures have advanced at a modest pace so far this year, generally holding up somewhat better than might have been expected, given the array of forces weighing on households and attitudes. In particular, with the labor market softening and consumer price inflation elevated, real earnings have been stagnant so far this year. Declining values in equities have taken their toll on household balance sheets, credit conditions have tightened, and indicators of consumer sentiment have fallen sharply. More positively, the fiscal stimulus package is providing some timely support to household incomes. Overall, consumption spending seems to be constrained over coming quarters. In the business sector, real outlays for equipment and software were about flat in the first quarter of the year, and construction of nonresidential structures slowed appreciably. In the second quarter, the available data suggests that business fixed investment appears to have expanded moderately. Nevertheless, surveys of capital spending plans indicate that firms remain concerned about the economic and financial environment, including sharply rising cost of inputs and indications of tightening credit, and they are likely to be cautious with spending in the second half of this year. However, strong export growth continues to be a significant boon to many U.S. companies. In conjunction with the June FOMC meeting, Board Members and Reserve Bank Presidents prepared economic projections covering the years 2008 through 2010. On balance, most FOMC participants expected that over the remainder of this year, output would expand at a pace appreciably below its trend rate, primarily because of continued weakness in housing markets, elevated energy prices, and tight credit conditions. Growth is projected to pick up gradually over the next 2 years as residential construction bottoms out and begins a slow recovery, and as credit conditions gradually improve. However, FOMC participants indicated that considerable uncertainty surrounded their outlook for economic growth and viewed the risks to their forecasts as skewed to the downside. Inflation has remained high, running at nearly a 3\1/2\ percent annual rate over the first 5 months of this year as measured by the price index for personal consumption expenditures. And with gasoline and other consumer energy prices rising in recent weeks, inflation seems likely to move temporarily higher in the near term. The elevated level of overall consumer inflation largely reflects a continued sharp run-up in the prices of many commodities, especially oil, but also certain crops and metals. The spot price of West Texas intermediate crude oil soared about 60 percent in 2007, and thus far this year has climbed an additional 50 percent or so. The price of oil currently stands at about 5 times its level toward the beginning of this decade. Our best judgment is that the surge has been driven predominantly by strong growth in underlying demand and tight supply conditions in global oil markets. Over the past several years, the world economy has expanded its fastest pace in decades, leading to substantial increases in the demand for oil. Moreover, growth has been concentrated in developing and emerging market economies, where energy consumption has been further stimulated by rapid industrialization and by government subsidies that hold down the price of energy faced by ultimate users. On the supply side, despite sharp increases in prices, the production of oil has risen only slightly in the past few years. Much of the subdued supply response reflects inadequate investment and production shortfalls in politically volatile regions where large portions of the oil reserves are located. Additionally, many governments have been tightening their control over oil resources, impeding foreign investment and hindering efforts to boost capacity and production. Finally, sustainable rates of production in some of the more accessible oil fields, such as those in the North Sea, have been declining. In view of these factors, estimates of long-term oil supplies have been marked down in recent months. Long-dated oil futures prices have risen, along with spot prices, suggesting that market participants also see oil supply conditions remaining tight for years to come. The decline in the foreign exchange value of the dollar has also contributed somewhat to the increase in oil prices. The precise size of this effect is difficult to ascertain, as the causal relationships between oil prices and the dollar are complex and run in both directions. However, the price of oil has risen significantly in terms of all major currencies, suggesting that factors other than the dollar, notably shifts in the underlying global demand for and the supply of oil, have been the principal drivers of the increase in prices. Another concern that has been raised is that financial speculation has added markedly to upward pressures on oil prices. Certainly, investor interest in oil and other commodities has increased substantially of late. However, if financial speculation were pushing above the levels consistent with the fundamentals of supply and demand, we would expect inventories of crude oil and petroleum products to increase as supply rose and demand fell. But, in fact, available data on oil inventories show notable declines over the past year. This is not to say that useful steps could not be taken to improve the transparency and functioning of futures markets, only that such steps are unlikely to substantially affect the prices of oil or other commodities in the longer term. Although the inflationary effect of rising oil and agricultural commodity prices is evident in the retail prices of energy and food, the extent to which the high prices of oil and other raw materials have been passed through to the prices of nonenergy, nonfood finished goods and services seems thus far to have been limited. But with businesses facing persistently higher input prices, they may attempt to pass through such costs into final goods and services more aggressively than they have so far. Moreover, as the foreign exchange value of the dollar has declined, rises in import prices have been greater upward pressure on business costs and consumer prices. In their economic projections for the June FOMC meeting, monetary policymakers marked-up their forecast for inflation during 2008 as a whole. FOMC participants continue to expect inflation to moderate in 2009 and 2010, as slower global growth leads to a cooling of commodity markets, as pressures on resource utilization decline, and as longer-term inflation expectations remain reasonably well-anchored. However, in light of the persistent escalation of commodity prices in recent quarters, FOMC participants viewed the inflation outlook as unusually uncertain and cited the possibility that commodity prices will continue to rise as an important risk to the inflation forecast. Moreover, the currently high levels of inflation, if sustained, might lead the public to revise up its expectations for longer-term inflation. If that were to occur, and those revised expectations were to become embedded in the domestic wage and price-setting process, we would see an unwelcome rise in actual inflation over the longer term. A critical responsibility of monetary policymakers is to prevent that process from taking hold. At present, accurately assessing and appropriately balancing the risks to the outlook for growth and inflation is a significant challenge for monetary policymakers. The possibility of higher energy prices, tighter credit conditions, and a still deeper contraction in housing markets all represent significant downside risks to the outlook for growth. At the same time, upside risks to the inflation outlook have intensified lately as the rising prices of energy and some other commodities have led to a sharp pickup in inflation, and some measures of inflation expectations have moved higher. Given the high degree of uncertainty, monetary policymakers will need to carefully assess incoming information bearing on the outlook for both inflation and growth. In light of the increase in upside inflation risk, we must be particularly alert to any indications, such as an erosion of longer-term expectations, that the inflationary impulses are becoming embedded in the domestic wage and price-setting process. I would like to conclude my remarks by providing a brief update on some of the Federal Reserve's actions in the area of consumer protection. At the time of our report last February, I described the Board's proposal to adopt comprehensive new regulations to prohibit unfair or deceptive practices in the mortgage market, using our authority under the Home Ownership and Equity Protection Act of 1994. After reviewing the more than 4,500 comment letters we received under the proposed rules, the Board approved the final rules on Monday. The new rules apply to all types of mortgage lenders and will establish lending standards aimed at curbing abuses, while preserving subprime lending and sustainable homeownership. The final rules prohibit lenders from making higher-priced loans without due regard for consumers' ability to make the scheduled payments, and require lenders to verify the income and assets on which they rely when making the credit decision. Also, for higher-priced loans lenders now will be required to establish escrow accounts so that property taxes and insurance costs will be included in consumers' regularly monthly payments. The final rules also prohibit prepayment penalty for higher-priced loans in cases in which the consumer's payment can increase during the first few years and restrict prepayment penalties or other higher-priced loans. Other measures address coercion of appraisers, servicer practices, and other issues. We believe the new rules will help to restore confidence in the mortgage market. In May, working jointly with the Office of Thrift Supervision and the National Credit Union Administration, the Board issued proposed rules under the Federal Trade Commission Act to address unfair or deceptive practices for credit card accounts and overdraft protection plans. Credit cards provide a convenient source of credit for many consumers, but the terms of credit cards loans have become more complex, which has reduced transparency. Our consumer testing has persuaded us that disclosures alone cannot solve this problem. Thus, the Board's proposed rules would require card issuers to alter their practices in ways that will allow consumers to better understand how their own decisions and actions will affect their costs. Card issuers will be prohibited from increasing interest rates retroactively to cover prior purchases except under very limited circumstances. For accounts having multiple interest rates, when consumers seek to pay down their balance by paying more than the minimum, card issuers will be prohibited from maximizing interest charges by applying excess payments to the lowest rate balance first. The proposed rules dealing with bank overdraft services seek to give consumers greater control by ensuring that they have ample opportunity to opt out of automatic payments of overdrafts. The Board has already received more than 20,000 comment letters in response to these proposed rules. Thank you. I have would be very pleased to take your questions. " CHRG-111shrg56415--32 Mr. Tarullo," It depends, I think, Senator, on the functions of that council. If it is a matter of analysis and scrutiny and trying to coordinate, then I think there is a good case to be made for it. If it is a matter of actually making some binding Federal law decisions, then it probably is not. Senator Tester. OK. Sheila, I have heard from banks that the FDIC is becoming more and more concerned about AG loans. Is that true? And I guess the question is why, even though the markets are in the tank. That probably answers it. Ms. Bair. Not that I am aware of, Senator. We have been monitoring it for some time, but this is the second time in a week that somebody has asked for that so maybe I will probe a little more. [Laughter.] Ms. Bair. But not that I am aware of, no. We are monitoring this. Senator Tester. I appreciate that. Ms. Bair. Senator, could I just go back to the borrower question? Senator Tester. Go ahead. Sure. Ms. Bair. One of the reasons we do whole bank transactions with loss share is if we can sell the whole bank, we do not run into this problem. A new bank gets those loans, services those loans, and it preserves the relationship with the borrower. It is only where we cannot do the whole bank transaction that we get into this problem. Senator Tester. OK. Well, I understand. You are kind of between a rock and a hard place, quite honestly, because it does not seem quite fair to let somebody else make a bunch of dough on it when you could cut that--anyway, I do not want to go there. Mr. Tarullo, there was a front-page story in the Wall Street Journal--we are going down a little different avenue here now--that talked about workers at the top 23 investment banks, hedge funds, asset managers, stock and commodity exchanges can expect to earn even more this year than they did in 2007, which was the peak year. I guess the question is, getting right to it: Are we returning to the attitude of greed that really occurred before the economic downturn--and that is being kind--in 2008? " CHRG-111hhrg52397--38 Mr. Murphy," Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee, thank you for inviting 3M to speak today on the importance of the over-the-counter derivatives market. Representative Bachmann, thank you for your kind introduction, as well as your kind words about 3M Company. As you know, my name is Timothy Murphy, and I am the foreign currency risk manager for 3M Company. As you now know, 3M is a U.S.-based employer headquartered in Minnesota. We are home to such well-known brands as Scotch, Post-It, Nexcare, Filtrete, Command, and Thinsulate. 3M has over 34,000 employees in the United States and operations in 27 States where over 60 percent of 3M's worldwide R&D and where 60 percent of our manufacturing occurs. While our U.S. presence is strong, being able to compete successfully in the global marketplace is critical. In 2008, 64 percent of our sales or over $16 billion were outside the United States. And this number is expected to grow to over 70 percent by 2010. It is because of the global success of our brands that we need to manage foreign currency risks via the OTC markets. Likewise, our desire to officially manage our raw material and financing costs gives rise to our use of OTC commodity and interest rate tools. I want to stress that 3M, like the majority of corporate end users, does not speculate with derivatives. All of our hedge transactions are carefully matched with underlying risks from the operation of our businesses. I am here today to share 3M's perspective on proposals to establish a regulatory framework for OTC derivatives. While 3M supports the objectives outlined in Treasury Secretary Geithner's recent proposal, as well as many of the ideas put forward by Members in the House and the Senate, we have strong concerns about the potential impact on OTC derivatives and 3M's ability to continue to use them to protect our operations from the risk of currency, commodity, and interest rate volatility. 3M agrees that the recent economic crisis has exposed some areas in our financial regulatory system that should be addressed. However, not all OTC derivatives have put the financial system at risk, and they should not all be treated the same. The OTC foreign exchange commodity and interest rate markets have operated largely uninterrupted throughout the economy's financial difficulties. We urge policymakers to focus on the areas of highest concern. 3M understands and respects the need for reporting and recordkeeping. Publicly-held companies are currently required by the SEC and FASB to make significant disclosures about our use of derivative instruments and hedging activities, including disclosures in our 10-Ks and 10-Qs. We would like to work with policymakers on ways to efficiently collect information into a trade repository to further enhance transparency. 3M opposes a mandate to move all derivatives into a clearing or exchange environment. One key characteristic of OTC derivatives for commercial users is the ability to customize the instrument to meet a company's specific risk management needs. Provisions that would require the clearing of OTC derivatives would lead to standardization, thus impeding a company's ability to comply with hedge accounting requirements for financial reporting, thereby exposing reported corporate financial results to unwarranted volatility and distracting from our operating results. While we are mindful of the reduction in credit risk inherent in a clearing or exchange environment, robust initial and variation margin requirements would create substantial incremental liquidity and administrative burden for commercial users, resulting in higher financing and operational cost. Scarce capital currently deployed in growth opportunities would need to be maintained as margin, which could result in slower job creation, lower capital expenditures, less R&D, and/or higher cost to consumers. The hedging of business risks could well be discouraged. 3M thanks the committee for studying the critical details related to financial system reforms and for considering our perspective in this important debate. Again, 3M respectfully urges the committee to preserve commercial users' ability to continue using OTC derivative products to manage various aspects of corporate risk while addressing concerns about stability of the financial system. 3M looks forward to working with the committee as you craft this important legislation. Thank you. [The prepared statement of Mr. Murphy can be found on page 171 of the appendix.] " FOMC20080625meeting--133 131,MR. KOHN.," Thank you, Mr. Chairman. I support the action and language of alternative B; Brian's striking of ""near-term"" is fine with me. This is a tough situation, as we all remarked yesterday. Commodity prices are at the center of the problem that we find ourselves in. In my view, we didn't cause the rise in commodity prices. We may have contributed a little around the edges, but whatever we contributed was a necessary byproduct of what we needed to do to cope with what was happening to the U.S. economy, and we can't reverse the rise in relative prices without tremendous cost to the U.S. economy. Or even the rise in headline inflation, we couldn't undo that without putting a huge amount of slack in the economy to force down wages, sticky prices, et cetera, and that would not be appropriate. I think the classic response that we've all been talking about is to take a temporary increase in inflation and in unemployment that facilitates the relative price changes that need to happen, concentrate on second-round effects, and make sure those increases are temporary. I think that's inadvertently what we've fallen into here. Given the housing and financial shocks, the 2 percent fed funds rate of alternative B is consistent for now with continuing along the path of the temporary increases in inflation and unemployment. Unlike many of you, I don't see the current rate as extraordinarily accommodative, given what else has happened in financial markets. There is no insurance in the staff forecast, right? The Greenbook forecast has zero insurance in it. My own forecast was a little stronger than the Greenbook's. I think all of ours were a little stronger than the Greenbook's, but even if I marked up r* by � point or 1 point, that's not a huge amount of insurance in the circumstances that we're facing. I note that no one sitting around this table predicted a decline in the unemployment rate over the balance of the year; so everybody has 5� percent or higher unemployment rates predicted by the end of the year. The staff thinks that the current 5� percent is a little too high. So they are expecting the unemployment rate to come down in the next month or two. Given this, we're all expecting the unemployment rate to rise over the balance of the year. I would think, given the lags in policy, that if you thought policy was hugely accommodative, you'd see some decline in the unemployment rate over the next six, seven, or eight months. I think our own forecasts suggest that some insurance might be here, but not the amount that I'm hearing some of you talk about. I don't see the consistency there. My own view is that there's probably a little insurance in it, and it's appropriate for now. I agree that the next move in interest rates is more likely to be up than down. I assumed, like President Yellen, that it would be at the end of this year or at the beginning of next year. The rising unemployment that we all expect should help damp inflation and inflation expectations and make it very hard to pass through all these cost increases that we're hearing from businesses that they want to pass through and certainly make it hard for wages and cost pressures to rise. So I agree with everyone else that the weight in the two tails has shifted. There's less weight in the downside risk tail for output and more weight in the upside risk tail for inflation. The statement does a very nice job of saying that explicitly, and I think that we just need to await incoming data and information about inflation expectations, costs, and whatnot to see when the appropriate time to move will be. Because I don't think there's a tremendous amount of insurance in there, I think we can afford to be a little patient and data dependent here. Thank you, Mr. Chairman. " FOMC20080625meeting--92 90,MR. KOHN.," Thank you, Mr. Chairman. My forecasts for both economic growth and inflation are within the central tendency of the rest of you and a little stronger than the staff's outlook. In fact, my 2008 projections for economic activity for the second half of the year were revised very little from two months ago. Growth turned out to be stronger than I expected in the first half, and that carries some weight going forward; but financial conditions are tighter with higher bond rates and lower equity prices, and of course oil prices are a lot higher and that will damp demand going forward. So I expect slow growth in the second half followed by expansion around, maybe a little above, the rate of growth of potential in '09 and '10, with the same basic story that everybody else has: drags on activity from declining housing activity, decreasing wealth, tight credit conditions, and higher petroleum prices. All of those drags will abate over time, allowing the natural resilience, with slightly accommodative financial conditions, to show through, and I assume a gradual tightening of monetary policy beginning next year. Incoming information on prices and costs has been mixed. Oil and food price increases will raise headline inflation, but core has been stable and has come in a little to the soft side of expectations, and labor costs as yet show no signs of accelerating. Going forward, I see a sharp decline in headline inflation later this year with the assumed leveling-out in oil prices and a gradual decrease in core as economic slack inhibits wage and price increases, offsetting the pass-through from oil prices. Now, that's my central tendency. I consider the odds on that being realized to be even lower than usual, and the usual odds are disappearingly small. It seems to me that the defining characteristics of the current situation are uncertainty and risk. We're facing multiple shocks, many of them unprecedented in size and persistence, in the housing market, financial markets, and commodities. The outlook is full of puzzles, and in my mind anyone who thinks he or she understands what's going on is either a lot smarter than I am or delusional--or both. [Laughter] I class the risks for both output and headline inflation as greater than usual, and let me tell you about some of the things I wrestled with. Financial conditions, are they accommodative? I continue to believe that the 2 percent nominal funds rate is not indicative of a highly accommodative financial condition, given the current state of financial markets. That is, in my view we have limited insurance. Spreads have widened sufficiently over the past 10 months both for long-term and short-term credit, and bank terms and conditions for loans and lines of credit have tightened enough that only a small part of the drop in the fed funds rate is showing through to the cost of capital for median households and firms. The staff's flow of funds estimates show a marked deceleration in the growth of both household and business debt in the first half of this year, from 10 percent for households last year to 3 percent in the first half of the year and from 12 percent for businesses to 7 percent in the first half of the year. A 2 percent fed funds rate will become accommodative as spreads narrow and financial functioning returns more toward normal, and that's one reason I assumed a gradually rising federal funds rate over 2009 and forward. The evidence about improving financial markets over the intermeeting period was decidedly mixed. Some spreads did come in from late April. Investment-grade businesses tapped bond markets in size, but almost all spreads remain unusually wide. We were reminded of the fragility of the evolving situation, especially in the financial sector, with the worries about continuing credit problems resulting in sharp declines in equity prices on financials and an uptick in their CDS spreads, which had narrowed the previous month or two; the downgrading of monolines and investment banks; and the increasing attention to the problems of regional banks. It would be surprising if these were not reflected in even greater caution by banks and other lenders in their lending practices. Also the securitization markets, especially for non-agency mortgages, are not functioning in a way to replace bank intermediation. This is going to be a prolonged process of reintermediation, deleveraging, and building liquidity with an uncertain endpoint. Like the staff, I assume that the conditions return to something approaching normal over the next 18 months, but the risks are skewed toward an even longer recovery period. The second topic is household spending. Households are facing a huge number of adverse shocks: higher oil prices, tighter credit, declining house prices, and rising unemployment. It's not surprising that confidence is at recessionary levels. It is surprising that spending is so resilient. I assumed that the saving rate would rise very gradually once the tax rebate effects wore off, but I think a more abrupt and sizable increase in household saving is a distinct downside risk. What about housing? Some sales measures have shown a few tentative indications of leveling off. I was encouraged by President Lockhart's report from Florida, but I'm also struck by renewed pessimism about housing in the financial markets. Equities of construction firms and builders have declined after stabilizing, actually rising, earlier this year. ABX indexes have turned down, reversing earlier improvements; and perhaps underlying the previous two developments, the Case-Shiller futures indexes remain in steep decline, though today's information was less weak than expected. The view of the financial markets, anyhow, is that the light at the end of the housing tunnel is receding, and declines in expected house prices must be an important reason for the erosion in market confidence in financial intermediaries. In sum, although the incoming data may have reduced the threat of a sharp drop in spending, in my view there remains a very pronounced downward skew around my outlook for modest growth in H2 and a strengthening next year. However, that downward skew around output did not translate into a downward skew around my forecast for headline inflation. In fact, I saw the risks on headline inflation as tilted to the upside, though roughly balanced around the gradual decrease in core. I think the upside risks result from two additional areas of uncertainty. One area is commodity prices, though the trend increases in commodity prices over the past few years can be attributed to rising demands from emerging market economies relative to sluggishly responding supplies. Despite Nathan's best efforts, I really don't think we have much of a clue about the cause of the spike in oil prices this year. It has been especially striking to me over the intermeeting period, when the prices of industrial commodities have been falling on balance. Presumably prices in these markets already incorporate expectations of reasonably strong global growth outside the United States as in the Greenbook. Absent any surprises, futures market quotes ought to be the best guide, but what we don't understand can fool us, especially when so much of the relevant information involves emerging market economies, where data are sparse and of questionable value. Given our experience over the past few years, I think continued increases in commodity prices would seem to be an upside risk. The other area is inflation expectations. I assume that as headline inflation comes down, both short- and long-term inflation expectations, especially in the survey data, will reverse their recent increases based a lot on the kind of information that President Yellen was observing about how the household survey has tended to follow contemporaneous inflation. I'm encouraged by the relatively flat readings on core inflation and labor compensation increases. Higher expectations have not so far become embedded in prices and costs, despite all the talk of passing along cost increases. But headline inflation is going to rise before it falls. Real wages will be further eroded by higher energy costs. Although this is a necessary part of an adjustment to an adverse terms-of- trade shock, it will be resisted. Hence, a further rise in inflation expectations and a stronger determination by households and businesses to act on those expectations will be a risk over coming months. With that further rise in oil prices, it's a bigger risk than it was a couple of months ago. In terms of the long-term projections, Mr. Chairman, I think I'm fine with something like your proposal. Our objective for adding a year was to give the public a better sense of where we're going over the long term. Given the shock to the economy, that's not as informative as it was before. I think we're close to where most people would say their inflation objective was, but not for the growth rate of potential or the NAIRU. I could live with option 3 or President Bullard's alternative to that--to state exactly what our long-term expectations are instead of talking about five to seven years or five to ten years. I don't think we'll gain a lot. I don't think the costs or benefits are very large on either side of this. Our problems now are not that people don't understand where we're going in the end. I think they have a pretty good idea that we want inflation to be a lot lower than it has been. But I think they don't really understand how we're going to get either to full employment or to price stability, given where we're starting. So I think the uncertainty about our objectives is a very small problem relative to the other problems now. But if we can reinforce what those objectives are, it might help a little around the edges. I do worry, as President Lacker said, that what we say about output and employment not be interpreted as goals but rather as a judgment about the state and the structure of the economy. I am hopeful that we could take care of that in what we say about what we're publishing. Thank you, Mr. Chairman. " fcic_final_report_full--543 Italicized terms within definitions are defined separately. ABCP see asset-backed commercial paper . ABS see asset-backed security . ABX.HE A series of derivatives indices constructed from the prices of  credit default swaps that each reference individual subprime mortgage–backed securities ; akin to an index like the Dow Jones Industrial Average. adjustable-rate mortgage A mortgage whose interest rate changes periodically over time. affordable housing goals Goals originally set by the Department of Housing and Urban Develop- ment (now by the Federal Housing Finance Agency) for Fannie Mae and Freddie Mac to allo- cate a specified part of their mortgage business to serve low- and moderate-income borrowers. ARM see adjustable-rate mortgage . ARS see auction rate securities . asset-backed commercial paper Short-term debt secured by assets. asset-backed security Debt instrument secured by assets such as mortgages, credit card loans or auto loans. auction rate securities Long-term bonds whose interest rate may be reset at regular short-term intervals by an auction process. bank holding company Company that controls a bank. broker-dealer A firm, often the subsidiary of an investment bank, that buys and sells securities for itself and others. capital Assets minus liabilities; what a firm owns minus what it owes. Regulators often require fi- nancial firms to hold minimum levels of capital. Capital Purchase Program TARP program providing financial assistance to -plus U.S. finan- cial institutions through the purchase of senior preferred shares in the corporations on stan- dardized terms. CDO see collateralized debt obligation . CDO squared CDO that holds other CDOs. CDS see credit default swap . CFTC see Commodity Futures Trading Commission . collateralized debt obligation Type of security often composed of the riskier portions of mort- gage-backed securities . commercial paper Short-term unsecured corporate debt. Commercial Paper Funding Facility Emergency program created by the Federal Reserve in  to purchase three-month unsecured and asset-backed commercial paper from eligible companies. Commodity Futures Trading Commission Independent federal agency that regulates trading in futures and options. 539 CHRG-110shrg50409--112 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM BEN S. BERNANKEQ.1. Inflation: Mr. Chairman, I have great concerns about inflation. Inflation degrades consumer's purchasing power and reduces the value of many investments, including people's homes. Additionally, continued food and energy price increases can have negative effects on consumer confidence and potentially unhinge inflation expectations. How large of a shift in expectations would the FOMC have to see before it began to tighten the target for the Federal Funds rate? Please comment on whether you have observed a pass-through of higher input prices for commodities and energy in the form of higher prices for finished goods?A.1. The inflationary effects of the sharp increases in oil and agricultural commodity prices earlier this year are clearly evident in the retail prices of energy and food. In particular, the PCE price index for food and beverages increased almost 6 percent over the 12 months ending in August 2008, while the PCE price index for energy moved up 28 percent over that same period. The acceleration in the price indexes for these two components of spending accounted for much of the pickup in the 12-month change in the overall PCE price index to 4.5 percent in August 2008 from 2 percent over the 12 months ending in August 2007. It appears that, to some extent, the earlier increases in the prices of oil and other raw materials have been passed through to the prices of non-energy, non-food finished goods and services. Prices for consumer items that have a high energy content--such as airfares and other transportation services, housekeeping supplies, and household operations--have moved up noticeably this year; moreover, energy and other basic input costs could well have pushed up prices for a range of other items for which the direct effect of commodity prices is more difficult to identify. In the aggregate, the PCE price index excluding food and energy rose at an annual rate of 2.6 percent over the 12 months ending in August 2008, about one-half percentage point faster than over the 12 months ending in August 2007. Thus far, however, we have not seen the sort of run up in labor compensation and inflation expectations that could lead to a deterioration in the longer term outlook for inflation. In particular, although some indicators of inflation expectations have increased, long-term inflation expectations still appear to be reasonably well anchored. Indeed, given the recent sharp declines in the prices for crude oil and other commodities and the weakening in economic conditions, the FOMC believes that inflation is likely to moderate later this year and in 2009. Of course, the Committee will continue to monitor the incoming information on inflation and inflation expectations carefully.Q.2. Update on Bear Stearns: Chairman Bernanke, the Federal Reserve created a limited liability corporation (Maiden Lane LLC) to acquire and manage certain assets from Bear Stearns, with the goal of maximizing repayment of the original loan back to the Federal Reserve Bank of New York. We all hope that this loan will be repaid in its entirety through the sale of these assets over time. How has the value of the Bear Stearns portfolio changed over time? In the few months since this transaction occurred, has anything changed that would lead to a reassessment of potential losses?A.2. As indicated in the Federal Reserve's weekly H.4.1 statistical releases, the fair value of the net portfolio holdings of Maiden Lane LLC was $29.816 billion as of March 14, 2008, $28.893 billion as of June 26, 2008, and $29.018 billion as of June 30, 2008. The Federal Reserve will publish in the H.4.1 statistical release an updated fair value of the net portfolio holdings of Maiden Lane LLC as of the end of each calendar quarter. The fair value of the net portfolio holdings of Maiden Lane LLC was $26.979 billion as of November 26, 2008, which reflects valuations as of September 30, 2008. As more fully explained in my testimony before the Committee on April 3, 2008, the Federal Reserve decided to finance a portion of Bear Stearns' assets to facilitate the acquisition of the firm by JPMorgan Chase to address the severe consequences that likely would have resulted from a disorderly liquidation of the firm in the unusually fragile circumstances that then prevailed. In taking this action, the Federal Reserve consulted closely with the Treasury Department. In order to maximize the returns to the Federal Reserve and the taxpayer, the Federal Reserve has engaged an independent portfolio management firm to professionally manage the assets held by Maiden Lane LLC. The assets will be managed with a long-term time horizon of at least 10 years. Although the value of the portfolio declined between March 14, 2008, and June 30, 2008, given the long-term time horizon for the portfolio it is too early to estimate what, if any, net losses might result from the eventual liquidation of the portfolio. Importantly, as previously announced, JPMorgan Chase will bear the first $1 billion of any losses on the collateral pool.Q.3. Negative Real Interest Rates: Chairman Bernanke, real interest rates appear to be negative at present, since the nominal short-term rate is lower than inflation. Does having a negative real rate of interest during a period of increased inflation harm the Fed's ability to work towards maintaining price stability? For how long can the Fed run a negative real interest rate before inflation pressures grow to dangerous levels?A.3. The FOMC has judged the current level of short-term interest rates as appropriate in light of its statutory objectives of maximum employment and price stability. Relatively low real short-term interest rates are currently necessary to counter the adverse effects of the broad range of factors restraining aggregate spending and output. Such factors include severe strains on financial markets and institutions, tight credit conditions, the ongoing housing correction, and elevated energy prices, which reduce households' discretionary income. As such, we do not believe that the current low level of real short-term interest rates is likely to have an adverse effect on the economy. Clearly, the highly accommodative stance of monetary policy cannot be maintained indefinitely. But, in view of the expectation for inflation to decline, such a stance is appropriate for a time to help foster moderate economic growth in the face of the range of factors that is restraining growth. The Committee believes that inflation is likely to moderate later this year and during 2009 as the effect of recent sharp drops in the prices of energy and other commodity prices shows through to broad price indexes and as slack in the economy resulting from slower economic growth reduces pressure on resources.Q.4. FOMC Statement Bias: Mr. Chairman, in the FOMC's most recent statement, the Committee seemed to shift its bias away from concerns over slower growth, towards concern about inflation and inflation expectations. Would you elaborate on what this shift means for future policy decisions? Additionally, how long would inflation rates have to stay elevated for the Committee to display unambiguous bias towards alleviating inflation concerns?A.4. In conducting monetary policy, the Committee carefully monitors ongoing developments in the economy and financial markets that influence the outlook for the economy and inflation. From time to time, the Federal Reserve adjusts its policy stance in view of the evolving economic outlook and risks to the outlook. After each meeting, the Committee issues a statement that explains any adjustment to its policy stance and characterizes the outlook for economic growth and inflation. In the period before the June meeting, incoming economic data had indicated that economic growth in the second quarter was stronger than had been expected. Also, financial market conditions appeared to have improved somewhat, although markets clearly remained under stress. Meanwhile, oil prices had increased further. In these circumstances, the Committee judged at its June meeting that the downside risks to growth diminished and the upside risks to inflation had increased. An important uncertainty in the outlook for inflation is whether the current elevated level of total inflation may lead to upward pressure on longer-term inflation expectations. At present, although some indicators of inflation expectations have increased, long-term inflation expectations still appear to be reasonably well anchored. However, the Committee is monitoring inflation and inflation expectations very carefully. ------ FOMC20080916meeting--130 128,MS. PIANALTO.," Thank you, Mr. Chairman. The recent financial market news is shaking people's confidence dramatically. But even before recent events, the evidence was already pointing to more effects of the financial crisis on the real economy than I had built into my projection at our last meeting. The reports from my District contacts and the incoming data caused me to revise down my near-term output projection even before the latest round of financial market troubles. The improvement in net exports that was reflected in the second-quarter GDP growth has not encouraged manufacturers in my District to revise up their export projections. They are still holding firmly to the opinion that the global economy is slowing and that export growth will slow with it for several quarters. Of course, manufacturers are concerned about weakness spreading further within their domestic customer base. The ongoing turmoil in financial markets continues to affect businesses in my District. Some of the banks in my District are finding it very, very difficult to attract new capital and to manage their way out of trouble. I am hearing that credit is harder to come by for many borrowers who in the recent past would not have thought twice about their creditworthiness. Last week I met with a business contact with a very long and successful track record of buying and operating private companies. He reported that he had reached a deal with a bank to finance a project at a 7 percent interest rate with the loan amortized over a fifteen-year term. On the morning of the close just three days later, the bank faxed him the paperwork, which reflected a 12 percent interest rate on a nonamortizing loan with a 10-year term. So the deal obviously is not going forward. One of my directors, who heads a very large regional banking organization, reported at our board meeting last week that many banks are shedding assets and that in some cases they are walking away from longstanding customer relationships in order to do so. He said that investors are very skeptical about putting new equity into banking deals and that those who have done so in the past vow not to be burned twice, let alone a third time. Of course, inflation remains an important issue as well. My contacts, as Dave mentioned in his report, are not so confident that a broad array of intermediate and retail prices are actually going to move back down as a result of the recent decline in energy and other commodity prices. Several of my contacts report that major suppliers are trying to maintain their prices despite the decline in raw material costs just to make up for a long period of absorbing price increases. Nevertheless, most of my contacts agree that the commodity price environment has stabilized considerably, making me more confident that core inflation will gradually slow over the next couple of years. At our last meeting, my forecast was broadly consistent with the Greenbook baseline. Today my forecasts for output and prices are broadly similar to the Greenbook's for 2009 and 2010, although I am expecting more weakness in economic activity in the second half of this year than the Greenbook is forecasting. My contacts in the manufacturing sector have persuaded me that exports are going to be weaker in the short term than I had previously thought, and I have also revised down my consumption path on the basis of the credit constraints on households. Although I am more encouraged about the recent decline in energy and commodity prices, I would like to see further evidence of price stability in these markets and also continued stability in inflation expectations for a while longer before I reduce the upside risk that I place on my inflation outlook. However, a growing risk to my outlook is that the short-term weakness that I have now built into my outlook extends further out into the forecast period. I worry that my outlook doesn't fully capture all of the many ways in which financial forces at work in the economy are actually going to restrain spending. On Friday, I was convinced that the best course of action was to keep an even keel in these rough seas--to be flexible, of course, but to look beyond the latest wave crashing over the bow. Only six weeks ago, inflation risks were on the verge of being unacceptable, and today the troubles of Wall Street are the focus. I was sure that we were going to be in for many more surprises; I just didn't know when and from where they would be coming. So I supported not only keeping our policy unchanged but also keeping our language changes to a minimum even if that language missed some nuances of the outlook. Given the events of the weekend, I still think it is appropriate for us to keep our policy rate unchanged. I would like more time to assess how the recent events are going to affect the real economy. I have a small preference for the assessment-of-risk language under alternative A. I think it captures my concern that the downside risks have intensified. However, I can support some of the comments and changes to highlight the financial market strains that were made by President Lockhart and President Stern. So I can support the language under alternative B with some additional comments about the financial strains that we are facing. Thank you, Mr. Chairman. " CHRG-111shrg54675--42 Chairman Johnson," Senator Bennet. Senator Bennet. Thank you, Mr. Chairman. Thank you very much for holding this hearing. It is very timely, at least from my perspective, coming from Colorado, where we have had a bank failure in rural Colorado, in Weld County that I wanted to talk to you about a little bit. I want to thank everybody here for your testimony. I think it is a very good reminder that we need to be very careful about how we think about our financial institutions in this country because they are not all the same and not all of them contributed to the situation that we now find ourselves in. With respect to ``too-big-to-fail,'' which people have talked about, from the point of view of the people living in Northeast Colorado who lost what to many people would seem was a very small bank, that bank was too big to fail for them. It has affected the entire region, because commodity prices are where they are, in this case particularly dairy prices. It has become incredibly hard to find replacement credit for the farmers and for the ranchers that are there. I wonder--we have asked the people administering the TARP whether or not they are taking into account those sorts of circumstances as they think about the distribution of the TARP money, and I wonder if any of you have a perspective on how well or how poorly TARP is being administered when it comes to small banks, to rural banks, community banks. The application process is an onerous one. The requirements for deposits are tough. I am just curious whether you think we are getting done what we need to get done with respect to TARP. " FOMC20080318meeting--154 152,MR. SAPENARO.," Mr. Chairman, excluding for the moment the market's expectations of a significant downward policy move at this meeting, I have a strong preference for alternative D, like President Hoenig. I see widespread evidence that the upside risk to inflation has increased appreciably, as evidenced by rapid money growth, a depreciating dollar, rising prices of energy and commodities traded on the world markets, and higher inflation compensation in bond markets. However, as we all know, the market does expect a significant reduction in the funds rate from this meeting, partly because of the state of the economy, partly because of the turbulence in the financial markets, and partly because of past statements and communications from Committee members. Consequently, under these conditions, I believe that a failure to accommodate much of this expectation would produce additional, major market turmoil. Hence, I was prepared to accept a 50 basis point reduction coming into the meeting and, with some trepidation, can accept a 75 basis point reduction. In my view, however, it would be desirable for the Committee's communications going forward to emphasize that we have not lost our zeal to fight inflation and that further rate cuts cannot solve solvency problems without unacceptable future inflation. Thank you, Mr. Chairman. " CHRG-111hhrg53241--3 Mr. Royce," Thank you, Mr. Chairman. We really do need regulation. And what happens when a regulator fails in his task to make certain that you don't have overleveraging in the financial institutions is something like what happened with AIG. You end up with overleveraging of 170 to 1. Banks typically are regulated to make certain they don't overleverage more than 10 to 1. The consequences are catastrophic when a regulator misses something like that. The consequences also are catastrophic when, for example, GSEs were leveraged 100 to 1. In this case, the regulators did catch it, but in this case we in Congress did not take the decisive action necessary to allow those regulators the power to deleverage Fannie Mae and Freddie Mac. And, likewise, you have a consequence there of an impact to the system, a shock to the system. And with that kind of overleveraging in a society, you end up also, of course, with a consequence of helping to create a boom or an expansion, an overexpansion in housing. Now we're here today again talking about the regulatory reform proposal issued by the Administration, and, logically, the consumer financial products agency is going to be discussed here today, as it was yesterday. We know what happens when you separate solvent protection from consumer protection. We saw it with the regulatory structure over Fannie and Freddie. OFHEO focused on safety and soundness and for years competed against HUD, who was enforcing the affordable housing goals, akin to mission oversight in that case so you had that competition. Those affordable housing goals pushed by one agency led to the build-up of junk loans in Fannie and Freddie, which ultimately led to their demise. Going forward, it will be very difficult to create a separate regulatory entity, charge it with consumer protection oversight, and not expect similar politically driven mandates to come further down the road. There is a reason why virtually every Federal safety and soundness regulator has expressed concern over this proposal that we are talking about today. And it isn't because they are trying to protect their regulatory turf. It is because it is a flawed idea. Consumers benefit from a competitive market with adequately capitalized institutions that consumers know will be there down the road. In many ways, solvency protection is the most effective form of consumer protection. Instead of bifurcating the mission of the various regulators, we should ensure consumers throughout the financial system have the tools necessary to make sound, educated financial institutions. What we are doing with the plan that is being put forward today, I am concerned, is you are going to eliminate choice by requiring government bureaucrats to define what are suitable financial products. And then it gives each State the ability to change those standards. To avoid litigation, institutions will have no choice but to sell only one-size-fits-all products. Also, the plan put forward here that we are discussing would add an additional layer of bureaucracy on top of the current regulatory patchwork, with broad, undefined, and arbitrary powers which would impose requirements that would likely conflict with those of other regulatory agencies. So the plan invites the kind of turf battles that will undermine rather than promote effective consumer protection. And lastly, in terms of lawsuits, we know what the consequence is going to be of outlawing mandatory arbitration clauses. Creating subjective standards for what constitutes acceptable products and reasonable disclosures, that is inevitably going to lead to more lawsuits. So the plan put forward here in this committee today I am afraid will impose new taxes and fees on consumer financial transactions, increase the cost of borrowing and create a government bureaucracy. And, frankly, what we should be doing is providing regulators with more investigative and enforcement tools, increasing civil penalties, and maximizing restitution of victims of fraud. That should be our focus here and we should streamline and consolidate regulations of financial institutions, including consumer protection, so that no institution can game the system. Thank you, Mr. Chairman. " FOMC20070628meeting--124 122,MR. POOLE.," Thank you, Mr. Chairman. Let me talk first about some of the anecdotal reports. A contact with a large software company suggested that the IT industry is doing fine. Labor is very tight because technical people are in such scarce supply. This company is expanding development facilities in China and India. They are not allowed to import the labor they need, and so they will send the operations abroad. My contacts with transportation industry people get the same information that Richard Fisher is emphasizing. Movement of goods is just really, really flat. The over-the-road trucking industry is actually taking down capacity, selling off the older, less efficient trucks. In the express business, UPS is taking down capacity. FedEx is more optimistic, probably taking market share. A contact with the fast food industry says that their business volume is down. The whole industry is down. Sales revenues are up a bit, but it is because of price increases. The casual dining industry is down even more. There is sort of a disconnect here between the overall view of the economy, I think, and the anecdotal reports that come from the movement of goods. Of course, the most cyclical part of the economy is always the goods part. The services part is much more stable. Perhaps what is going on here is simply what is also in the Greenbook’s second-quarter numbers, because the goods part of the economy—consumption—is pretty flat. I think consumption is only—I forget the exact number—1.6 or something. That is an annual rate. You have to divide that by 4 to tell you what is actually going on in the quarter itself. Of course, the housing industry continues to decline. So maybe these anecdotal reports really are consistent with what is going on and what is in the Greenbook picture. The Greenbook picture makes a lot of sense to me. Let me talk a little more about housing. The staff presentation had a point that I want to underscore—that the housing downturn is unlike any other that we have had. I think the chart went back to 1972, but you could go back before that. If you look at the housing downturns and the recessions of the 1950s, they were all related to a very standard cyclical pattern. Interest rates would rise, housing—starts, permits, construction—would start to turn down well before the cycle peak, and then housing would start to recover after the cycle peak as interest rates came down. The current situation is completely different from that standard pattern. Here we had a housing boom driven by a period of very low interest rates. The period really got started when we were holding the fed funds rate at 1 percent. Then you had a lot of these financial innovations and subprime mortgages that added a sector to the market that hadn’t traditionally been there. Interest rates came up, housing prices are flattening out, and my concern is that there is a lot more to go. This is an asset market that does not work anything like securities markets. It is completely different from the stock market and the bond market. Housing starts and permits peaked in the early part of last year, and the adjustment really got under way. But if you think about how much of the adjustment is complete—well, there is not much sign that much is complete because the inventory of unsold new houses is close to its peak. There is no convincing evidence that it is really starting to come down. We have seen some bankruptcies of builders, but not very many. A lot of banks—I know from our contacts—are putting pressure on their builders to sell out their houses and pay off the loans. The same thing is true of “the ground,” as the real estate people like to put it. Builders are stopping their development of new land for housing developments because they don’t have the financing to support it anymore. The banks are starting to turn off the credit spigot because these companies are getting pretty close to the edge. They have laid off a large number of workers, but they have to sell out their inventory. Still, the number of months’ supply that they are sitting on is abnormally high; it really hasn’t come down. We also know that prices in this market respond with a very substantial lag to the underlying determinants of prices. So prices of existing homes are only gradually adjusting, and I think there is probably more of that to go. We know that there will be a lot more resets of these adjustable-rate mortgages. The projections are that a lot more defaults than we have yet seen will occur in that area. So I think that we have a long adjustment to go here. Whether that will spread into the rest of the economy, I don’t know. I share the Greenbook estimate that probably there won’t be major fallout, but it seems to me that the risk there is significant. I just wanted to underscore that point because I think this risk is by far the biggest that we face at this time. Thank you." FOMC20080625meeting--99 97,CHAIRMAN BERNANKE.," Thank you, and thank you all. First, on the long-term projections, I think there's consensus that we should just go ahead and have a trial run. The staff should review the transcript and make gold out of straw there. We should consult with the subcommittee, and we should think about maybe even a couple of alternatives. Maybe we could try a couple of alternative ways of doing it in October. So let's go ahead and do something along those lines and keep thinking about how best to do it. Let me first, as I usually do, try to summarize the discussion around the table, and I'll add some comments of my own. Beginning with the summary, the incoming data were stronger than expected, notably for consumer spending but for some other components as well. As a result, economic growth in the second quarter, though not robust, was likely positive, continuing the pattern of weak but positive growth since the fourth quarter of 2007. However, to the extent that strength in consumption was transitory or due primarily to fiscal stimulus, some of the growth in the second quarter may have been borrowed from the second half. Participants generally saw growth continuing at a slow pace the rest of the year and improving in 2009. There was, however, some divergence of views, with some expecting a longer period of slow growth. Recent numbers on retail sales suggest that the consumer is holding up better than expected. Consumer finances may be better than feared, and the fiscal stimulus may already be having an effect. However, as many have noted, there are substantial drags on consumption going forward, including falling wealth and income, credit constraints, and the recent rise in energy prices. Sentiment has also fallen noticeably further. Weaker consumption may, thus, restrain growth later this year, particularly after the effect of the stimulus wanes. Labor markets continue to soften but at a relatively moderate pace. The peak in unemployment is projected to be between 5� percent and 6 percent. That's what I generally heard around the table. Prospects for housing continue weak, with falling prices, high inventories, and weak demand. Some saw a possible bottom forming but noted that the recovery of this sector is still some way off. As has been the case for a while, businesses are quite cautious, noting economic uncertainties and surging input costs, with one or two mentions of tighter credit, although that was not a dominant theme today. Real exports continue to grow and are partially offsetting weaker domestic demand, especially in the case of manufacturing. Financial conditions have been mixed since the last meeting, although the improvements from March have largely been maintained and the risk of systemic crisis may have receded to some degree. Funding markets are generally doing better. The concerns about credit losses have led the stock prices of banks, including regional banks and investment banks, to fall sharply. Capital raising continues, though at less favorable terms and with perhaps declining availability. As the economy continues weak and housing contracts further, more credit losses for banks may well be in store, adding to financial market stress and reducing the availability of new credit. Progress in the financial markets is likely to be slow as the deleveraging process will take a while. Stock prices in general are also lower. Financial conditions in the housing market remain important downside risks to growth, with the spurt in oil prices adding to those risks. Uncertainties about the growth prospects are great. However, tail risks may have moderated somewhat. Readings on core inflation have remained relatively moderate. However, the sharp rise in oil prices and some other commodity prices, in part reflecting flooding in the Midwest, is likely to lead to very high levels of headline inflation over the next few months. Gas and food prices have become perhaps the most important economic issue for consumers, and firms are feeling everincreasing cost pressures. Moreover, inflation pressures are global. There are increasing reports of firms being able to pass through these costs, which could lead to an increase in core inflation. On the other hand, slack may restrain core inflation increases. Measures of longer-term inflation expectations have been up a bit on net since April, depending to some extent on the measure chosen. Nominal wage growth is still slowing. Participants debated how much comfort to take from slow wage growth, some arguing that, by the time wages reflected higher inflation expectations, it would be too late. Most saw inflation risks as now to the upside, with the primary concern being the possibility that inflation expectations could rise further as headline inflation rises and more costs are passed through. That's my very, very quick summary. If anyone has any comments, I'd be happy to hear them. If not, let me just say a couple of words on my own views here. This may come as a surprise to some of you, but I am not a fine-tuner. I think that the objective of the Federal Reserve ought to be to avoid a very bad outcome, and so my concerns are primarily with tail risks on both sides of our mandate. I think that the evidence of the last month or so provides a bit of reassurance, on both the real side and the financial side, that the tail risks on the growth side of the mandate have moderated somewhat. That being said, I think they remain and are still significant. In particular, as I mentioned in the summary, I am at this point still suspicious of the strength that we saw in the second quarter. If we look at the fundamentals for consumption--including wealth, income, employment, and energy prices--and look at the plunge in sentiment, which is at remarkably low levels, I think there's a very good chance that consumers will weaken going forward and bring the rest of the economy along with them. In addition, of course, housing remains extremely uncertain. We are at best some distance from stabilization in that market. Even when residential construction begins to stabilize, we'll still see continuing declines in house prices, which will affect consumer spending and, importantly, will affect financial markets as well as the value of mortgages. With respect to financial markets, I agree certainly that the crisis atmosphere that we saw in March has receded markedly, but I do not yet rule out the possibility of a systemic event. We saw in the intermeeting period that we have considerable concerns about Lehman Brothers, for example. We watched with some concern the consummation of the Bank of America�Countrywide merger. We worried about a bank in the Midwest. Other regional banks are under various kinds of stress. We're seeing problems with the financial guarantors, with the mortgage insurers. So I think that those kinds of risk are still there, and we need to be very careful in observing them. Moreover, even if systemic risks have faded, we still have the eye-of-the-storm phenomenon--we may now be between the period of the write-downs of the subprime loans and the period in which the credit loss associated with the slowdown in the economy begins to hit in a big way and we see severe problems at banks, particularly contractions in credit extension. So I'm not yet persuaded that the tail risks are gone. I think it would be very valuable to have some more data, some more observations, to see how the financial markets and the economy are proceeding. But I want to say that I do agree that the developments in financial markets and the surprisingly strong data in the second quarter should lead us to feel somewhat better. I think we should take a little credit for our various efforts to support both the financial system and the economy. Now, what about tail risks on the other side--on inflation? The increase in oil prices that we've seen in the past six weeks is obviously very, very bad news. I think that the combination of the commodity price increases and what we're going to see as very ugly headline inflation numbers is beginning to generate a tail risk on that side of the mandate as well, and I am becoming concerned about that. Indeed, I think that it's now appropriate that we begin, as some of us already have, to move rhetorically toward acknowledging that risk and agreeing that it may be at the point where it even exceeds the risk that we see on the growth side, although I think we're very uncertain about that. Now, the concern I have is the following, which is that there has been a lot of talk about policy action. I don't think that a 25 basis point or even a 50 basis point move, if it's not viewed as being the start of a continued increase, is going to do very much on the inflation side, frankly. We had a good test of that over the intermeeting period. Partly because of our rhetoric and for other reasons, the dollar strengthened. The two-year rate rose 50 or 60 basis points, and oil prices went up $25. I do not think that with a small change in our stance we can do anything about commodity prices, and frankly, it's commodity prices that you're hearing about from your Board members and from people you talk to. It's the real change in the relative price of those commodities that is painful and the real change in the terms of trade coming through the dollar which is painful, and I don't think we can do very much about those in the short term. Our objective, of course, as everyone has noted, is to prevent that from becoming a sustained and persistent source of inflation. So the problem then is that a small amount of movement will not solve the problem. A small to moderate movement, however, might create some serious financial strains given the fragility of the system. I think what we need to do is to decide when we reach that tipping point. There will be a tipping point at which we're sufficiently confident that the system is stabilizing and that we can begin to turn in a serious way to the inflation concern. A partial one step, unless it signals a longer-term tightening program, could give us the worst of both worlds. We will just have to make the judgment about when we have reached the point of having to switch from our previous approach of supporting the economy and financial system to an approach that is aimed more at containing inflation. It's going to be a very difficult and delicate situation, but I want to express again my agreement with those of you who are worried about inflation and my belief that the time might be relatively soon. But it's going to be a very, very delicate decision and one that we have to make with great concern and consideration. A little anticlimactically, I would like to say just a couple of words about the 1970s because they keep coming up and I do think that these comparisons are a bit misleading. First, in the current episode, commodity prices--particularly oil prices--are basically most or almost all the inflation that we're seeing. That was not the case in the '70s. In particular, inflation rose considerably before the first oil price shock in 1973. PCE inflation was 5 percent in 1970, which prompted the wage� price controls, of course, which is an episode we're all familiar with; and in 1972, before the oil shock, average hourly earnings were growing between 7 and 8 percent. There was already a serious inflation problem before the oil price shocks came. Hence, credibility was already damaged at the time of the oil price shocks. That is not the case here. Second, the movement in wages and core inflation following the oil price shocks in the 1970s was very striking. From the time of the oil price shock right before the second quarter of 1973 until the first quarter of 1975, total inflation rose a little over 5 percentage points, reflecting the quadrupling of oil prices. During the same period, core inflation rose more than 6 percentage points. In other words, core inflation responded almost one for one to total inflation. Moreover, average hourly earnings rose more than 2 percentage points, and productivity and cost compensation rose 3� percentage points in that year and a half. So there was a very strong sensitivity of expectations and pass-through to these commodity price shocks. Obviously, we've been seeing oil price increases since 2003, and they have not yet shown anything like that effect on core inflation or on wages. The final observation I'd make about the 1970s is that we shouldn't forget that, even in that very bad situation with very poorly anchored inflation expectations, the slowing of the economy did do something to reduce inflation. In particular, core inflation fell 3� percentage points during 1975 following the 1973�75 recession. So while we cannot do much about oil prices, I do think that there is some hope that weakness in the economy is going to provide some restraint on core inflation, which of course will generate a more stable total inflation rate if and when commodity prices stabilize. So I've been very all over the map here. I apologize. I tried to organize my thoughts in the meeting. My bottom line is that I think the tail risks on the growth and financial side have moderated. I do think, however, that they remain significant. We cannot ignore them. I'm also becoming concerned about the inflation side, and I think our rhetoric, our statement, and our body language at this point need to reflect that concern. We need to begin to prepare ourselves to respond through policy to the inflation risk; but we need to pick our moment, and we cannot be halfhearted. When the time comes, we need to make that decision and move that way because a halfhearted approach is going to give us the worst of both worlds. It's going to give us financial stress without any benefits on inflation. So we have a very difficult problem here, and we are going to have to work together cooperatively to achieve what we want to achieve. The last thing I'd like to say is on communications. Just talking about communications following this meeting, I'd like to advise everyone, including myself, to lean, not to lurch. That is, we are moving toward more concern about inflation, but we still have concerns about economic growth and financial markets. We should show that shift in emphasis as we talk to the public, but we should not give the impression that inflation is the entire story or that we have somehow decided that growth and financial problems are behind us, because they are not. So if we can convey that in a sufficiently subtle way, I think we will prepare the markets for the ultimate movements that we're going to have to make. Again, I very much appreciate your insights and your attention today. We have a dinner at 7:30, and for that reason I think we should probably bring this to a close. We'll start tomorrow morning with Brian's presentation of the policy options. The statement is essentially the same as the Bluebook's. There won't be any surprises there. So we'll begin with that first thing in the morning. Thank you. [Meeting recessed] June 25, 2008--Morning Session " FinancialServicesCommittee--17 We have already launched initiatives that will address many of the issues illuminated last week. Earlier this year, we issued a con- cept release on market structure that solicited public comments on steps to minimize short-term volatility and systemic risk. We also formally proposed creating a large trade reporting system to en- hance the Commission’s surveillance and enforcement capabilities. And we have proposed strong broker-dealer risk management con- trols when a broker allows a customer direct access to our markets. In order to help regulators keep pace with technology and trad- ing patterns, we have also been working on a proposal to create a consolidated order tracking system, or consolidated audit trail. Within the next few weeks, I expect the Commission to consider this proposal, which would capture all the data needed for effective cross-market surveillance. This will significantly improve our abil- ity to conduct timely and accurate trading analyses for market re- constructions and complex investigations like that which is cur- rently underway. In conclusion, the SEC is making progress in its ongoing review. We will ultimately find the cause or causes of the disruption and will put in place safeguards that will help prevent the type of un- usual trading activity that occurred last week. I look forward to working with you on these issues in the coming weeks, and, of course, we would be pleased to answer any ques- tions. [The prepared statement of Chairman Schapiro can be found on page 114 of the appendix.] Chairman K ANJORSKI . Thank you very much, Madam Chairman. Next, we have the Chairman of the Commodity Futures Trading Commission, Chairman Gensler. Incidentally, Mr. Gensler, thank you very much for responding, too, as quickly as you did. Fortunately, I did not have to call you, because I did not think it stretched to the futures market. That be- coming apparent, it is good that you can be here as a corollary reg- ulator so we can get to the bottom of this. Mr. Gensler, you are under the same restrictions, hopefully to give us about a 5-minute presentation so we can get to questions. STATEMENT OF THE HONORABLE GARY GENSLER, CHAIRMAN, U.S. COMMODITY FUTURES TRADING COMMISSION Mr. G ENSLER . Thank you, Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee. I am pleased to be here alongside SEC Chair Mary Schapiro, with whom we have been working very closely and diligently since last Thursday to explore and see what we can find out about the events. Before I turn to those events, let me just say something about the stock index futures market. Stock index futures trade on cen- tralized exchanges and they are based upon the broad market index. The total outstanding is about $360 billion. This compares to the approximately $13 trillion of the overall equity markets; however, stock index futures do play an integral role to the pricing of the overall market. The largest contract, the E-Mini S&P 500 contract, trades on the Chicago Mercantile Exchange. It is about 80 percent of that market, and we will focus on that a little bit in our testimony. CHRG-110shrg50415--2 Chairman Dodd," The Committee will come to order. Let me welcome everyone to the hearing this morning. I want to welcome my colleagues who are here. Senator Crapo, I welcome you and thank you very much for being here this morning. Senator Akaka, Senator, how are you this morning? Good to see you as well. And, Sherrod, thanks for being here this morning. Let me thank our witnesses as well. What I am going to do, if we can here this morning, is to make an opening statement, turn to my colleagues for any opening comments they would like to have this morning, and then we will get to our witnesses. Any and all statements or supporting documents that you would like to have included in the record, we will certainly make it a part of the record. Just so people can be aware, my intention over the coming weeks is to have a series of hearings and meetings--some of them more informal, some of them more formal--to do what we are doing today, obviously, to go back and examine how we arrived at the situation we are in today; but just as importantly--in fact, I would argue even more importantly--what do we need to do from here forward so as to minimize these problems from ever occurring again. Second, we want to watch and we are going to monitor very carefully, of course, the rescue plan that was adopted several weeks ago. As I think all of you are aware, there are provisions in that bill that literally require almost hourly reporting, every 48 hours or so on various transactions that occur, and we want to watch very carefully following the auditing process that we wrote into the legislation with the GAO and the Inspector General as well. And so the Committee will be working at that almost on a daily basis. Then, third, the issue of financial regulatory reform. Secretary Paulson a number of weeks ago now, months ago, submitted a proposal on regulatory financial reform, and we never got to having the hearings we wanted to have on that, frankly, over the summer because of events with the foreclosure crisis and more recently with the broader economic crisis. But I would like over these coming weeks between now and the first of the year to have this Committee, both formally and informally, meet with knowledgeable people--and there are some at this very panel who could be of help in this regard--as to what the architecture and structures of our financial services system ought to look like in light of the changes that have obviously occurred, updating a system that in many instances actually dates back more than 80 years. The world has obviously changed dramatically, as we are all painfully aware, and having an architecture and a structure that reflects the world we're in today is going to be a critical challenge. This is not an easy task. It will require a lot of thought, and careful thought, about how you do this. But I thought it would be worthwhile to begin that process, and then with a new administration arriving on January 20th, to already have sort of an up-and-running effort that we could then work with the new administration, be it a McCain administration or an Obama administration, to move that process along rather than just wait until after January 20th to begin a process that I think will take some time, quite candidly, given the complexity involved, going back to the 1933 act and other provisions. And as I said, several of you on this panel here have a wealth of knowledge about those laws and how they work or do not work. So I may very well be calling on some of you to participate, either informally or more formally, in that conversation and discussion. Today's hearing is entitled ``Turmoil in the U.S. Credit Markets: The Genesis of the Current Economic Crisis,'' and I want to share some opening comments if I can on this and, again, turn to Senator Crapo and then to others to share some thoughts as well, if they care to, before we turn to our witnesses. This morning the Committee examines the genesis, as I said a moment ago, of the crisis in our credit markets. Such an examination is in keeping with this Committee's extensive work over the past 21 months to understand the implosion of the mortgage markets and how that implosion has infected the wider economy. All told, this Committee has held 73 hearings and meetings since January of 2007 when I first became the Chairman of this Committee. No less than 31 of those hearings have addressed in one form or another the origins and nature of the current market turmoil. Today's meeting is essential to understand not only how we got here, but just as importantly--and I would argue even more importantly--where we as a nation need to go. Only if we undertake a thorough and complete postmortem examination of the corpus of this damaged economy will we have any chance to create a world where the mistakes of the past are less likely to be repeated and where all Americans will have a fair chance at achieving security and prosperity. It is by now beyond dispute that the current conflagration threatening our economy started several years ago in what was then a relatively discreet corner of the credit markets known as subprime mortgage lending. The Chairman of the Federal Reserve, Ben Bernanke, and Treasury Secretary Hank Paulson and many other respected individuals have all agreed on that fact. Mortgage market participants, from brokers to lenders to investment banks to credit rating agencies formed an unholy alliance conceived in greed and dedicated to exploiting millions of unsuspecting, hard-working American families seeking to own or refinance their homes. Relying on two faulty assumptions that housing prices would continue to rise maybe forever and that new financial instruments would allow them to shift the risk to others, these market participants flouted the fundamentals of prudent lending. Certainly some borrowers themselves sought unjust enrichment in the process. They deserve neither our sympathy nor our assistance. But the millions of American homebuyers who today face foreclosure and financial ruination, the vast majority were victims, not perpetrators, of what will be remembered as the financial crime of the century. Indeed, the misdeeds of a few have robbed nearly every American. Whether they suffer from the loss of a home, retirement security, a job, or access to credit, Americans are reeling from the credit crisis. Sadly, in my view, this crisis was entirely preventable. It is clear to me that greed and avarice overcame sound judgment in the marketplace, causing some very smart people to act in very stupid ways. But what makes this scandal different from others is the abject failure of regulators to adequately police the markets. Regulators exist to check the tendency to excess of the regulated. They are supposed to step in to maintain transparency, competition, and fairness in our economy. In this case, though, our Nation's financial regulators willfully ignored abuses taking place on their beat, choosing to embrace the same faulty assumptions that fueled the excessive risk taking in the marketplace. Instead of checking the tendency to excess, they permitted and in some ways even encouraged it. They abandoned sensible and appropriate regulation and supervision. No one can say that the Nation's financial regulators were not aware of the threats posed by reckless subprime lending to homeowners, communities, and, indeed, the entire country. That threat had already been recognized by Congress. In fact, the Congress had already taken strong steps to neutralize it. In 1994, 14 years ago, then President Clinton signed into law the Home Owners and Equity Protection Act. This law required--let me repeat, required, mandated--the Federal Reserve Board as the Nation's chief financial regulator, and I quote, ``to prohibit unfair, deceptive, and excessive acts and practices in the mortgage lending market.'' Despite this direct requirement and mandate, the Federal Reserve Board under its previous leadership decided to simply ignore the law--not for days, not for weeks, not for months, but for years. Indeed, instead of enforcing the law by simply imposing the common-sense requirements that a mortgage loan be based on a borrower's ability to repay it, the Fed leadership actually encouraged riskier mortgage products to be introduced into the marketplace. And the public information on this point is massive. The Fed's defiance of the law and encouragement of risky lending occurred even as the Fed's own officials warned that poor underwriting in the subprime mortgage market threatened homeownership and wealth accumulation. And it was incompatible with safe and sound lending practices. The Fed's defiance of the law and encouragement of risky lending occurred despite warnings issued by Members of Congress, I would add, including some of us who served on this Committee, that occurred despite warnings from respected economists and others that the Fed and its sister agencies were playing with fire. It was only this year, 14 years after the enactment of the 1994 law, that the Fed finally published regulations to enforce the bill's provisions, the needed protections. By that time, of course, the proverbial horse was out of the barn. Trillions of dollars in subprime mortgages had already been brokered, lent, securitized, and blessed with unrealistic credit ratings. Millions of American homeowners faced foreclosure, nearly 10,000 a day in our country. I spoke to a housing group from my State yesterday. There are 1,000 legal foreclosure proceedings every week in the State of Connecticut, and we have a foreclosure rate that is lower than the national average. A thousand cases a week in the courts in Connecticut in foreclosures. Tens of millions more are watching as their most valuable asset--their homes--decline in value. And the entire global financial marketplace has been polluted by toxic financial instruments backed by these subprime mortgages, which has caused a financial meltdown of unprecedented proportions and laid low our economy. The evidence is overwhelming. This crisis is a direct consequence of years of regulatory failures by government officials. They ignored the law. They ignored the risks to homeowners. And they ignored the harm done to our economy. Despite this clear and unimpeachable evidence, there are still some who point fingers of blame to the discretion of Fannie Mae, Freddie Mac, and the Community Reinvestment Act. These critics are loud and they are shrill. They are also very wrong. It is no coincidence that they are some of the very same sources who were the greatest cheerleaders for the very deregulatory policies that created the financial crisis. Let's look at the facts, or as Pat Moynihan used to say, ``Everyone's entitled to their own opinions, but not their own facts.'' On Fannie Mae and Freddie Mac, the wrong-headed critics say Fannie and Freddie lit the match of the subprime crisis. In fact, Fannie and Freddie lagged in the subprime market. They did not lead it. Between 2004 and 2006, the height of the subprime lending boom, Fannie and Freddie's share of subprime securitizations plummeted from 48 percent to 24 percent. The dominant players were not Fannie and Freddie, but the Wall Street firms and their other private sector partners: the mortgage brokers and the unregulated lenders. In fact, in 2006, the height of the subprime boom, more than 84 percent of subprime mortgages were issued by private lenders. Private lenders. One of the reasons Fannie and Freddie lagged is because they were subject to tougher underwriting standards than those rogue private unregulated lenders. So it was the private sector not the Government or Government-sponsored enterprises that was behind the soaring subprime lending at the core of this crisis. At the risk of stating the obvious, it is worth noting that at the height of the housing boom, the President and his supporters in and out of Government did nothing to criticize or stop predatory lending. They did nothing to support, much less advance, the legislation that some of us were working on to move in the Congress that would have cracked down on predatory lending. Regarding the Community Reinvestment Act, the critics are also speaking in ignorance of the facts. The overwhelming majority of predatory subprime loans were made by lenders and brokers who were not, I repeat were not, subject to CRA. In 2006, for example, 24 of the top 25 subprime lenders were exempt--exempt--from the CRA. In fact, CRA lending is in no way responsible for the subprime crisis. CRA has been the law of the land for three decades. If it were responsible for creating a crisis, this crisis would have occurred decades ago. The late Ned Gramlich, the former Fed Governor, put it well when he said that two-thirds of CRA loans did not have interest rates high enough to be considered subprime. Rather than being risky, lenders have found CRA loans to have low default rates. According to former Governor Gramlich, ``Banks that have participated in CRA lending have found that this new lending is good business.'' So people are entitled to their own opinions, as Pat Moynihan would say, but they are not entitled to their own facts. And Ronald Reagan once said, ``Facts are stubborn things.'' Indeed, they are, as they should be in this regard. Let me also say that I have learned over the years from this debacle that the American consumers, when all is said and done, remain the backbone of the American economy and deserve far better than they have been getting from too many people. The lessons, obviously, of this crisis are already becoming clear to us. One of the central lessons is that never again should we permit the kind of systematic regulatory failures that allowed reckless lending practices to mushroom in the global credit crisis. Anther is that never again should we allow Federal financial regulators to treat consumer protection as a nuisance or of secondary importance to safety and soundness regulation. If we have learned one thing from all of this, it is, as I said a moment ago, the American consumer, when all is said and done, remains the backbone of the American economy, that consumer protection and safe and sound operation of financial institutions are inextricably linked. I look forward to hearing from our distinguished panel of witnesses and from my colleagues this morning as we go back and look at what occurred here and the ideas that can be put forward as to how do we minimize these problems from ever occurring again. Again, I thank the witnesses very much and my colleagues for interrupting their time back in their respective States and districts to be here this morning to participate in the hearing. With that, Senator Crapo. FOMC20080318meeting--148 146,MR. FISHER.," Pizza the Hutt, that's right. Vice Chairman Geithner made a very interesting point, and that was that we have to be very careful about how we talk about inflation and even saying what we think. What worries me about going down alternative A's path, if that's the wisdom of the Committee, is that the second paragraph says a little too much of what we think. It really says that we're not done. If you want to say that, that's fine; but it keeps hammering on, even after 75 basis points, that things are soft, things are soft, things are soft. You may disagree with me on that, but I would suggest that we take out the justification reflecting, in paragraph 3, ""a projected leveling out of energy and other commodities."" To me that's a wing and a prayer, and you suggested that you might be willing to take it out. Were I you, advocating 75 basis points, acting as I think you are about to act, with one dissent, I would take that wing and a prayer language out of there. Then I would suggest one other thing--in fact, I would ask for one other thing. In the very last sentence--""The Committee will act in a timely matter as needed to promote sustainable economic growth without sacrificing long-term price stability""--that's really what we're talking about on the upside and on the downside. So I would ask for that change because that's really what we're saying. You're saying that we're worried about the downside. We're all worried about that, but we're going to promote sustainable economic growth without sacrificing long-term price stability. Those are my suggestions, Mr. Chairman, and thank you for putting up with me. " FOMC20070131meeting--32 30,MR. DUDLEY.,"1 Thank you. In terms of market developments, I would like to focus on three major topics. First is the sharp adjustment in market expectations concerning monetary policy since the last FOMC meeting. Second, I will talk about the persistence of high risk appetites in credit markets, with a focus on what may be the most vulnerable market in the United States—the subprime mortgage sector. Third, I want to discuss the possible factors behind some of the sharp shifts we have seen in commodity prices since the last FOMC meeting, in particular whether these price movements reflect a shift in risk appetite among noncommercial investors or fundamental developments in supply and demand. First, there has been a sharp shift in market expectations with respect to interest rates since the last meeting. At the time of the December meeting, the consensus view among market participants was that the FOMC would begin to lower its federal funds rate target this spring and that this easing process would continue into 2008, with cumulative rate cuts of about 75 basis points. As you can see in chart 1, which looks at the federal funds futures market, and chart 2, which looks at the yield spreads between the March 2008 and the March 2007 Eurodollar futures contracts, expectations have shifted very sharply over the past month. There is now no easing priced in through midyear 2007 and a residual of only about 25 basis points of easing priced in beyond that. This shift in expectations can also be seen across the Treasury yield curve. As chart 3 shows, the Treasury yield curve is now slightly above where it was at the time of October FOMC meeting. Since the December FOMC meeting, there has been a rise of about 35 to 40 basis points in yields from two-year to thirty- year maturities. The shift in expectations is reflected predominately in real interest rates. As can be seen in chart 4, breakeven inflation rates have not changed much since the last FOMC meeting—the decline in breakeven rates that occurred early in the intermeeting period has been reversed more recently, and so we are at or slightly above where we were at the December meeting. This upward shift in real rates appears to reflect a reassessment by market participants not only about the near-term path of short-term rates but also about what level of real short-term rates is likely to prove sustainable over the medium and longer term. The buoyancy of the recent activity data may have caused some market participants to reassess what level of the real federal funds rate is likely to prove “neutral” over the longer term. Regarding the issue of risk appetite, there appears to be no significant change since the last FOMC meeting. Risk appetite remains very strong. Corporate credit spreads remain very tight—especially in the high-yield sector (as shown in chart 5)— and implied volatilities across the broad market categories—equities and interest rates (see chart 6) and foreign exchange rates (see chart 7)—remain unusually low. Moreover, the turbulence in some emerging debt and equity markets experienced 1 Material used by Mr. Dudley is appended to this transcript (appendix 1). early this month was mostly transient and has subsided as well. So things appear calm. But what are the areas of greatest risk? In the United States, the subprime mortgage market appears to be a particularly vulnerable sector. The vulnerability stems from four factors. First, this market is relatively new and untested. Chart 8 shows the overall trend of first residential mortgage originations and the share of these mortgages by type—conforming, jumbo, subprime, and alt-A, which is a quality category that sits above subprime but is not quite as good as conforming. As can be seen in this chart, subprime mortgage originations have climbed in recent years, even as overall originations have fallen. In 2006, subprime mortgages were 24 percent of total originations, up from a share of about 10 percent in 2003. The second factor is that credit standards in this market appear to have loosened in 2006, with the proportion of interest-only loans and low- documentation loans climbing as a share of the total. As a result, there are some signs that strains in this market are increasing. As chart 9 shows, delinquency rates have moved somewhat higher. In contrast, charge-offs remain low, held down by the rapid house price appreciation that we saw in recent years. Most noteworthy, as shown in chart 10, the most recent 2006 vintage of subprime mortgages is showing a much more rapid rise in delinquencies than earlier vintages showed. The third factor is that most outstanding subprime mortgage loans have adjustable rates. There is significant reset risk given the rise in short-term rates in 2005 and the first half of 2006 and the fact that many of these loans started with low “teaser” rates. Fourth, housing prices are under some pressure, and this could contribute to further credit strains. I see some risk of a vicious cycle. If credit spreads in the securitized market spike because loan performance is poor, a sharp downturn in lending could result as the capital market for securitized subprime mortgage products closes. This constriction of credit could put downward pressure on prices and lead to more credit problems among borrowers. The result would be additional credit quality problems, wider credit spreads, and a further contraction of credit. Fortunately, to date the news is still fairly favorable. The strong demand for the credit derivatives obligations created from subprime mortgage products has restrained the rise in credit spreads. As can be seen in chart 11, spreads are still well below the peaks reached in late 2002 and early 2003. Thus, the economics of making such loans and securitizing them into the capital markets still work. But this situation could change very quickly, especially if the labor markets were to become less buoyant and the performance of the underlying loans were to deteriorate, leading to a surge in delinquencies and charge-offs. Let me now turn to the commodity markets. The issue I wish to examine here is whether some of the sharp movements in commodity prices that we have observed since the last FOMC meeting represent shifts in the risk appetite among noncommercial investors who have put funds into commodities as a new asset class versus the contrasting view that these price movements predominantly represent changes in the underlying supply and demand fundamentals. To get a sense of this, let’s look briefly at three commodities that have moved the most and are representative of their classes—copper, corn, and crude oil. As chart 12 shows, the sharp decline in copper prices appears linked to the large rise in copper inventories at the London Metal Exchange. If anything, the price decline appears overdue. For corn, the rise in prices also appears consistent with declining stocks both in the United States and globally (see chart 13) as well as the growing demand anticipated for corn in the production of ethanol. For crude oil, the decline in prices is more difficult to tie back to inventories. Although U.S. inventories remain high relative to the five-year historical average (as shown in chart 14), this situation has persisted for some time without having a big effect on prices. Instead, the shift in oil prices appears to be driven mostly by longer-term forces. This can be seen in two ways. First, as shown in chart 15, the change in oil prices has occurred in both spot and forward prices. The oil curve has shifted downward in mostly a parallel fashion, which also calls into question the role of unseasonably warm weather as the primary driver. If weather were the primary factor, then the decline in prices should have been reflected much more strongly in the spot and very short-end of the oil price curve. Second, as shown in chart 16, OPEC spare production capacity has been increasing and is expected to continue increasing in 2007. This growing safety margin reflects both slower growth in global demand and the expansion of non-OPEC output. The improved safety margin may be an important factor behind recent developments in the energy sector. Finally, there were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the December FOMC meeting." FOMC20081007confcall--49 47,MR. STERN.," Thank you, Mr. Chairman. I support reducing the funds rate target 50 basis points and doing it now. I think we ought to take advantage of the situation that has arisen with regard to coordinated action with other central banks. That seems to me to be important and appropriate at this point, given the extraordinary circumstances that we confront. I'd just make a couple of other comments. Larry Slifman marked down the economic outlook for the next several quarters for sure and I guess longer than that. If I were doing my forecast today, I would mark down the near-term outlook even more. It seems to me that the restraints on the economy together with the nature of the incoming evidence suggest that the nearterm outlook at least is not terribly promising--not that we can do very much about that, of course. But I think maybe more important, I have been one who for some time thought that it was likely that inflation would diminish relatively quickly. That apparently isn't going to happen or didn't happen in the third quarter as measured by core, but the incoming evidence both nationally and globally suggests to me that inflation risks have diminished. I've expected that to be the case. It seems to be unwinding in that fashion. Obviously I didn't anticipate the path of commodity prices and the stress in the financial markets to the degree that it has occurred, but they only reinforce my confidence that inflation, in fact, will run lower from here. Thank you. " fcic_final_report_full--25 Cioffi’s investors and others like them wanted high-yielding mortgage securities. That, in turn, required high-yielding mortgages. An advertising barrage bombarded potential borrowers, urging them to buy or refinance homes. Direct-mail solicita- tions flooded people’s mailboxes.  Dancing figures, depicting happy homeowners, boogied on computer monitors. Telephones began ringing off the hook with calls from loan officers offering the latest loan products: One percent loan! (But only for the first year.) No money down! (Leaving no equity if home prices fell.) No income documentation needed! (Mortgages soon dubbed “liar loans” by the industry itself.) Borrowers answered the call, many believing that with ever-rising prices, housing was the investment that couldn’t lose. In Washington, four intermingled issues came into play that made it difficult to ac- knowledge the looming threats. First, efforts to boost homeownership had broad po- litical support—from Presidents Bill Clinton and George W. Bush and successive Congresses—even though in reality the homeownership rate had peaked in the spring of . Second, the real estate boom was generating a lot of cash on Wall Street and creating a lot of jobs in the housing industry at a time when performance in other sec- tors of the economy was dreary. Third, many top officials and regulators were reluc- tant to challenge the profitable and powerful financial industry. And finally, policy makers believed that even if the housing market tanked, the broader financial system and economy would hold up. As the mortgage market began its transformation in the late s, consumer ad- vocates and front-line local government officials were among the first to spot the changes: homeowners began streaming into their offices to seek help in dealing with mortgages they could not afford to pay. They began raising the issue with the Federal Reserve and other banking regulators.  Bob Gnaizda, the general counsel and policy director of the Greenlining Institute, a California-based nonprofit housing group, told the Commission that he began meeting with Greenspan at least once a year starting in , each time highlighting to him the growth of predatory lending prac- tices and discussing with him the social and economic problems they were creating.  One of the first places to see the bad lending practices envelop an entire market was Cleveland, Ohio. From  to , home prices in Cleveland rose , climb- ing from a median of , to ,, while home prices nationally rose about  in those same years; at the same time, the city’s unemployment rate, ranging from . in  to . in , more or less tracked the broader U.S. pattern. James Rokakis, the longtime county treasurer of Cuyahoga County, where Cleveland is located, told the Commission that the region’s housing market was juiced by “flip- ping on mega-steroids,” with rings of real estate agents, appraisers, and loan origina- tors earning fees on each transaction and feeding the securitized loans to Wall Street. City officials began to hear reports that these activities were being propelled by new kinds of nontraditional loans that enabled investors to buy properties with little or no money down and gave homeowners the ability to refinance their houses, regardless of whether they could afford to repay the loans. Foreclosures shot up in Cuyahoga County from , a year in  to , a year in .  Rokakis and other public officials watched as families who had lived for years in modest residences lost their homes. After they were gone, many homes were ultimately abandoned, vandalized, and then stripped bare, as scavengers ripped away their copper pipes and aluminum siding to sell for scrap. “Securitization was one of the most brilliant financial innovations of the th cen- tury,” Rokakis told the Commission. “It freed up a lot of capital. If it had been done responsibly, it would have been a wondrous thing because nothing is more stable, there’s nothing safer, than the American mortgage market. . . . It worked for years. But then people realized they could scam it.”  CHRG-111shrg52619--207 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM JOSEPH A. SMITH, JR.Q.1. It is clear that our current regulatory structure is in need of reform. At my subcommittee hearing on risk management, March 18, 2009, GAO pointed out that regulators often did not move swiftly enough to address problems they had identified in the risk management systems of large, complex financial institutions. Chairman Bair's written testimony for today's hearing put it very well: `` . . . the success of any effort at reform will ultimately rely on the willingness of regulators to use their authorities more effectively and aggressively.'' My questions may be difficult, but please answer the following: If this lack of action is a persistent problem among the regulators, to what extent will changing the structure of our regulatory system really get at the issue? Along with changing the regulatory structure, how can Congress best ensure that regulators have clear responsibilities and authorities, and that they are accountable for exercising them ``effectively and aggressively''?A.1. First of all, CSBS agrees completely with Chairman Bair. In fact, in a letter to the Government Accountability Office (GAO) in December 2008, CSBS Executive Vice President John Ryan wrote, ``While there are clearly gaps in our regulatory system and the system is undeniably complex, CSBS has observed that the greater failing of the system has been one of insufficient political and regulatory will, primarily at the federal level.'' Perhaps the resilience of our financial system during previous crises gave policymakers and regulators a false sense of security and a greater willingness to defer to powerful interests in the financial industry who assured them that all was well. From the state perspective, it is clear that the nation's largest and most influential financial institutions have themselves been major contributors to our regulatory system's failure to prevent the current economic collapse. All too often, it appeared as though legislation and regulation facilitated the business models and viability of our largest institutions, instead of promoting the strength of consumers or encouraging a diverse financial industry. CSBS believes consolidating supervisory authority will only exacerbate this problem. Regulatory capture by a variety of interests would become more likely with a consolidated supervisory structure. The states attempted to check the unhealthy evolution of the mortgage market and it was the states and the FDIC that were a check on the flawed assumptions of the Basel II capital accord. These checks should be enhanced by regulatory restructuring, not eliminated. To best ensure that regulators exercise their authorities ``effectively and aggressively,'' I encourage Congress to preserve and enhance the system of checks and balances amongst regulators and to forge a new era of cooperative federalism. It serves the best interest of our economy, our financial services industry, and our consumers that the states continue to have a role in financial regulation. States provide an important system of checks and balances to financial oversight, are able to identify emerging trends and practices before our federal counterparts, and have often exhibited a willingness to act on these trends when our federal colleagues did not. Therefore, CSBS urges Congress to implement a recommendation made by the Congressional Oversight Panel in their ``Special Report on Regulatory Reform'' to eliminate federal preemption of the application of state consumer protection laws. To preserve a responsive system, states must be able to continue to produce innovative solutions and regulations to provide consumer protection. Further, the federal government would best serve our economy and our consumers by advancing a new era of cooperative federalism. The SAFE Act enacted by Congress requiring licensure and registration of mortgage loan originators through NMLS provides a mode for achieving systemic goals of high regulatory standards and a nationwide regulatory roadmap and network, while preserving state authority for innovation and enforcement. The SAFE Act sets expectations for greater state-to-state and state-to-federal regulatory coordination. Congress should complete this process by enacting a federal predatory lending standard as outlined in H.R. 1728, the Mortgage Reform and Anti-Predatory Lending Act. However, a static legislative solution would not keep pace of market innovation. Therefore, any federal standard must be a floor for all lenders that does not stifle a state's authority to protect its citizens through state legislation that builds upon the federal standard. States should also be allowed to enforce-in cooperation with federal regulators-both state and federal predatory lending laws for institutions that act within their state. Finally, rule writing authority by the federal banking agencies should be coordinated through the FFIEC. Better state/federal coordination and effective lending standards is needed if we are to establish rules that are appropriately written and applied to financial services providers. While the biggest institutions are federally chartered, the vast majority of institutions are state chartered and regulated. Also, the states have a breadth of experience in regulating the entire financial services industry, not just banks. Unlike our federal counterparts, my state supervisory colleagues and I oversee all financial service providers, including banks, thrifts, credit unions, mortgage banks, and mortgage brokers.Q.2. How do we overcome the problem that in the boom times no one wants to be the one stepping in to tell firms they have to limit their concentrations of risk or not trade certain risky products? What thought has been put into overcoming this problem for regulators overseeing the firms? Is this an issue that can be addressed through regulatory restructure efforts?A.2. Our legislative and regulatory efforts must be counter-cyclical. A successful financial system is one that survives market booms and busts without collapsing. The key to ensuring our system can survive these normal market cycles is to maintain and strengthen the diversity of our industry and our system of supervision. Diversity provides strength, stability, and necessary checks-and-balances to regulatory power. Consolidation of the industry or financial supervision could ultimately product a financial system of only mega-banks, or the behemoth institutions that are now being propped up and sustained by taxpayer bailouts. An industry of only these types of institutions would not be resilient. Therefore, Congress must ensure this consolidation does not take place by strengthening our current system and preventing supervisory consolidation.Q.3. As Mr. Tarullo and Mrs. Bair noted in their testimony, some financial institution failures emanated from institutions that were under federal regulation. While I agree that we need additional oversight over and information on unregulated financial institutions, I think we need to understand why so many regulated firms failed. Why is it the case that so many regulated entities failed, and many still remain struggling, if our regulators in fact stand as a safety net to rein in dangerous amounts of risk-taking? While we know that certain hedge funds, for example, have failed, have any of them contributed to systemic risk? Given that some of the federal banking regulators have examiners on-site at banks, how did they not identify some of these problems we are facing today?A.3. To begin, the seeming correlation between federal supervision and success now appears to be unwarranted and should be better understood. The failures we have seen are divided between institutions that are suffering because of an extreme business cycle, and others that had more fundamental flaws that precipitated the downturn. In a healthy and functional economy, financial oversight must allow for some failures. In a competitive marketplace, some institutions will cease to be feasible. Our supervisory structure must be able to resolve failures. Ultimately, more damage is done to the financial system if toxic institutions are allowed to remain in business, instead of allowed to fail. Propping up these institutions can create lax discipline and risky practices as management relies upon the government to support them if their business models become untenable. ------ fcic_final_report_full--207 And if a relatively small number of the underlying loans were to go into fore- closure, the losses would render virtually all of the riskier BBB-rated tranches worth- less. “The whole system worked fine as long as everyone could refinance,” Steve Eisman, the founder of a fund within FrontPoint Partners, told the FCIC. The minute refinancing stopped, “losses would explode. . . . By , about half [the mortgages sold] were no-doc or low-doc. You were at max underwriting weakness at max hous- ing prices. And so the system imploded. Everyone was so levered there was no ability to take any pain.”  On October , , James Grant wrote in his newsletter about the “mysterious alchemical processes” in which “Wall Street transforms BBB-minus-rated mortgages into AAA-rated tranches of mortgage securities” by creating CDOs. He es- timated that even the triple-A tranches of CDOs would experience some losses if na- tional home prices were to fall just  or less within two years; and if prices were to fall , investors of tranches rated AA- or below would be completely wiped out.  In , Eisman and others were already looking for the best way to bet on this disaster by shorting all these shaky mortgage-related securities. Buying credit default swaps was efficient. Eisman realized that he could pick what he considered the most vulnerable tranches of the mortgage-backed bonds and bet millions of dollars against them, relatively cheaply and with considerable leverage. And that’s what he did. By the end of , Eisman had put millions of dollars into short positions on credit default swaps. It was, he was sure, just a matter of time. “Everyone really did believe that things were going to be okay,” Eisman said. “[I] thought they were certifi- able lunatics.”  Michael Burry, another short who became well-known after the crisis hit, was a doctor-turned-investor whose hedge fund, Scion Capital, in Northern California’s Silicon Valley, bet big against mortgage-backed securities—reflecting a change of heart, because he had invested in homebuilder stocks in . But the closer he looked, the more he wondered about the financing that supported this booming mar- ket. Burry decided that some of the newfangled adjustable rate mortgages were “the most toxic mortgages” created. He told the FCIC, “I watched those with interest as they migrated down the credit spectrum to the subprime market. As [home] prices had increased on the back of virtually no accompanying rise in wages and incomes, I came to the judgment that in two years there will be a final judgment on housing when those two-year [adjustable rate mortgages] seek refinancing.”  By the middle of , Burry had bought credit default swaps on billions of dollars of mortgage- backed securities and the bonds of financial companies in the housing market, in- cluding Fannie Mae, Freddie Mac, and AIG. Eisman, Cornwall, Paulson, and Burry were not alone in shorting the housing mar- ket. In fact, on one side of tens of billions of dollars worth of synthetic CDOs were in- vestors taking short positions. The purchasers of credit default swaps illustrate the im- pact of derivatives in introducing new risks and leverage into the system. Although these investors profited spectacularly from the housing crisis, they never made a single subprime loan or bought an actual mortgage. In other words, they were not purchasing insurance against anything they owned. Instead, they merely made side bets on the risks undertaken by others. Paulson told the FCIC that his research indicated that if home prices remained flat, losses would wipe out the BBB-rated tranches; meanwhile, at the time he could purchase default swap protection on them very cheaply.  On the other side of the zero-sum game were often the major U.S. financial insti- tutions that would eventually be battered. Burry acknowledged to the FCIC, “There is an argument to be made that you shouldn’t allow what I did.” But the problem, he said, was not the short positions he was taking; it was the risks that others were ac- cepting. “When I did the shorts, the whole time I was putting on the positions . . . there were people on the other side that were just eating them up. I think it’s a catas- trophe and I think it was preventable.”  FOMC20071211meeting--152 150,MS. PIANALTO.," Thank you, Mr. Chairman. I favor a 25 basis point cut in our fed funds rate target and the language in alternative B. More losses at financial companies, in combination with uncertain year-end funding pressures, obviously have unsettled financial markets again. As I said earlier, sentiment about business conditions next year have become considerably more pessimistic in the past few weeks. In this environment, leaning toward caution and providing the added short-term liquidity that markets appear to need makes sense to me. Although I can see the arguments for a 50 basis point adjustment in our policy rate, I am inclined to think that a lesser policy response is called for. As others have indicated, it may be that a 25 basis point action is going to prove to be insufficient, and another cut might be necessary. But I am also mindful that efforts to address the problems that are affecting the real economy have the potential to aggravate inflation expectations. Indeed, by some cuts of the TIPS data and from a few reports that I am receiving from business contacts about rising commodity prices and rising import prices, inflation expectations may be tugging on their anchor just a bit. Given these considerable uncertainties, I think smaller moves are preferable to larger ones. At this time, I simply can’t assess with any useful precision how to weigh the risks we face, only that the risks we face are very difficult. Consequently, I favor the language expressed in alternative B as it is currently written. Thank you, Mr. Chairman." CHRG-110hhrg38392--35 Mr. Green," Thank you, Mr. Chairman. I thank you for your judicious approach in managing the committee, and I am honored to associate myself with your comments, and I also thank the ranking member. Mr. Chairman, thank you for visiting with us today. I would like to visit with you very briefly about a crisis that continues, and it seems to go unabated, notwithstanding cyclical and temporary factors; notwithstanding excess inventories and the lack thereof; notwithstanding core inflation; commodity prices, whether they increase or flatten; notwithstanding energy prices and how they impact the economy; headline inflation, core inflation. We have a crisis, in my opinion, and we consistently find that one segment of our society has an unemployment rate that is always twice that of another segment of our society. White unemployment is, as of June 2007, 4.0 percent. Black unemployment is 8.5 percent. Poverty among whites is 10.4 percent. Poverty among blacks is 25.6 percent. This is not something that is anomalous. It occurs consistently. There is a trend that is easy to track, and we consistently find that black unemployment is always twice that of white unemployment and is likely to be twice that of the national unemployment. The trend is there. The poverty trend is there. The question that I have for you is similar to the one that the chairman posed, but it relates to this segment of society, and the question is: Do you see a change in this trend? Is it possible for us to have African American employment to achieve parity with white employment? Is this trend going to continue? " FOMC20060920meeting--60 58,MS. JOHNSON.," In the international economy, the striking development over the intermeeting period has been the rapid and substantial drop in crude oil prices and in prices for some nonfuel commodities. The spot price of WTI crude reached a recent high of about $77 per barrel on August 7, following news of problems with the BP pipelines at Prudhoe Bay. Since then, it has declined to less than $62 in trading yesterday, decreasing about $15 per barrel. The far futures price is down somewhat less, nearly $10 per barrel, leaving a barrel of WTI crude for delivery in 2012 priced about the same as a barrel of crude in the current spot market. As has been our practice for many years, we have assumed for the Greenbook baseline forecast that oil prices over time will match those contained in the futures price curve that held when we finalized the forecast last week. The timing of our forecast this Greenbook and last and the smoothing from quarterly averaging results in our forecast path for the oil import price shifting a bit less than did the spot price of crude. The downward revision in the oil import price amounts to nearly $12 per barrel in the near term and narrows to somewhat more than $8 per barrel by the end of 2007. Some other commodity markets were remarkably volatile over the intermeeting period as well. The spot prices for gold declined more than $60 per fine ounce since the time of the August FOMC meeting. Many of the industrial metals also moved down sharply in the past week or two, but in some cases these declines merely retraced run-ups earlier in the intermeeting period and resulted in only small net changes. Regarding the implications of the lower oil prices for our forecast, it is helpful to remember that our assumed price for WTI crude in the fourth quarter is near, but still more than $1 per barrel above, the average price that prevailed in the first quarter of this year, when we regarded oil prices as very elevated. In addition, the forecast path for WTI now rises into 2007 and then is about flat at close to $70 per barrel through the end of 2008. It also is relevant for constructing the forecast to ask why oil prices have come down as they have. The new developments that triggered the reaction in market prices seem to be importantly about the risks attached to future supply. Some aspects of geopolitical tensions, such as the conflict in Lebanon and the ongoing dispute with Iran over its nuclear program, seem to have eased. The Atlantic Ocean hurricane season has pleasantly surprised, with fewer storms than previously expected and none so far threatening the Gulf of Mexico. One factor that likely influenced the price reaction to the apparent lessening of risks to supply is the high level of inventories of crude oil at the present time. Current demand and supply plus market expectations of future demand and supply combine to determine spot and future prices plus desired inventories. With inventories already high, news that future supply is less uncertain sharply lowered the price required to clear the spot market and the premium that buyers are willing to pay to ensure future access to oil. Nevertheless, the positive slope to the futures curve over the forecast period suggests that, on balance, market participants are not expecting future supply to be as abundant relative to demand as is the case currently. With respect to the implications for our forecast of foreign growth and inflation, we needed to consider the direct effects of lower energy prices and also to ask whether actual or prospective slowing of global economic activity and, hence, demand for oil and other primary commodities have contributed to the downward shift in these prices. On balance, our outlook for real GDP growth abroad generally remains quite strong. However, we do expect a decrease in the average rate of growth of foreign real GDP from about 4 percent at an annual rate in the second quarter to 3¼ percent in the second half of this year and over the remainder of the forecast period. In both the industrial countries and the emerging-market economies, the pace of real growth was particularly vigorous during the first half of this year and contributed to continued strong demand for oil and other commodities. Monetary policy has been tightened in response to concerns of inflation and overheating in many countries, measures to tighten fiscal policy have been passed in some cases, and officials in China have imposed additional administrative measures to restrain growth. Prospective moderation of the rate of foreign growth was a feature of our forecast in August. Data from Canada and Japan already provide evidence of a lessening in the rate of growth in those countries. However, available data on activity in the euro area, China, and Mexico continue to be buoyant. In putting the pieces of the forecast together, we have concluded that the lower oil prices are consistent with overall foreign growth remaining moderately strong and will help to ensure that it remains so. At the same time, the projected pace of global economic activity is consistent with oil prices remaining quite elevated and rising somewhat into next year. We judged that the implications for foreign growth of the downward revision to the outlook for U.S. real output growth were partly offset by some boost to foreign growth that we otherwise would have incorporated in response to the reduced energy costs, although these factors differ across countries. As a result and given data received since the August forecast, the path for foreign real GDP growth was little revised on balance from that in the previous Greenbook. We have revised down our forecast for headline consumer price inflation abroad a few tenths for the second half of this year and next as a consequence of the lower path for energy prices. We project that in the industrial countries other than Japan inflation will move down somewhat over the forecast period. In contrast, Japanese inflation is expected to edge up but to remain below 1 percent. Some emerging-market economies in Asia still have controls on or subsidies of domestic fuel prices, which delays any pass-through of higher energy prices into domestic inflation. Accordingly, we project that increases in global oil prices earlier this year will push inflation in emerging Asia temporarily above 3 percent during the first half of next year. We look for inflation in Latin America to remain contained near present rates. We see the risks to this forecast in many respects as balanced. We have been surprised on the upside by the strength in foreign real activity during the first half of the year, and strong domestic demand in some regions could push off into the future some of the slowing that we are projecting. Alternatively, foreign activity may be more sensitive to the U.S. slowdown than we currently envisage. We feel especially uncertain with respect to the outlook for oil prices, given market reaction to recent events; the sharp change in prices caught us and the futures market by surprise. Although we are once again assuming that oil prices will follow the path implied by futures prices, we recognize that a much larger move up or down is quite possible. David and I will be happy to answer any questions." FOMC20080109confcall--19 17,MR. STOCKTON.," So, indeed, I think this combination of weaker economic growth and higher inflation is an unfortunate situation for you as policymakers. I do think there are some upside risks that you face on inflation, and the recent rise in oil prices probably intensifies those upside risks. We are taking some comfort from two other pieces of information in the constellation of the inflation data that the process isn't slipping away to the upside on inflation. One is, as Bill noted, that we haven't really seen any deterioration in the TIPS-based measures of inflation expectations. We have seen an uptick in the Reuters/Michigan survey of households in the last month or so, on both near-term and long-term inflation expectations. That does tend to happen in periods when gasoline prices are spiking up. I would hate to throw that observation out completely, but I guess as we look at this, we don't really see as yet convincing evidence that there has been a deterioration in inflation expectations. The other thing is that we haven't really seen anything in the way of serious deterioration on the labor cost side. So those two things combine, at least in my mind, not to eliminate but probably to limit some of the upside risks that you're facing on the inflation side. But, clearly, anecdotes are there--not just the data but also anecdotes--that suggest that businesses are facing some considerable cost pressures associated with higher energy and other commodity prices. " CHRG-110shrg50409--25 Mr. Bernanke," Senator, this is really the CFTC's function and responsibility. We are trying to assist them, and we are trying to work as quickly as possible to gather information and try to make some useful recommendations. Senator Menendez. Well, many of us believe we need to pursue market speculation now as a critical element of helping to drive down particularly gas prices. Let me ask you this: There is one thing squarely within your realm, and that is the question of a weaker dollar. In 2000, we ran a budget surplus. Ever since then, the Federal Government has been running up larger budget deficits. We added to that a $1.6 trillion tax cut and a $700 billion war that would generally contribute to a larger budget deficit. And if you look at that and you look at the twin deficits of both trade and the budget in combination, you have a low--with a low domestic savings rate, you have all of the makings of a weakening dollar. In 2002, the barrel of oil cost $23 and 23 euros. Now it costs--well, the Chairman had even a higher figure than I had. I had $145 and 90 euros. I am sure it just changed overnight. Do you agree with the Commodity Futures Trading Commission and others that the weakening dollar has contributed to the higher price of oil as an elemental part of our challenge? " fcic_final_report_full--430 China and other Asian economies grew, their savings grew as well. In addition, boosted by high global oil prices, the largest oil-producing nations built up large cap- ital surpluses and looked to invest in the United States and Europe. Massive amounts of inexpensive capital flowed into the United States, making borrowing inexpensive. Americans used the cheap credit to make riskier investments than in the past. The same dynamic was at work in Europe. Germany saved, and its capital flowed to Ire- land, Italy, Spain and Portugal. Fed Chairman Ben Bernanke describes the strong relationship between financial account surplus growth (the mirror of current account deficit growth) and house price appreciation: “Countries in which current accounts worsened and capital in- flows rose . . . had greater house price appreciation [from  to ] . . . The rela- tionship is highly significant, both statistically and economically, and about  percent of the variability in house price appreciation across countries is explained.”  Global imbalances are an essential cause of the crisis and the most important macroeconomic explanation. Steady and large increases in capital inflows into the U.S. and European economies encouraged significant increases in domestic lending, especially in high-risk mortgages. The repricing of risk Low-cost capital can but does not necessarily have to lead to an increase in risky in- vestments. Increased capital flows to the United States and Europe cannot alone ex- plain the credit bubble. We still don’t know whether the credit bubble was the result of rational or irra- tional behavior. Investors may have been rational—their preferences may have changed, making them willing to accept lower returns for high-risk investments. They may have collectively been irrational—they may have adopted a bubble mental- ity and assumed that, while they were paying a higher price for risky assets, they could resell them later for even more. Or they may have mistakenly assumed that the world had gotten safer and that the risk of bad outcomes (especially in U.S. housing markets) had declined. For some combination of these reasons, over a period of many years leading up to the crisis, investors grew willing to pay more for risky assets. When the housing bub- ble burst and the financial shock hit, investors everywhere reassessed what return they would demand for a risky investment, and therefore what price they were willing to pay for a risky asset. Credit spreads for all types of risk around the world increased suddenly and sharply, and the prices of risky assets plummeted. This was most evident in but not limited to the U.S. market for financial assets backed by high-risk, nontradi- tional mortgages. The credit bubble burst and caused tremendous damage. Monetary policy The Federal Reserve significantly affects the availability and price of capital. This leads some to argue that the Fed contributed to the increased demand for risky in- vestments by keeping interest rates too low for too long. Critics of Fed policy argue that, beginning under Chairman Greenspan and continuing under Chairman Bernanke, the Fed kept rates too low for too long and created a bubble in housing. Dr. John B. Taylor is a proponent of this argument. He argues that the Fed set in- terest rates too low in – and that these low rates fueled the housing bubble as measured by housing starts. He suggests that this Fed-created housing bubble was the essential cause of the financial crisis. He further argues that, had federal funds rates instead followed the path recommended by the Taylor Rule (a monetary policy formula for setting the funds rate), the housing boom and subsequent bust would have been much smaller. He also applies this analysis to European economies and concludes that similar forces were at play. CHRG-110hhrg44901--51 Mr. Bernanke," Congresswoman, as I indicated in my testimony, we at this point are balancing various risks to the economy. And as we go forward, my colleagues and I are going to have to, you know, see how the data come in and how the outlook is changing and try to find the policy that best balances those risks and best achieves our mandate of sustainable growth and price stability. So I don't know how to answer beyond that, other than to say that we are going to be responsive to conditions as they evolve. I noted today the importance of not letting inflation from commodities enter into a broader and more persistent and more pernicious inflation. That is certainly an important priority. But in general, we are going to have to just keep evaluating the new information and see how it affects the outlook. Monetary policy works with a lag. We can't look out the window and do something that will affect the economy today. So the best we can do is try to make forecasts and try to adjust our policy in a way that brings the forecast towards the desired outcome. Ms. Velazquez. Well, Mr. Chairman, I understand all the steps and actions taken by the Fed. But it seems to me that the lending tools are proving to be ineffective at this point. Doesn't this prove that the current economic conditions have moved beyond a liquidity crisis that can be mitigated through Federal lending and is now proven to be a capital crunch? " FinancialCrisisInquiry--170 So what’s happened post-crisis, there’s still no initial margin to the best of my knowledge. Now, maybe between some dealers, there is. Between the big ones, to the best of my knowledge, there isn’t. They’ve just narrowed the bands of variance margin. The variance margin bands used to be wide enough to drive a truck through, and now they’re much narrower. So you can be on the hook for $5 million or $10 million before they force you to post it. And now, maybe it went from $5 million or $10 million to $1 million, but you’re still not posting any initial collateral. So theoretically, you could take very, very large positions and not be recognized or noticed until it starts moving against you. BORN: Do you think it would be beneficial to have a clearinghouse for standardized derivatives that would have initial collateral requirements and, also, do the margin calls and things like that? BASS: I think it’s absolutely mandatory. BORN: You know, in 2000, Congress passed a statute called the Commodity Futures Modernization Act that virtually deregulated the over-the-counter derivatives market and also preempted most state laws from governing over-the-counter derivatives. And I was struck, Mr. Solomon, by your discussion and your written testimony about the impact of deregulation on the financial situation and as a cause of financial crisis. And I wondered—I gathered from your written testimony that you attributed part of the deregulation that we’ve seen in the last 20 years to the political power of large financial institutions. Is that right? SOLOMON: FOMC20080318meeting--49 47,MR. HOENIG.," Thank you, Mr. Chairman. I thought I would talk a bit about some events in our region that I think have global implications--that is to say, I will talk a bit about agriculture. You have heard others here this morning talk about some of the price movements, and I think it is worth perhaps spending a few minutes on their effects. First of all, agricultural commodity prices have surged to record highs, driven by obviously strong demand, lean supplies, and a weak dollar. Since the fall of 2007, winter wheat prices have doubled, and corn and soybean prices have risen about 70 percent, to record highs. Rising crop prices are boosting farm income. In real terms, U.S. net farm income is expected to climb to the second highest level on record, trailing only 1972, when abrupt sales of U.S. wheat to Russia pushed up farm income. An emerging concern is the growing disarray in futures markets for agricultural commodities caused by a surge in investment by index and hedge funds going forward. Recent reports indicate that hedge and index fund investment in futures markets for corn, soybeans, and wheat rose from $10 billion in January 2006 to $45 billion this past January. Early this month, index funds held more than 40 percent of the long positions on wheat contracts on the Chicago Board of Trade. At this rapid pace of investment--since the beginning of this year averaging $1 billion per week--the funds would own the nation's entire 2008 corn, wheat, and soybean crops by early 2009. Now, that is obviously theoretical, but that is how much money is going into this market. The resulting market disarray is constraining the traditional use of commodity futures to hedge market risk. Grain elevators, which use futures to hedge their contracts to purchase crops from producers for future delivery, are facing much larger than normal margin calls on their futures positions. Some reports indicate that lenders are beginning to restrict their funding of elevator hedges. As a result, an increasing number of elevators are limiting their contracts for crop purchases to no more than sixty days in advance of the delivery instead of the normal one to two years. Now, this surge in crop prices and farm income is pushing up farmland values. According to our bank's agricultural credit survey in the fourth quarter of 2007, non-irrigated cropland values jumped 20 percent over 2006 levels, with strong gains also reported in irrigated cropland and ranchland. Our directors and other contacts report a further strong gain since the beginning of the year, and some have reported as much as a 20 percent increase in the first quarter alone. Adjusted for inflation, the average price of farmland across the nation now tops the early 1980s peak, which immediately preceded the plunge in the early to mid 1980s. To date, crop production budgets suggest that the recent run-up in farmland values is supported by current revenues from crop production. However, farm input costs have also risen sharply, driven by higher energy costs, suggesting that a drop in crop prices could quickly erode farm cash flow and undermine these values. District bankers report a surge in farm capital spending. In February, sales of four-wheeled major equipment rose 45 percent above 2007 levels, and combine harvester sales were up 13 percent. Farm equipment prices have risen sharply, and our directors and other contacts report that some equipment dealers are rationing purchases among their customers. In the past month, anecdotal reports from District contacts indicate that nonfarm investors have boosted their farmland purchases. Our contacts at a national farm management company based in Omaha stated that the number of inquiries for farmland purchases by corporate interests has jumped significantly recently. Similarly, one of our directors reported that a hedge fund with assets of more than $7 billion is expected to invest $500 million in cropland from Texas and Nebraska. This fund recently purchased nearly 25 square miles of corn acreage in western Nebraska. Now, we continue to watch for signs of rising leverage, but to date farm debt levels have risen modestly only, and agricultural banks seem to remain healthy. Bankers report continued use of cash to finance farmland purchases, but I would note that leverage is being brought into the picture, and I think that will accelerate as opportunism and greed have their way. Total farm lending in the District banks has increased a modest 14 percent over the past four years, with most of that growth being in farm real estate lending. But District bank examiners and respondents to our surveys reported that the Farm Credit System was being more aggressive in funding farm real estate transactions. Real estate mortgage loans held by the Farm Credit System rose about 12 percent in 2007. Asset quality at our ag banks remains, at this point, solid. Noncurrent assets--all assets, not just farm loans--at ag banks are up only slightly from a year ago and remain well below historical averages. Net loan losses are still very low. Earnings have remained solid primarily because of cost control and very low loss provisions. I am very pleased, but I will tell you that, going forward, in terms of the surveys with the kinds of pressure and price appreciation going on, I think the push for leverage is just beginning. At the national level, in terms of the Greenbook, every indication is that the economy is slowing. Whether it is recession or very slow growth is a matter of degree, but I think our projections are in the same direction as the Greenbook. Turning to the inflation outlook, I am concerned, as I have said before, about the upside risk to inflation. Though I certainly agree with others around the table that weaker economic activity may put some downward pressure on goods price inflation, I think we can also agree that a number of factors could push inflation higher, including rapidly rising commodity prices worldwide and a weaker dollar. As discussed in the Bluebook, there is some indication that inflation expectations may be moving higher as well. As I have indicated before, I am increasingly concerned that, in our need to respond to signs of economic weakness, we risk losing our hard-won credibility on inflation. For the past four years, core PCE inflation has averaged about 2.1 percent, considerably above the numbers that this Committee has put forward in its long-term projections. Frankly, I do not think that many people outside this room think that this Committee can deliver the longer-run projections that we have put forward. I don't think that we can keep inflation expectations anchored only by talk if actual inflation rises further in the months ahead and we continue to ease policy in a rising inflationary environment. This is something that we need to keep in mind as we discuss our policy options today. Thank you. " FOMC20050202meeting--154 152,MR. KOHN.," Thank you, Mr. Chairman. My forecast for economic activity in 2005 and 2006, like the rest of yours, was for growth a little faster than the trend rate of growth in potential. That reflects my judgment that the forces that had been holding back the economy in recent years have largely dissipated, allowing the effect of relatively stimulative financial conditions to continue to show through and raising the level of production relative to potential. My projection for growth in 2005 and 2006 is in line with the rate of growth in 2004. Yet energy prices, whose rise must have damped growth to some degree in 2004, are expected to be flat or somewhat lower. In addition, financial conditions have eased since the middle of the year, with bond rates and the exchange rate lower and stock prices a little higher. So, as I thought about my projection, the logical question seemed to be whether we were on the verge of a much stronger pace of economic growth. Although that’s a possibility, I see several factors that should keep growth to a moderate pace. Monetary policy and fiscal policy are at the top of the list. On the fiscal side, the partial-expensing provisions probably brought forward some capital expenditures from 2005 to 2004. For monetary policy, I assumed a continued gradual withdrawal of monetary stimulus along the lines built into the staff’s forecast or the market’s. That should lead to rising real intermediate- February 1-2, 2005 106 of 177 investment spending directly, take something off the increase in house and equity prices—holding down gains in wealth—and support the dollar. Of course, that hasn’t been the experience over the last six months or so, as President Lacker just pointed out. But longer-term real rates have fallen to such a low level that I find it difficult to believe they won’t rise from here, provided moderate growth is sustained. Indeed, I see an important downside risk to the forecast from the possibility of a sizable jump in longer-term real interest rates, which could have a pretty serious effect on house prices and consumption if it results from an unwinding of special factors or from a revision of unreasonably low expectations rather than from an unexpectedly faster pace of economic activity. Until those rates ratchet higher, however, their low level, along with the basically sideways movement of equity prices since late last year, would seem to suggest that caution among savers and spenders has not dissipated entirely. At the very least, the behavior of bond yields and stock prices seems inconsistent to me with a new more ebullient attitude that would presage boom-like conditions. In addition, the behavior of the trade deficit is likely to be damping the growth of demand on U.S. resources for a while. The staff forecast, which has net exports making a modest net negative contribution on average over the next two years, is itself premised on a pickup in foreign demand—a pickup we don’t yet see in the data. This suggests to me another source of downside risk. Over the long haul, as people become more reluctant to send us growing proportions of their savings, the deficit will have to fall. That will put considerable pressure on productive capacity in the United States, but it’s not at all clear when that will begin to happen. Finally, in making my forecast of real growth, I took account of my serial forecast errors. I’ve been overpredicting growth since I got on the Committee, so I used a sophisticated algorithm to compensate for this propensity: I decided what I really wanted to forecast and I took a little off! February 1-2, 2005 107 of 177 My projection for core PCE inflation for 2005 and 2006 that goes with this path of output is slightly higher than the staff forecast. I gave some weight to the market-based core PCE numbers, which have been running higher than the total core PCE, but that forecast remains below 2 percent, and it is stable at that level. For inflation, the question I wrestled with was: Why not further increases this year after the acceleration of 2004? In that regard, the recent data from the last part of 2004 have been supportive, I think, of a stable inflation forecast. With these data, every broad index of core inflation—from GDP prices to the CPI to PCE—grew less rapidly in the second half of last year than in the first— and significantly less rapidly, by at least ½ percentage point. This pattern is not consistent with accelerating prices. It reinforces the hypothesis that a good portion of the pickup in core inflation in the first half of 2004 was attributable to special factors: a reversal of the unexplainable undershoot in inflation in 2003 and the pass-through of higher energy, commodity, and other import prices from late 2003 and early 2004. At least in terms of energy prices—not imports, which are a big question mark—I think these upward pressures should not be a factor in 2005. In labor markets, increases in measures of compensation also slowed from the first half of the year to the second. Now, this is particularly noteworthy in that one might have expected the previous run-up in energy prices and the strength in productivity increases in recent years to put upward pressure on compensation gains. As a consequence, I think I’m a little less concerned than some others of you that slack has already been absorbed. I can only explain the recent pace of compensation data if appreciable slack is persisting in labor markets to balance these other upside pressures. In this environment, continued intense competitive conditions are likely to limit labor cost increases and the ability or willingness of firms to pass through shorter-term increases in unit labor costs into prices and thus risk market share. Finally, inflation came in lower in the second half of 2004 than I had expected. My projection was at the low end of our collective central tendency, so most of you were a little higher February 1-2, 2005 108 of 177 decline in the unemployment rate. But energy and import prices rose more than I had anticipated. Consequently, I also wondered whether at midyear I had given enough weight to the factors restraining inflation—slack, elevated markups, and stable inflation expectations. To be sure, slack should be diminishing, businesses will try to resist any squeeze on markups, and the economy may be closer to potential than it appears right now. If the dollar declines substantially, import prices will increase, reducing foreign competitive pressure. Or if trend productivity slows more than projected, firms could be more insistent and more successful in passing through costs than is consistent with keeping inflation in check. Still, for now, I think low, stable inflation is the most likely outcome for the next few years, provided policy continues gradually to firm, as slack slowly diminishes and output grows at a moderate pace. As for the balance of risks, I’ve always thought that that phrase applies primarily, or first and foremost, to the most likely path for inflation and output relative to our objectives at the assumed path for policy. And, in that context, the risks still seem to me to be balanced. The fact that I found myself asking these particular questions about the outlook suggests, perhaps, a slight skew to the distribution around these modal outcomes. But I think we should await further developments to assess whether those skews will become large enough to influence the central tendencies, the balance of risks, and the path on which we remove policy accommodation, or whether, as the market and the staff expect, we actually will need to slow the pace of tightening in the future. Thank you, Mr. Chairman." CHRG-111hhrg51698--165 Mr. Boccieri," Life is like that these days, I guess. Mr. Chairman, thank you for your leadership in having this Committee panel assembled here. Having a bit of an economics degree in college, it is amazing to me that it seems as if we are throwing the laws of supply and demand out the door. We are creating these artificial bubbles with these CDSs that drive price fluctuations up and down that have absolutely nothing to do, in my humble opinion, with supply and demand. When you have, for instance, oil prices spiking at $4 a gallon, even though there was more supply in the market a year ago than there was previous to that, there seems to be a push away from this notion that supply and demand should be running the market, rather than CDSs. I am a little bit concerned, and confused, about the argument that we are making here today for supporting this unregulated, unchecked, artificial price spike, if you will, of commodities and futures that are very important to American families. Having a stable market, a reliable market that underscores that when a consumer, a family goes to a gas station that they can have a reliable price there that they know was equitable and fairly traded, and that was marked by supply and demand and not by speculation, or manipulation like Mr. Damgard had suggested. I guess my question to the panel is this, that some of the panel have suggested that we take a broader look at manipulation, and that our concern about the test for manipulation is limited to conscious efforts versus those that are unconscious. Manipulation is a crime, and there are penalties associated with it. If the market participants are impacting markets unconsciously, but with the same impact as those who have attempted manipulation, shouldn't they be punished the same as those conscious manipulators? " CHRG-110hhrg44900--7 Mr. Kanjorski," Mr. Chairman, this hearing comes at a critical juncture. As the economy reels from a widespread, far-reaching financial crisis that continues to wreak havoc on everything from the housing market to student loans, while we remain focused on many current economic difficulties average Americans face, we must simultaneously look to the future to determine how to prevent or at least mitigate future crises. Financial innovation and the proliferation of complex and exotic financial instruments are probably inevitably going to occur under our capitalist system. But we must develop innovative, regulatory and oversight responses to keep pace as these market transactions evolve. One such proposal worth considering is the Systemic Risk Reduction Act of 2008 put forth by the Financial Services Roundtable. This bill seeks to make regulation more efficient by closing gaps in our regulatory structure and by promoting consolidation and cooperation among regulatory agencies. Their proposal includes a provision of particular interest to me; namely, it proposes establishing a bureau similar in concept to the Office of Insurance Information which passed the Capital Markets Subcommittee yesterday. Without a Federal repository to collect and analyze information on insurance issues, we cannot fully understand and control systemic risk. The Roundtable proposal would also expand the authority of the Federal Reserve so that investment banks who borrow from the Fed's discount window in various facilities do not get a free pass. No one else can borrow money without conditions, and the American people do not expect that the investment bank be allowed to do so. Chairman Bernanke spoke 2 days ago and raised many of these issues and offered ideas for consideration, noting that the financial turmoil since August underscores the need to find ways to make the financial system more resilient and more stable. I whole-heartedly agree. He further stated that the Fed's powers and responsibilities should be commensurate. It is the job of Congress to strike that proper balance. While many concur that the Federal Reserve's move to bail out Bear Stearns in March of this year was necessary to prevent a financial meltdown, most also agree that we should be concerned about setting precedents with broad ramifications down the road. Taxpayers cannot be asked to bail out financial institutions, and we should look for ways to prevent such dire situations from arising in the future. Another area germane to today's discussion is speculation. Specifically, we must determine to what extent speculation in commodities futures has hurt American consumers by artificially inflating the price of oil, energy, and other goods. I appreciate the ongoing debate on speculation with economists, traders, pundits, and politicians staking out various positions on the issue. To the extent that we can glean further insight from our panelists today, that would be of tremendous help, for it is true that speculators bear blame. Then congressional action in the form of increased oversight in authority is warranted. on a related note, I am very interested in consolidating the regulation of our securities and commodities markets. While the CFTC currently has jurisdiction of this market, the Treasury's recommendation to merge SEC and FCTC seems a sensible course of action for Congress. We need to take this action now and I look forward to working with the Administration. " FOMC20080130meeting--188 186,MS. PIANALTO.," Thank you, Mr. Chairman. In my view, economic conditions have deteriorated significantly since our December meeting. Taken as a whole, the stories that have been relayed to me by my Fourth District business contacts have been downbeat, and several of the contacts are concerned that we may be slipping into a recession. I'm hearing that consumer spending has declined appreciably since the soft December retail sales numbers were reported. The CFO of one of the nation's major department store chains told me last week that her company's January sales are shaping up to be the worst that they have seen in the past twenty years. She said that they had already cut back some of their buying plans because of the weak holiday sales, but after seeing the numbers for the first three weeks of January, she is concerned that they have not cut back buying plans enough. In December I had heard some upbeat assessments about the demand for capital goods and exports, but in January the incoming numbers are softer, and expectations for the coming year are less optimistic than they were just a month ago. I'm also concerned that I'm now detecting the first signals of a credit crunch. Bankers in my District tell me that they're finding it much more difficult to issue debt and that they are safeguarding their capital. I've heard several motivations for this, depending on the institution. Some bankers are simply preparing for further losses. Some are expecting to have to bring some downgraded assets back onto their balance sheets. Even those bankers who have adequate capital say that they have become much more disciplined about how they're going to allocate that capital. Collectively, the concerns that bankers have expressed to me about capital have convinced me that credit will be less available and more expensive than it has been in quite a while. Deals that bankers would have done for creditworthy borrowers not long ago are simply not being done today. Of course, it's possible that nonbank financial companies will step in and fill the gap, but it is not clear to me that they have the capital and the risk appetites to do so. These developments have had a significant influence on the economic projection that I submitted for today's meeting. Like many around the table, I continue to mark down my outlook for residential and nonresidential investment in response to the incoming data and also in response to greater business pessimism about the economic prospects. In addition, I've built in a sharper and more protracted slowing in consumer spending stemming from greater deterioration in the household balance sheet and tighter credit market conditions. These adjustments have caused me to cut my 2008 GDP growth projection about 1 percentage point since the December meeting, and some of that weakness spills over to the out years. If credit conditions deteriorate further than I have expected, then my projection would more closely resemble the persistent weakness alternative scenario described in the Greenbook. But that isn't my projection for the economy. Rather, my projection is roughly in line with the Greenbook baseline. My inflation outlook hasn't changed much from where it was in December--or October, for that matter. Like the Greenbook, I still project inflation to moderate as commodity prices level off and business activity wanes, but the risks to my inflation outlook have shifted to being weighted to the upside. The December CPI report was not much improved from the troubling November data, and my business contacts continue to report that commodity prices are being passed downstream. So I have less conviction in the inflation moderation than I did a month ago. That said, the downside risks to the economy still dominate my thinking about the outlook today. I do believe, however, that our policy response to date combined with an additional rate cut tomorrow will allow the economy to regain some momentum as we move into the second half of 2008. Thank you, Mr. Chairman. " FOMC20050920meeting--74 72,MS. JOHNSON.," Let me take it in two halves. I’ll talk a little about global energy use, and then we’ll come to the import price part. We model energy demand, energy consumption, energy production, and the implied change in inventories on a global basis. And we do it using all of the information we can muster. But it is understood by the people in that world that there is a lack of good information. There has been an outcry for more transparency about energy production and energy capacity than now exists. Some of the volatility that President Fisher was speaking to derives from the fact that when the IEA makes an announcement of a change in their estimate of what demand was last year it will move the market. So, the quality of the information that is available for the global market is certainly far from ideal. And some of the countries involved, of course, are in rather troubled political areas where being transparent about anything is not in their interest, so they don’t provide data. So that adds to the complexity. But we have an oil model and we use a lot of judgment—the add factors that David was talking about—and we attempt to account for total oil production in essence by country. It’s not that we think any individual number in that mix is going to be right in any sense, but we try to be consistent through the story. So we start with the futures curve for WTI, and we make some judgments about the spreads on things like Dubai and other oils that loom large in the global market, and we use the model to infer what the balance of supply and demand would have to be. And given that we have relied on the futures markets—basically for want of a view that we could do better than the futures market—supply becomes the residual. So we have forecasts of global demand of GDP. And we have different weights that apply to those that are the oil-using September 20, 2005 32 of 117 Now, part of your question was how often we change those weights and how sensitive we are to the shifts in production that are taking place in the world. I can’t speak to that specifically, but in general we revise our weights every year. It’s not as if we have weights from 1970 and we just keep cranking away using those weights. We’ve gone to this variable weight approach as in the GDP and everything else. So, we specifically do at least attempt to take account of how different countries use energy versus how other things happen. We have a set of energy-using weights that we apply to world GDP, and that gives us, in essence, a different aggregate for world growth than if we were doing it for some other purpose, which we do. So we’ve got a price and we’ve got demand, and we back out supply; supply becomes the residual. For example, two years ago when prices seemed to us to be rather high, we were inferring a need for supply to pull back in order to sustain those prices. And OPEC has played that role—Saudi Arabia, in particular. Go back and read Greenbooks from two to three years ago, and we had a story about expecting supply to contract in certain places in order for futures curve prices to be realized, as oil suppliers target prices, and so forth. That has not been so true lately. Indeed, we’ve been tapping capacity increasingly over the last two years. And the notion that global supply was more than enough to explain the prices we were seeing has flipped to become a question of where we are going to get the extra supply. For a time Russia and the FSU [Former Soviet Union] were a big source of extra non-OPEC supply. That seems to have changed more recently. So, there is a supply story that tries to take these things into account that matches demand and the futures curve to give a crude oil picture. September 20, 2005 33 of 117 contradiction there, we would have to go back and say something to ourselves about our assessment of demand. We take that picture, and for the United States—particularly this time more so than most—we have to ask questions about domestic capacity to supply the residual part. Would that have to be imported? And what would be the mix of those imports? So we try to make all of that fit. That leaves us then with an oil import price which can move differently than global crude prices because of the mix factor. And the oil import price is what feeds into the domestic economy and then drives the elements of pass-through and domestic production and so forth. Now, in our forecast of import prices the oil price portion is distinct from the non-oil portion, and it is non-oil import prices that in the projection come down. Those prices have been kicked around hugely by natural gas and by non-oil primary commodities. We have now internally, but we don’t put it in the Greenbook, import prices less natural gas as a check on whether we are fully incorporating what we think is happening to natural gas. But we don’t have a comparable setup for the supply and demand balance of natural gas that we have for oil, and the natural gas that would be relevant, obviously, is for North America as an almost isolated market. There is liquefied natural gas on the margin. There are some imports on the margin. But we are thinking that we might have to do something about the quantity of natural gas because it’s a hidden uncertainty in the overall non-oil import price, and it’s uncomfortable that we haven’t been able to have a better control over that. Even so, the non-oil, non-energy primary commodities have been the big story in import prices; they caused the import prices to move up. And the fact that those futures markets are September 20, 2005 34 of 117 that import prices are decelerating yet again—and to very low levels in 2006 and into 2007. That outlook is really a combination of what we think the non-energy futures markets are telling us about commodity prices and the maintained assumption we make about the dollar. Either of those things could change, and the forecast is completely conditional on them, with the added wrinkle of this role of natural gas that is embedded in non-oil import prices, but which probably should be separated out. Now, at least in terms of the work we do, we try to do that partially but maybe we should do it more explicitly." CHRG-111shrg54589--139 RESPONSES TO WRITTEN QUESTIONS OF SENATOR SCHUMER FROM GARY GENSLERQ.1. Chairman Gensler, isn't the same true regarding the potential impact of derivatives on commodities markets? Shouldn't all derivative products that impact commodities prices be overseen by your agency?A.1. Answer not received by time of publication.Q.2. Chairman Gensler, do you agree that broad-based and narrow-based derivatives products can both have an impact on the underlying markets that they reference?A.2. Answer not received by time of publication.Q.3. Chairman Gensler, I am very concerned by efforts by the European Commission to implement protectionist restrictions on derivatives trading and clearing. A letter signed by many of the world's largest financial institutions earlier this year under significant pressure from European Commission, commits them to clearing any European-referenced credit default swap exclusively in a European clearinghouse. This kind of nationalistic protectionism has no place in the 21st-century financial marketplace. What steps can you and will you take to combat these efforts to limit free trade protect free access to markets? If Europe refuses to alter its position, what steps can be taken to protect the United States' position in the global derivatives markets?A.3. Answer not received by time of publication.Q.4. Chairman Gensler, one of many important lessons from the financial panic last fall following the collapse of Lehman Brothers and AIG, it is that regulators need direct and easier access to trade and risk information across the financial markets to be able to effectively monitor how much risk is being held by various market participants, and to be able to credibly reassure the markets in times of panic that the situation is being properly managed. A consolidated trade reporting facility, such as the Trade Information Warehouse run by the Depository Trust and Clearing Corporation for the credit default swaps markets, is the critical link in giving regulators access to the information this kind of information. Currently, there is no consensus on how trade reporting will be accomplished in domestic and international derivatives markets, and it is possible that reporting will be fragmented across standards established by various central counterparties and over-the-counter derivatives dealers. Do you agree that a standardized and centralized trade reporting facility would improve regulators' understanding of the markets, and do you believe that DTCC is currently best equipped to perform this function?A.4. Answer not received by time of publication.Q.5. Chairman Gensler, in response to the need for greater transparency in the derivatives market, a joint venture between DTCC and NYSE was recently announced called New York Portfolio Clearing. Market innovations such as these, which intend to provide a single view of risk across asset classes, can help close regulatory gaps that currently exist between markets. Do you agree that this one approach that would help increase market efficiency and could reduce systemic risk? Should we expect the Commission to support this initiative?A.5. Answer not received by time of publication. ------ CHRG-111shrg57320--401 Mr. Bowman," Good afternoon, Chairman Levin. My name is John Bowman. I am a career Federal employee who became Acting Director of the Office of Thrift Supervision a little over 1 year ago during the height of the financial crisis after about 5 years as the agency's chief counsel. It is not a role that I sought, but I am honored to serve.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Bowman appears in the Appendix on page 181.--------------------------------------------------------------------------- My written testimony summarizes OTS' supervision of Washington Mutual, and the reasons why WaMu failed. It is important to note that this failure came at no cost to the Deposit Insurance Fund and at no cost to the American taxpayer unlike recent failures of other financial institutions and the near collapse of some of the Nation's largest banks which were deemed ``too big to fail'' and, therefore, provided government assistance. The demise of WaMu came early in the procession of more than 200 banks and thrifts that have closed during this crisis. Lifelines, such as the Treasury's TARP program and the FDIC's increase in deposit insurance coverage, came too late for WaMu. During the real estate boom before the crisis, WaMu and other financial firms made a critical error by widely underwriting home mortgages based more on the value of the collateral represented by the homes than on the borrower's documented ability to repay. As home prices continued to rise, these practices supported a widely praised initiative to increase homeownership in America. Yet, as we now know, homeownership reached unsustainable levels and became too much of a good thing. Like all of the players in the home mortgage market, bank managers at WaMu and elsewhere mistakenly believed that they were effectively averting risks by moving loans off their books and securitizing them. Similarly, homeowners perceived little risk in their adjustable-rate mortgages because they thought they could sell their homes at a profit before rate resets kicked in. Investors believed mortgage-backed securities carried little risk because credit rating agencies rated them highly. Those beliefs proved misplaced when the real estate market collapsed, the secondary market froze, and the risks turned out to be all too real. The fallout hit financial institutions large and small, with State and Federal charters, overseen by every banking industry regulator. Since WaMu's failure, the OTS has taken lessons to heart from our own internal review of failed thrifts and from the Treasury Inspector General's Material Loss Reviews, and we have made strides to address the resulting recommendations. We have instituted controls to better track problems identified in their examination reports and to take timely, effective action when necessary. We have established a Large Bank Unit to keep close watch over our largest regulated institutions, strengthened oversight of our OTS regions, enhanced supervisory consistency among regions, tightened scrutiny of problem banks, and set deadlines for taking enforcement actions after safety and soundness downgrades. In short, we have made meaningful changes. Although some thrifts helped to overinflate the housing bubble, traditional thrifts whose managers stuck to their conservative business practices of lending to people they knew and keeping loans on their books weathered this economic storm and continue to provide badly needed credit in their communities. Because consumer and community lending remains important for American families, I continue to believe in the thrift charter and the need for thrifts to have a separate regulator. With the changes we have instituted, I believe we have made the OTS significantly stronger for the future. Thank you again, Mr. Chairman. I am happy to answer your questions. Senator Levin. Thank you very much, Mr. Bowman. Throughout the last few years of WaMu's operation, the FDIC as the back-up regulator made repeated requests to participate in OTS exams and was continually rebuffed. We heard in the second panel how the FDIC sought to participate in OTS exams of Washington Mutual, was limited in terms of staff, forbidden to do file review. For periods of time, OTS blocked FDIC access to exam material. Mr. Bowman, are you familiar with that, and was that the right course of action? " FOMC20080430meeting--188 186,MR. HOENIG.," Mr. Chairman, I'm glad that reasonable people can differ. I do continue to hold the view that easing policy today is a mistake. If I were voting on it, I would vote to hold where we are. With the fed funds rate at the level it currently is, I think that continuing to ease policy in an environment of rising inflationary pressures gives serious erosion to our long-run credibility. We are seeing increasing signs that inflation expectations are rising. I see it constantly, as the public's inflation psychology is changing as well. This change reflects the large, sustained now, increases in food, energy, and other commodities and accelerating import prices. I am concerned that maintaining at this highly accommodative policy level for an extended period, while it may bring some short-run stimulus into the economy, increases inflationary risk to an unacceptable level, which will, over the not-too-distant future, begin to distort long-run investment decisions and continue to increase the risk of financial instability and imbalances in the longer-run. Finally, on the psychology of the markets, holding rates constant, although it might disappoint some on Wall Street, will please many, many on Main Street. I judge that it will confirm to the world that we are turning our attention to these longer-run issues, and I'm disappointed that we're not seizing the opportunity to make that statement. Thank you " CHRG-110hhrg46591--83 Mr. Seligman," The Department of Treasury Blueprint started a conversation and it deserves credit for that. But in spite of the fact it was a reasonably long document, it did not seem to have the detailed understanding of the purposes of the separate regulatory agencies that do exist, understand their advantages, and understand their institutional context. I think that is important as you consider how to go forward. I thought the first tier of recommendations made more sense with respect to market stabilization. I call it a crisis manager. There are other terms. And clearly the notion that you need to have one hand firmly on the till makes sense. I thought scrapping the SEC and some of the other initiatives in the second and third tier were quite question-begging. I was struck by a starkly ideological tone. The notion that in effect, the core principles articulated by the Commodities Futures Trading Commission, were necessarily the wisest approach to address issues like market manipulation is quite question-begging. The history of addressing market manipulation require statutes, rules, and case determinations. It is quite case-specific. Having said that, the point that was useful in that exercise, and it was like an academic exercise, was it did focus us on the fact that we are not just dealing with an immediate economic emergency, we are dealing with a fundamental changes in the dynamics that actuate regulation at the Federal level. When the underlying markets change, regulation must change in constructive ways to address it. " FOMC20070628meeting--122 120,MS. PIANALTO.," I also extend my heartfelt congratulations to the Spurs on their fourth and final NBA championship. [Laughter] Now, turning to inflation, I am hearing reports of upward price pressures across a handful of industrial commodities, and notably for metals. But wage pressures remain modest. Nevertheless, for the first time in more than a year, I am hearing from my business contacts that they are concerned about inflation. They are bringing inflation concerns up with me, and they are telling me that they concur with the Committee’s assessment that inflation remains a risk. To be sure, there were many positive signs in the May CPI report. The traditional core CPI beat expectations, and while the trimmed mean estimators that we produce in Cleveland were a little higher than the measure excluding food and energy, even those indicators were consistent with the moderation and the longer-term inflation trend we expect to see. Looking at the core measures enables me to be encouraged by the May CPI report. But that view is a rather hard sell to a public that saw headline CPI inflation rise 8½ percent at an annualized rate last month. Indeed, our readings of the underlying inflation trend and what people are feeling in their wallets have been at odds for many years now. I understand that our policies are not well advised or even equipped to address transitory price movements. But at some point, large and persistent price disturbances, such as we have seen in energy markets, warrant our attention. If these isolated price pressures become more generalized and enter into consumer and business decisionmaking, we could easily find ourselves living in the Greenbook’s “drifting inflation expectations” scenario. In summary, I think the housing market still presents a risk that the economy may not resume a more typical growth trajectory over the forecast period. Nonetheless, that concern is trumped by the risk that we may yet lose the public’s confidence that we are making sustainable progress against inflation. Therefore, I continue to believe that the predominant risk going forward is that inflation will fail to moderate as expected. Thank you, Mr. Chairman." CHRG-111hhrg63105--56 Mr. Chilton," Congressman, by and large they are a factor of the fundamentals, but I couldn't--and I am not an economist. Neil Cavuto tried to get me to say, well, how much is speculators and how much is price demand, and I wasn't going there. I am not an economist and it would be irresponsible. But to go to this thing about we need to document, we need to do this before we impose. The purpose of the Commodity Exchange Act says that we are to prevent and deter fraud, abuse, and manipulation. So all of a sudden we have been given, for people who don't want the regulation, this new hurdle to say, well, you have to prove beyond a shadow of a doubt that this equals that. These are very complicated markets, and it is not always easy to put things together like that. So to protect consumers, to ensure the folks in your districts are using these vehicles, like they want to, for adequate risk mitigation, that is why these limits are important to put in place thoughtfully. I get letters every day, Congressman. I have one right here from Dunkin' Donuts we received last night. They are concerned about speculation. Swift says they are thinking about getting out of the market in part because of speculation. Delta Airlines wrote the other day. These are real concerns about people, the hedgers who are in these markets that are concerned they can't use them. Look, nobody is talking about going crazy on this. We just want to--I just want to do what Congress intended and try to do it in a reasonable fashion; doesn't make anything crazy, just do what we are told. " CHRG-111shrg57322--1081 Mr. Blankfein," The selection agent had engaged in a lot of these portfolios and was one of the biggest portfolio managers in that asset class. When we talk about investors and deals, it sounds like this is a broad distribution. There were only three professional investors engaged in the whole transaction. This was--in effect, there was no transaction--this was not a transaction that had to be done. This was a transaction that only worked if the longs and the shorts agreed on what the portfolio was. And I realize that is not intuitive, but those professional investors wanted those exposures. Senator McCaskill. And I am not sure that, frankly, it is a thing of value that most Americans would be comfortable that we would be backing up and providing taxpayer bailouts to companies that were engaging in that, especially if you weren't actually really dealing with a commodity or dealing with a product at the base of the transaction, that you were making up securitizations for people to, in fact, take positions on only for that reasons. It seems like hamsters in a cage trying to get to compensation as opposed to societal value that investment banks in this country, I think, have represented for many years. I really appreciate you being here today. I hope you stay at the table with us as we work on this legislation. I think, clearly, this hearing has shown in the work this Subcommittee has done, and the staff has done amazing work here, that we have conflict of interest issues, we have disclosure issues, and we have transparency issues, and we need to get all of those fixed to make sure we don't have a repeat of this debacle. Thank you, Mr. Chairman. Senator Levin. Thank you, Senator McCaskill. Senator Pryor. Senator Pryor. Thank you, Mr. Chairman. I would like to start, if I can, with the topic of asking you about credit rating agencies. In retrospect, how accurate were the credit rating agencies in rating the various tranches of CDOs? " FOMC20060629meeting--115 113,MR. KROSZNER.," Thank you, Mr. Chairman. At the last meeting I believe Dave Stockton, when he was describing the outlook, said that he was a bit schizophrenic about it. Given the comments of President Moskow, it is clear that he is no longer schizophrenic but that one side has taken over—the dark side. [Laughter] That does not seem to reflect exactly where everyone is, but I think the issues that have been brought out in the Greenbook are extremely important to consider. I, too, have knocked down my growth estimates a bit, although not quite as much as the Greenbook; and I, too, as many people have said, share a concern that some of the numbers coming in on both headline and core inflation are a bit higher than I had hoped, although I think they are still not out of a manageable range. Obviously, payroll employment growth is a bit less robust than in the previous forecast. Since that forecast, we’ve had a little more cooling in housing and some softening of retail demand. I take a slightly different view of the high tax receipts that have been pouring into the Treasury because they are not only corporate tax receipts but also individual tax receipts. In some sense that’s putting a bit of a drag on real disposable income because people seem to be paying a little more in taxes and, at the same time, labor costs and pay have not been going up. So taxes are potentially a bit of a drag, and the Administration seems able to pursue a tighter expenditure policy this year than it has in the past, so we won’t be getting as much of a boost on the fiscal side as we have had. A number of bright spots have been mentioned here, particularly related to business fixed investment, durable goods orders, and business confidence. But what are some of the key risks that we have before us? Obviously, housing has been discussed in great detail, and so I won’t go through it in more detail. I noted, as Governor Bies did, the importance of cancellations in suggesting a change in the way people are dealing with these markets. If cancellations go up significantly, then a lot more housing stock that is searching for a buyer could be left on the market. Anecdotally, I’ve heard the same kinds of things that President Guynn mentioned, that the equivalent of the toaster is perhaps being given out. Such incentives are not showing up in the reported housing price, but other adjustments are. I’m not quite as optimistic about world economic growth as the forecast is. I think a lot of uncertainties exist there. We have seen and are seeing a lot of elections, particularly in emerging markets. Mexico obviously has one coming up very soon, which could have a significant effect on a very important trading partner of the United States. Also, as a number of people have mentioned, we’re seeing a lot of policy tightening around the world. The obvious question is whether the central banks outside the United States are behind the curve or ahead of the curve. Well, wherever they are, they are moving along a curve, and they seem to be moving more aggressively than they have in the past. I think the tightening is going to have more of an effect than has been embedded in a number of the forecasts, not only here but also at the IMF. Another concern that I have relates to something that President Pianalto mentioned—a disconnect between the numbers that we’re seeing on consumption and business optimism about investment. My concern is about what’s going to be happening to demand for their products down the line. It’s certainly disconcerting to hear that one of the largest private institutions in the world—Wal-Mart—is missing its growth targets fairly significantly. They are a very important part of retail sales. One could even say that they effectively know what retail sales are before the numbers are reported because their sales are so highly correlated with overall retail sales. So my concern is that we’re having the economy do the right sort of thing by moving more toward business investment and a little away from consumption, but if we move too much away from consumption, the demand won’t be there to make the investment pay off. We saw a bit of this in the late 1990s as we moved much more in the investment direction, but the investment turned out not to have the kinds of returns that people were expecting. Now we’re in a very fortunate situation because, even if those returns decline dramatically, a lot of profitability is out there, as Governor Warsh said. So profits could drop quite significantly, but we’re not going to see a real problem in the corporate sector, as we might have in other circumstances. I don’t want to overemphasize this concern, but to me it’s a bit of a puzzle, and I see it definitely as a risk. Turning to the inflation outlook, people have mentioned both here and publicly a cavalcade of concerns about the upticks in PCE and CPI core numbers, which have helped in turn to reduce inflation expectations. Term premiums continue to remain low, and forward rates continue to remain low. Often inflation seems to have a bit of momentum—it continues to move up or stays elevated—even as the economy begins to slow a bit. We have to be careful in deciphering what will continue to move up and what is just inflation that is lagging a bit as the economy slows. We have seen a dramatic change in commodity prices since our last meeting. Basically, within a few days of the meeting on May 10, almost all the major commodities, whether copper, gold, or whichever one you want, came to a peak. Since then, oil has come down a little, although not all that much. I think it’s heartening for the inflation outlook going forward that those elevated levels didn’t stay that elevated. Although those commodity prices are much higher in 2006 than they had been previously, oil prices have not increased that much during 2006. So what’s going to happen to core inflation going forward? I think the excellent presentation that we had, in particular the discussion of the attempts to see how well we are modeling historical inflation and inflation going forward, shows that we have a long way to go and that we don’t really understand those dynamics very well. I share Governor Kohn’s intuition, for the reasons that he articulated, that core inflation going forward will soften a bit more than the Greenbook projects. I’m not going to repeat those reasons; but as Governor Kohn said, there’s a lot of uncertainty about them, and we don’t understand all that much. Ultimately, as a number of people have mentioned, it comes down a lot to the type of statements that we make, the credibility that we have. That’s true not only here but around the world, where we are seeing inflation rates and expected inflation rates come down quite a bit. That’s something that ultimately we control very directly. In today’s circumstances, when inflation is not really out of control but is moving up a little, being very clear about what our concerns are can have benefits in bringing down expectations and perhaps changing the inflation dynamic. Thank you, Mr. Chairman." FOMC20071031meeting--11 9,MR. SHEETS.," Although the foreign economies appear to have grown at a moderate pace during the third quarter as a whole, indicators for September and October suggest that the recent financial turmoil may yet leave an imprint on activity in some countries. Perhaps the most striking evidence on this score has been the ECB’s survey of euro-area bank lending. In the third quarter, this survey showed the sharpest shift toward tightening in its five-year history, along with evidence of more- stringent credit standards for business and housing loans. In addition, we have seen downward moves in surveys and measures of sentiment in the euro area, particularly in Germany, although these indicators have generally remained in expansionary territory. In the United Kingdom, the growth of mortgage lending continued on a downward path in September, and a recent Bank of England survey suggests a tightening of corporate credit conditions. All in all, we see this (admittedly fragmentary) evidence as broadly consistent with our assumption in the September Greenbook that fallout from the financial turmoil is likely to exert some drag on growth over the next several quarters in the euro area, the United Kingdom, and Canada. This assessment, however, is marked by significant upside and downside risks—as it is still too soon to gauge these effects with much confidence. As in our previous forecast, we do not see the turmoil weighing directly on activity in Japan or the emerging-market economies. More generally, the contours of our forecast remain similar to those in September. Recent data have confirmed our expectation that average economic growth abroad declined to about 3½ percent in the third quarter, cooling from the very rapid rate in the first half of the year. We see growth edging down further in the current quarter, to just over 3 percent, and remaining at about that pace in 2008 and 2009. After the Greenbook went to bed, we received Chinese GDP data, which according to our seasonally adjusted quarterly estimate grew at an annual rate of just over 8 percent in the third quarter—a little slower than we had expected and down from the 14 percent rate in the first half of the year. This deceleration appears to have been led by a slowing in investment and a smaller contribution from the external sector. Going forward, economic growth in China should remain below its previous double-digit pace, as the Chinese authorities take further action to cool the country’s booming real estate market and the rapid growth of bank lending. In addition to uncertainty about the eventual effects of the financial turmoil on real activity, other risks to our generally favorable foreign outlook are worth noting. First on this list is the possibility of a softer-than-expected performance from the U.S. economy. Although there is talk in some quarters about so-called decoupling—that is, that the foreign economies may now be less linked to developments in the United States than has been the case in the past—the jury is still out on this point. Although domestic demand does appear to have firmed in some foreign countries in recent years, a marked slowing in U.S. growth would affect the rest of the world through trade channels (particularly Canada, Mexico, and emerging Asia) and, as highlighted by the recent turmoil, probably through financial channels as well. As a second risk, house-price valuations in many advanced economies appear elevated. Given that, a correction in housing markets abroad—with potentially sizable accompanying wealth effects—strikes us as an important downside risk for some countries. Third, although we see average foreign inflation remaining well behaved, at near 2½ percent over the next two years, inflation risks cannot be dismissed. After several years of exceptionally strong economic growth, the foreign economies on average are now operating near potential, and resource constraints may be more binding than we currently envision. In addition, food prices have moved up in many countries, and the prices of oil and other commodities are at high levels. Indeed, recent developments in oil markets seem to pose intensified risks. The spot price of WTI is trading today at nearly $92 a barrel, up $5 since the Greenbook went to bed. Since your last meeting, the spot WTI price has climbed $13 per barrel, while the far-futures price has increased about $10 per barrel. It suffices to say that underlying supply-demand conditions in the oil market are exceptionally tight. Over the past several years, as the global economy has expanded briskly, oil production has increased only sluggishly—reflecting both OPEC supply restraint and diminishing production from OECD countries. Against this backdrop, the price of oil has been driven up further in recent weeks by reports of decreasing inventories (at a time of year when such stocks are typically on the rise) and by intensified concerns about the stability of Middle East oil production, triggered by tensions between Turkey and Iraq and by concerns about U.S. relations with Iran. We see OPEC’s plans to expand production 500,000 barrels per day beginning on November 1, even if fully implemented, as unlikely to go very far in defusing the tightness in the market. Futures markets call for WTI prices to remain elevated, in the neighborhood of $80 per barrel, through 2015. I conclude with some upbeat news on U.S. external performance. Exports continue to surprise on the upside, having shown exceptional strength in the July and August trade data, as exports of aircraft, autos, and agricultural products have all expanded briskly. Consequently, as Dave mentioned, real exports of goods and services are now thought to have surged at a pace of 17 percent in the third quarter, up 3½ percentage points from the last forecast. We estimate that real imports in the third quarter grew at a comparatively modest rate. Taken together, these data suggest that net exports made an arithmetic contribution of 1¼ percentage points to U.S. real GDP growth in the third quarter. Going forward, we see export growth moderating to just under 8 percent in the current quarter and proceeding at a solid 6½ percent average rate through the next two years. Relative to our September forecast, the path of export growth is up nearly 2 percentage points in the fourth quarter and by lesser—but still sizable—amounts in 2008 and 2009. This higher projection reflects stimulus from recent declines in the dollar, which have exceeded our previous projections. The broad dollar index has dropped more than 3 percent since your last meeting. But in addition to support from the weaker dollar, we now see greater underlying strength in exports than we had previously thought. Our projected path for imports, in contrast, is little changed from the last Greenbook. Import growth is slated to bounce up in the current quarter, largely because of a seasonal rebound in oil imports. Thereafter, the projected strengthening of U.S. growth and a deceleration in core import prices should provide increasing support to imports. All told, we see the external sector making a neutral contribution to U.S. real GDP growth in the fourth quarter, contributing 0.4 percentage point to economic growth next year, and returning to neutrality in 2009 as imports accelerate. Thus, to the extent that our forecast materializes, large negative contributions from net exports might very well be a thing of the past. Brian will now continue our presentation." fcic_final_report_full--163 In late , Moody’s would throw out its key CDO assumptions and replace them with an asset correlation assumption two to three times higher than used before the crisis.  In retrospect, it is clear that the agencies’ CDO models made two key mistakes. First, they assumed that securitizers could create safer financial products by diversi- fying among many mortgage-backed securities, when in fact these securities weren’t that different to begin with. “There were a lot of things [the credit rating agencies] did wrong,” Federal Reserve Chairman Ben Bernanke told the FCIC. “They did not take into account the appropriate correlation between [and] across the categories of mortgages.”  Second, the agencies based their CDO ratings on ratings they themselves had as- signed on the underlying collateral. “The danger with CDOs is when they are based on structured finance ratings,” Ann Rutledge, a structured finance expert, told the FCIC. “Ratings are not predictive of future defaults; they only describe a ratings man- agement process, and a mean and static expectation of security loss.”  Of course, rating CDOs was a profitable business for the rating agencies. Includ- ing all types of CDOs—not just those that were mortgage-related—Moody’s rated  deals in ,  in ,  in , and  in ; the value of those deals rose from  billion in  to  billion in ,  billion in , and  billion in .  The reported revenues of Moody’s Investors Service from struc- tured products—which included mortgage-backed securities and CDOs—grew from  million in , or  of Moody’s Corporation’s revenues, to  million in  or  of overall corporate revenue. The rating of asset-backed CDOs alone contributed more than  of the revenue from structured finance.  The boom years of structured finance coincided with a company-wide surge in revenue and profits. From  to , the corporation’s revenues surged from  million to  billion and its profit margin climbed from  to . Yet the increase in the CDO group’s workload and revenue was not paralleled by a staffing increase. “We were under-resourced, you know, we were always playing catch-up,” Witt said.  Moody’s “penny-pinching” and “stingy” management was re- luctant to pay up for experienced employees. “The problem of recruiting and retain- ing good staff was insoluble. Investment banks often hired away our best people. As far as I can remember, we were never allocated funds to make counter offers,” Witt said. “We had almost no ability to do meaningful research.”  Eric Kolchinsky, a for- mer team managing director at Moody’s, told the FCIC that from  to , the increase in the number of deals rated was “huge . . . but our personnel did not go up accordingly.” By , Kolchinsky recalled, “My role as a team leader was crisis man- agement. Each deal was a crisis.”  When personnel worked to create a new method- ology, Witt said, “We had to kind of do it in our spare time.”  The agencies worked closely with CDO underwriters and managers as each new CDO was devised. And the rating agencies now relied for a substantial amount of their revenues on a small number of players. Citigroup and Merrill alone accounted for more than  billion of CDO deals between  and .  The ratings agencies’ correlation assumptions had a direct and critical impact on how CDOs were structured: assumptions of a lower correlation made possible larger easy-to-sell triple-A tranches and smaller harder-to-sell BBB tranches. Thus, as is discussed later, underwriters crafted the structure to earn more favorable ratings from the agencies—for example, by increasing the size of the senior tranches. More- over, because issuers could choose which rating agencies to do business with, and be- cause the agencies depended on the issuers for their revenues, rating agencies felt pressured to give favorable ratings so that they might remain competitive. The pressure on rating agency employees was also intense as a result of the high turnover—a revolving door that often left raters dealing with their old colleagues, this time as clients. In her interview with FCIC staff, Yuri Yoshizawa, a Moody’s team managing director for U.S. derivatives in , was presented with an organization chart from July . She identified  out of  analysts—about  of the staff— who had left Moody’s to work for investment or commercial banks.  CHRG-111hhrg52397--28 Mrs. Bachmann," Thank you, Mr. Chairman and Mr. Garrett, for holding this important meeting today. I am also pleased that the committee has invited Mr. Timothy Murphy to speak before us today. He is the foreign currency risk manager for 3M Corporation to testify about 3M's use of these financial products. Headquartered in St. Paul, Minnesota, it is a hometown company we have been proud of for years. They provide 34,000 people with jobs, and more than 60 percent of the manufacturing operations are located here inside the United States. With over 20 years experience in the over-the-counter derivative market, Tim presently manages 3M's currency and commodity risk programs, as well as the share re-purchase program. He is personally responsible for the management and execution of the company's foreign exchange hedging policy, including identifying the appropriate exposure estimates to be used as the basis of foreign exchange hedging activity and balance sheet hedging. Prior to joining 3M, he worked at U.S. Bank for more than 10 years managing their foreign currency and trading relation with corporate mutual fund and banking clients. As our committee considers the future of over-the-counter derivatives, we must remember that many United States companies responsibly utilize these financial products to manage their risks and limit damage to their balance sheets. We need to ask the question of those before us today: How will jobs be impacted by the measures that are before us today? These are America's job creators. Congress should be careful not to overreach and infringe on their ability to hedge risks responsibly. I look forward to today's important discussion. I yield back, Mr. Chairman. " FinancialCrisisReport--321 A. Background (1) Investment Banks In General Historically, investment banks helped raise capital for business and other endeavors by helping to design, finance, and sell financial products like stocks or bonds. When a corporation needed capital to fund a large construction project, for example, it often hired an investment bank either to arrange a bank loan or to raise capital by designing, financing, and marketing an issue of shares or corporate bonds for sale to investors. Investment banks performed these services in exchange for fees. Today, investment banks also participate in a wide range of other financial activities, including providing broker-dealer and investment advisory services, and trading commodities and derivatives. Investment banks also often engage in proprietary trading, meaning trading with their own money and not on behalf of a customer. Many investment banks are structured today as affiliates of one or more banks. Under the Glass-Steagall Act of 1933, certain types of financial institutions had been prohibited from commingling their services. For example, with limited exceptions, only broker- dealers could provide brokerage services; only banks could offer banking; and only insurers could offer insurance. Each financial sector had its own primary regulator who was generally prohibited from regulating services outside of its jurisdiction. 1240 Glass-Steagall also contained prohibitions against proprietary trading. 1241 One reason for keeping the sectors separate was to ensure that banks with federally insured deposits did not engage in the type of high risk activities that might be the bread and butter of a broker-dealer or commodities trader. Another reason was to avoid the conflicts of interest that might arise, for example, from a financial institution pressuring its clients to obtain all of its financial services from the same firm. A third reason was to avoid the conflicts of interest that arise when a financial institution is allowed to act for its own benefit in a proprietary capacity, while at the same time acting on behalf of customers in an agency or fiduciary capacity. Glass-Steagall was repealed in 1999, after which the barriers between banks, broker- dealers, and insurance firms fell. U.S. financial institutions not only began offering a mix of financial services, but also intensified their proprietary trading activities. The resulting changes in the way financial institutions were organized and operated made it more difficult for regulators to distinguish between activities intended to benefit customers versus the financial institution itself. The expanded set of financial services investment banks were allowed to offer also contributed to the multiple and significant conflicts of interest that arose between some investment banks and their clients during the financial crisis. 1240 Federal law has never established a “super-regulator ” with jurisdiction to police compliance and conduct across banking, brokerage, investment advisory, and insurance sectors, and that remains the case today. 1241 See Section 16 of the Banking Act of 1933, Pub. L. 73-66 (also known as the Glass-Steagall Act). ( 2) Roles and Duties of an Investment Bank: fcic_final_report_full--187 The OTS approved Countrywide’s application for a thrift charter on March , . LEVERAGED LOANS AND COMMERCIAL REAL ESTATE: “YOU ’VE GOT TO GET UP AND DANCE ” The credit bubble was not confined to the residential mortgage market. The markets for commercial real estate and leveraged loans (typically loans to below-investment- grade companies to aid their business or to finance buyouts) also experienced similar bubble-and-bust dynamics, although the effects were not as large and damaging as in residential real estate. From  to , these other two markets grew tremen- dously, spurred by structured finance products—commercial mortgage–backed se- curities and collateralized loan obligations (CLOs), respectively—which were in many ways similar to residential mortgage-backed securities and CDOs. And just as in the residential mortgage market, underwriting standards loosened, even as the cost of borrowing decreased,  and trading in these securities was bolstered by the development of new credit derivatives products.  Historically, leveraged loans had been made by commercial banks; but a market for institutional investors developed and grew in the mid- to late s.  An “agent” bank would originate a package of loans to only one company and then sell or syndi- cate the loans in the package to other banks and large nonbank investors. The pack- age generally included loans with different maturities. Some were short-term lines of credit, which would be syndicated to banks; the rest were longer-term loans syndi- cated to nonbank, institutional investors. Leveraged loan issuance more than dou- bled from  to , but the rapid growth was in the longer-term institutional loans rather than in short-term lending. By , the longer-term leveraged loans rose to  billion, up from  billion in .  Starting in , the longer-term leveraged loans were packaged in CLOs, which were rated according to methodologies similar to those the rating agencies used for CDOs. Like CDOs, CLOs had tranches, underwriters, and collateral managers. The market was less than  billion annually from  to , but then it started grow- ing dramatically. Annual issuance exceeded  billion in  and peaked above  billion in . From  through the third quarter of , more than  of leveraged loans were packaged into CLOs.  As the market for leveraged loans grew, credit became looser and leverage in- creased as well. The deals became larger and costs of borrowing declined. Loans that in  had paid interest of  percentage points over an interbank lending rate were refinanced in early  into loans paying just  percentage points over that same rate. During the peak of the recent leveraged buyout boom, leveraged loans were fre- quently issued with interest-only, “payment-in-kind,” and “covenant-lite” terms.  Payment-in-kind loans allowed borrowers to defer paying interest by issuing new debt to cover accrued interest. Covenant-lite loans exempted borrowers from stan- dard loan covenants that usually require corporate firms to limit their other debts and to maintain minimum levels of cash. Private equity firms, those that specialized in investing directly in companies, found it easier and cheaper to finance their lever- aged buyouts. Just as home prices rose, so too did the prices of the target companies. One of the largest deals ever made involving leveraged loans was announced on April , , by KKR, a private equity firm. KKR said it intended to purchase First Data Corporation, a processor of electronic data including credit and debit card pay- ments, for about  billion. As part of this transaction, KKR would issue  billion in junk bonds and take out another  billion in leveraged loans from a consortium of banks including Citigroup, Deutsche Bank, Goldman Sachs, HSBC Securities, Lehman Brothers, and Merrill Lynch.  FOMC20080318meeting--53 51,MS. YELLEN.," Thank you, Mr. Chairman. Since we met at the end of January, there has been an utter dearth of good news concerning both the real and the financial sides of the economy. On the real side, I just can't recall any intermeeting period in which nearly every single data point was dismal. On the financial side, there have been occasional good days, but the net changes over the intermeeting period have been negative across the board in both the equity and the credit markets, so financial conditions have unambiguously tightened. These developments are familiar to all of us, and I won't take up time to review the specifics. My overall sense at this point is that the effects of the severe and prolonged housing downturn, the financial market implosion, and the price increases for oil and other commodities have now spread to most corners of the economy, including the major segments of consumption and business fixed investment. Exports represent about the only source of strength, and while that is welcome, I must say that the economy is pretty clearly in trouble when the contribution to real GDP growth from exports exceeds overall real GDP growth, as may well happen this year. The bottom line is that, like nearly everyone else, I have downgraded my economic outlook substantially. Assuming that the stance of policy is eased substantially at this meeting and additionally by midyear, I see the economy as essentially in recession during the first half before picking up somewhat in the second because of the effects of monetary and fiscal policy. However, I certainly see large downside risks to my forecast, and I think the Greenbook's view that recessionary nonlinearities have already set in seems to me to be within a reasonable range of outcomes. In fact, we have also been looking at monthly data on coincident business cycle indicators, and that examination suggests to us that the NBER may well date the beginning of the recession to last November. The prospect of this outcome has been made more palpable for me by the rather sudden increase in the frequency and intensity of pretty dire comments I am hearing from my contacts. First, I have heard widespread reports of reductions in capital spending plans due to caution or pessimism regarding economic growth. For example, a large manufacturer and retailer of outdoor sports equipment reported that technology and infrastructure spending has been cut by at least a third in 2008. In another example, a large player in commercial real estate in the San Francisco Bay area described how projects are being canceled because the financing spigot has been shut. Indeed, nonresidential construction is one sector where I think the Greenbook may be too optimistic. I envision growing weakness there. Second, my retail contacts suggest that spending has softened further in the wake of a weak holiday season, and expectations are for continued weakness at least through spring. For example, the CEO of a large high-end national retail operation reports that for January and February he has seen declines in sales that haven't been experienced for almost fifteen years. These declines have created tremendous pressure on inventory levels requiring large markdowns with negative effects on profits. Vendors are reeling from the cancellation of orders, the return of goods, and sharp reductions in new orders. Third, a number of contacts have provided comments reinforcing the view that a significant credit crunch is under way. Slightly more than half of the comments received on this topic indicate that credit standards have tightened significantly in recent months. In one example, the CEO of a bank in my District reports that several of the nation's largest mortgage lenders have suspended withdrawals from open home equity lines out of concern that borrowers could now owe more than their homes are worth. As a final anecdote, a banker in my District who lends to wineries noted that high-end boutique producers face a distinctly softening market for their products, although sales of cheap wine are soaring. [Laughter] Now let me turn to inflation and inflation expectations. Of course, much of the recent data have been disappointing, having been pushed up by rising energy and other commodity prices. Though I was heartened by Friday's CPI report, this one observation hasn't changed my overall impression that prospects for core inflation this year have worsened a bit since we met in January, and I have raised my projection for core PCE inflation about � percent in 2008, to 2� percent. These data raise the issue of whether cutting rates as much as needed to fight a recession may risk persistently higher inflation and inflation expectations. But I tend to think this risk is manageable. First, as I have said before, I view inflation as less persistent now than it once was, tending to revert fairly quickly to its longer-run trend. We have recently reviewed and updated our econometric evidence for this and found it to be even more convincing now than it was a couple of years ago. Of course, it is important to remember that the current lack of persistence presumably is due to our enhanced credibility, so we do have to be careful to maintain it. Recent increases in inflation compensation in Treasury markets highlight the risk that our attempts to deal with problems in the real economy possibly could lead to higher inflation expectations and an erosion of our inflation credibility. But inflation compensation is just one indicator of inflation expectations. I very much like the Board staff's approach, which is in the current Bluebook, of combining the information from a wide variety of indicators into a principalcomponent-type model. I found it reassuring that the resulting index of inflation expectations and uncertainty is still within the range of variation that we have seen over the past decade or so. Second, I tend to think that developments in labor compensation are an important part of the transmission process for monetary policy to inflation. Before we get into too much trouble with inflation and inflation expectations, I would expect to see labor compensation begin to rise more rapidly. I find it reassuring that both our broad measures of compensation have expanded quite moderately over the past year, and productivity growth has been fairly robust. So after incorporating its effects, unit labor costs are up less than 1 percent over the past four quarters. Finally, the more pronounced slowdown that I expect for economic activity is likely to put somewhat greater downward pressure on inflation going forward. Overall, I expect core PCE inflation to fall below 2 percent next year under an assumed leveling out of energy and other commodity prices and the projected weakening of labor and product markets. " FOMC20060920meeting--125 123,MR. LACKER.," Thank you, Mr. Chairman. The Fifth District’s economy has grown at a somewhat faster pace in recent weeks, reflecting a solid uptick in manufacturing. Preliminary results from our September survey are showing increases in all manufacturing measures, with a particularly strong performance of shipments and new orders. The six-months-ahead outlook measures are also coming in broadly stronger. Growth in the District services sector continues at a moderate pace. Retail sales remain somewhat sluggish, however, held down by soft big-ticket sales, which we understand were mainly in auto and building materials. The residential real estate market shows signs of further cooling, especially in Maryland and Northern Virginia. As has been the case for several months, however, real estate activity varies widely across the District, with the Carolinas, which were less affected by the boom, reporting continued strength. Labor market conditions remain taut, with job growth generally reported to be solid. Complaints that skilled workers are hard to find continue to be heard, and survey evidence suggests continued wage pressures. Recent reports regarding District price pressures generally tilt toward the firm side on balance. Early reports for September for the manufacturing sector show a notable acceleration in both current prices paid and current prices received and large increases in six-months-ahead expectations for both. Reports on service-sector prices are more mixed. Our respondents from the retail sector report moderation in current price trends but see more-rapid six-months-ahead price gains than they did last month. Our other service-sector firms report no change in current price trends but expect some moderation in coming months. Regarding the national economy, since our last meeting we have received largely positive news pertaining to the outlook for consumer spending. There was a sizable upward revision to the current level of labor income, which improves the outlook for real disposable income growth. Lower energy prices should provide an additional, though one-time, boost to consumer spending. So on net I find myself, again, a bit more optimistic than the Greenbook on consumption. The housing data certainly have been weaker than anticipated, and I now expect a somewhat steeper decline, as does the Greenbook. Forecasting this housing adjustment is particularly difficult because, as President Minehan pointed out, we have only one or two episodes for comparison in the post-Reg Q regime, and as David Wilcox pointed out, they don’t seem to closely resemble our current situation. I find this Greenbook’s more pessimistic outlook for housing itself plausible, but I’m still fairly skeptical of large indirect spillover effects on employment or consumption. For overall activity, I expect real GDP growth to be somewhat below trend, especially this quarter, but above the Greenbook through the end of next year. My views on the inflation situation have not changed much since our last meeting. The lower reading on July’s core PCE was encouraging, and the easing of energy prices is clearly providing some relief on headline inflation. However, July’s lower numbers were not particularly broad based, and the August CPI report shows a significant rebound in core inflation, as President Fisher noted. While labor compensation numbers have been hard to interpret, they also appear to point in the direction of greater price pressures, which I take it to be the staff’s view. The downward movement in TIPS inflation compensation since the last meeting has been quite striking—more than 30 basis points at the five-year horizon. I’ve made a lot of comments on TIPS inflation compensation spreads in past meetings, and it’s not clear that this downward movement signals much of an improvement in the outlook for core inflation in the near term. I pointed out earlier that the Bluebook shows that the fall in near-term inflation compensation has occurred mainly at a three-month or four-month horizon. Compensation for the period running from October/November this year to the same period next year has hardly fallen at all, and this to me suggests no significant change in the rate at which the public expects core inflation to moderate over the next year or two. Moreover, one-year-forward expected inflation rates five and ten years out have not fallen much, so I do not view the recent fall in TIPS inflation compensation as terribly comforting. Overall, regarding inflation, I’m quite apprehensive about waiting for core inflation to decline as slowly as it does in the Greenbook or about letting a new reduced-form model do our work for us." FOMC20061025meeting--55 53,MR. HOENIG.," Mr. Chairman, I’ll start with the District this time, and I will tell you that conditions in the District remain generally good. Energy activity remains strong, both in the traditional sectors, such as gas, oil, and coal, and in our new sector called ethanol. [Laughter] They are booming, I’m afraid. Despite the recent decline in energy prices, we are not yet hearing, in talking to different producers in the region, about any significant pullback in energy production. In part, this situation reflects a prevailing view right now among those producers that the weakness in energy prices is likely to be temporary. However, if energy prices remain at current levels or move lower at a sustained rate, I think we will then see some pullback in retail activity and so forth—more than we’ve seen so far. In other areas of the District economy, we saw some softening in manufacturing activity in the third quarter, but our manufacturing survey shows that businesses remain mostly optimistic about future hiring and capital expenditure plans. Housing activity has certainly slowed across the District. However, we have received few reports of unusual weakness in our recent meetings with directors and economic advisory council members. So it is slowing but shows no sign of collapse, at this point anyway. We have also seen, with the decline in energy prices, strengthening in District retail sales activity and a sharp rebound in expectations for retail activity in the fourth quarter—except for domestic auto sales. Labor markets remain firm across the District. Unemployment rates are low, and our directors and other contacts continue to report shortages of skilled labor across the District. District agricultural conditions remain rather mixed. Drought continues to affect much of the western part of our region. However, livestock and crop prices have been supported by strong world demand and lower supply, so those farmers who are able to bring in a crop are doing quite well. Turning to the national economy, I think that the recent decline in energy prices will provide important support to the near-term outlook. Currently, I see second-half growth of around 2 percent, rebounding to between 2½ and 3 percent as we get into next year. Generally speaking, I am more optimistic than the Greenbook, both in the near term and for the next year. Indeed, with the current financial conditions that others have talked about, I don’t envision the pullback in consumer spending and business investment spending that the Greenbook has projected at this point. One area that is worth discussion—and Dave talked about it a bit in responding to a question—is the employment outlook, an area for which the Greenbook continues to have, as Dave said, a different perspective. Although demographic forces will clearly work in the direction of slower labor force growth in the coming years, I’m not as convinced that the slowdown will be as sharp or as sudden as the Greenbook suggests right now. I say that because I want to be cautious about viewing the recent slowing in monthly employment growth as being driven by these demographic factors. I believe the recent slowing in employment largely reflects some employer caution about the economic outlook, combined with the effects of weakness in housing and retail sales. Support for this view can be found in the recent slowing of growth in temporary help that has been reported to us. Should the economic growth pick up, as I anticipate, we should begin to see some stronger employment numbers as we get into next year. As to the effects of demographics—again, I think they are going to play a very important part, but another significant factor to keep in mind is the educational composition of the labor force and the skills composition as we move forward in terms of labor demand, because that’s the shortage we’re always hearing about. Now, returning to the near-term outlook, the recent decline in energy prices has helped to counter the effects of housing weaknesses. Consequently, the downside risk to the outlook has diminished somewhat. However, because we have not necessarily seen the bottom of the housing market, I do believe that that is an important downside risk to the economy. Finally, let me share some of my perspective on the inflation outlook. My overall views on inflation have not changed materially since the last meeting. I continue to expect core CPI inflation to moderate from about 2.8 percent to about 2.5 percent next year and, similarly, core PCE inflation to moderate from about 2.3 percent to 2.1 percent. A significant fall in prices for oil and gasoline and natural gas in recent weeks has already begun to show through to overall inflation. I believe this is a positive development in helping to ensure that inflation expectations remain anchored and perhaps in helping to moderate core inflation next year. Although the decline in energy prices has reduced the upside risk to inflation somewhat, I agree with others that core inflation does remain too high, and I think we have to keep that in mind as we consider our policy options. Thank you." FinancialCrisisReport--347 In January 2007, after a trader asked Mr. Lippmann why the CDO market hadn’t imploded, Mr. Lippmann responded: “league table, fees, never has one blown up yet.” 1326 The reference to “league table credit” indicates that investment banks considered it prestigious to be listed as the leading producer of a complex structured finance product like CDOs, and used their standing in the tables that tracked total origination numbers as a way of burnishing their reputations, attracting top talent, and generating new business. An October 2006 “Progress Report” on its CDO business, for example, which was prepared internally by the bank, included a slide entitled, “CDO Primary Revenue Forecast and League Tables,” in which a chart ranked Deutsche Bank third in CDO issuance, behind Merrill Lynch and Citigroup. 1327 The slide indicated that Deutsche Bank had completed 38 CDOs to date, had a 7% share of the CDO market, and “expected to close 50 deals by year end,” with the “pipeline for Q1 and Q2 2007 building.” The final page of the presentation, providing a chart listing the top 20 Deutsche Bank CDO salespersons by region, together with their individual sales credits, identifies some of the bank personnel invested in the continuation of the CDO business. On the issue of fees, the head of Deutsche Bank’s CDO Group Michael Lamont told the Subcommittee that he estimated the bank received 40-200 basis points for each CDO created, depending upon the complexity of the CDO. 1328 He indicated those fees translated into about $5 to $10 million per CDO. 1329 When asked what he meant by saying “we have a budget to make,” Mr. Lippmann explained that new CDO deals had to be completed continuously to produce the revenues needed to support the budgets of the CDO desks and departments involved with their creation. 1330 1325 8/26/2006 email from Greg Lippmann to Richard Axilrod at Moore Capital, DBSI_PSI_EMAIL01618236-42. On August 1, 2006, Mr. Lippmann wrote to Mr. Milman, “who has all this crap and let me know which ones to look at looks like a lot of crappy deals.” 8/1/2006 email from Greg Lippmann to Jordan Milman, DBSI_PSI_EMAIL01510643. Mr. Lippmann’s negative views were shared by his traders. In an email originally sent by one of the traders on his desk, Rocky Kurita, the CDO business is set to a song, “CDO Oh Baby,” by Vanilla Ice with the following lyrics: “Yo vip let’s kick it! CDO oh baby, CDO oh baby. All right, stop, collaborate and listen. Spreads are wide with a technical invasion. Home Eq Subs were trading so tightly. Until Hedge Funds Bot Protection daily and nightly. Will they stop? Yo I don’t know. Turn up the Arb and let’s go. To the extreme Macro Funds do damage like a vandal. Now, BBs are trading with a new handle. Print, even if the housing bubble looms. There are never ends to real estate booms. If there is a problem, yo, we’ll solve it. Check out the spreads while my structurer revolves it. CDO oh baby, CDO oh baby.” 11/8/2005 email from Jordan Milman to Greg Lippmann, DBSI_PSI_EMAIL00686597-601 (forwarding an 11/8/2005 email from Rocky Kurita at Deutsche Bank). 1326 1/5/2007 email from Greg Lippmann to Chris Madison at Mast Capital, DBSI_PSI_EMAIL02333467-68. 1327 10/2006, “CDO Primary Update Progress Report,” DBSI_PSI_EMAIL03970167-72, at 68. 1328 Subcommittee interview of Michael Lamont (9/29/2010). 1329 Id. 1330 Subcommittee interview of Greg Lippmann (10/18/2010). CHRG-111hhrg74855--17 Mr. Stearns," Thank you very much, Mr. Chairman. I think the consensus on both sides is that FERC has done a good job of closely regulating and monitoring the regional transmission organizations and independent systems operator through the use of tariffs and audits and investigations and they should, I think the consensus is at least both parties here that they should remain the sole regulatory authority over such markets. However, obviously this bill acts in such a way to establish a new and I believe overly expansive definition of swap that would give the Commodity Futures Trading Commission this exclusive authority over a number of transactions that are already extensively regulated by FERC. Now, the regulation by FERC for 15 years here has been successful and, my colleagues, the products that they regulate did not contribute to the meltdown so it is not clear to me why we are moving forward on this. We all agree that transparency is important. Accountability and stability in the nation's financial market is important to minimize systematic risk and prevent another financial crisis but the organized power in the markets and the FERC regulatory system did not cause this meltdown. Any over-the-counter derivative legislation should address problems associated with unregulated financial derivatives and not inadvertently include FERC regulated markets that do not involve this type pf risk that this legislation is proposing. Continued unhindered operation of our energy markets are vital obviously to meeting our electricity needs of millions of Americans and obviously many of us don't see there is a need for a major shift in the oversight of these markets. So I think, Mr. Chairman, you and Mr. Waxman and Mr. Upton have all voiced this clearly and I think that it is very good that we have a hearing and confirm that we all believe. " fcic_final_report_full--19 BEFORE OUR VERY EYES In examining the worst financial meltdown since the Great Depression, the Financial Crisis Inquiry Commission reviewed millions of pages of documents and questioned hundreds of individuals—financial executives, business leaders, policy makers, regu- lators, community leaders, people from all walks of life—to find out how and why it happened. In public hearings and interviews, many financial industry executives and top public officials testified that they had been blindsided by the crisis, describing it as a dramatic and mystifying turn of events. Even among those who worried that the housing bubble might burst, few—if any—foresaw the magnitude of the crisis that would ensue. Charles Prince, the former chairman and chief executive officer of Citigroup Inc., called the collapse in housing prices “wholly unanticipated.”  Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway Inc., which until  was the largest single shareholder of Moody’s Corporation, told the Commission that “very, very few people could appreciate the bubble,” which he called a “mass delusion” shared by “ million Americans.”  Lloyd Blankfein, the chairman and chief executive officer of Goldman Sachs Group, Inc., likened the financial crisis to a hurricane.  Regulators echoed a similar refrain. Ben Bernanke, the chairman of the Federal Reserve Board since , told the Commission a “perfect storm” had occurred that regulators could not have anticipated; but when asked about whether the Fed’s lack of aggressiveness in regulating the mortgage market during the housing boom was a failure, Bernanke responded, “It was, indeed. I think it was the most severe failure of the Fed in this particular episode.”  Alan Greenspan, the Fed chairman during the two decades leading up to the crash, told the Commission that it was beyond the abil- ity of regulators to ever foresee such a sharp decline. “History tells us [regulators] cannot identify the timing of a crisis, or anticipate exactly where it will be located or how large the losses and spillovers will be.”  In fact, there were warning signs. In the decade preceding the collapse, there were many signs that house prices were inflated, that lending practices had spun out of control, that too many homeowners were taking on mortgages and debt they could ill afford, and that risks to the financial system were growing unchecked. Alarm bells  were clanging inside financial institutions, regulatory offices, consumer service or- ganizations, state law enforcement agencies, and corporations throughout America, as well as in neighborhoods across the country. Many knowledgeable executives saw trouble and managed to avoid the train wreck. While countless Americans joined in the financial euphoria that seized the nation, many others were shouting to govern- ment officials in Washington and within state legislatures, pointing to what would become a human disaster, not just an economic debacle. “Everybody in the whole world knew that the mortgage bubble was there,” said Richard Breeden, the former chairman of the Securities and Exchange Commission appointed by President George H. W. Bush. “I mean, it wasn’t hidden. . . . You cannot look at any of this and say that the regulators did their job. This was not some hidden problem. It wasn’t out on Mars or Pluto or somewhere. It was right here. . . . You can’t make trillions of dollars’ worth of mortgages and not have people notice.”  Paul McCulley, a managing director at PIMCO, one of the nation’s largest money management firms, told the Commission that he and his colleagues began to get wor- ried about “serious signs of bubbles” in ; they therefore sent out credit analysts to  cities to do what he called “old-fashioned shoe-leather research,” talking to real es- tate brokers, mortgage brokers, and local investors about the housing and mortgage markets. They witnessed what he called “the outright degradation of underwriting standards,” McCulley asserted, and they shared what they had learned when they got back home to the company’s Newport Beach, California, headquarters. “And when our group came back, they reported what they saw, and we adjusted our risk accord- ingly,” McCulley told the Commission. The company “severely limited” its participa- tion in risky mortgage securities.  FOMC20080625meeting--146 144,MS. PIANALTO.," Thank you, Mr. Chairman. I support keeping the fed funds rate target at its current level and the language in alternative B. I see some hopeful signs that stress in financial markets has diminished as has the threat of a sharp recession. Despite these recent signs, I expect that the growth momentum in the economy will build only slowly. Moreover, I continue to worry that the residential real estate market could deteriorate even more than I had put in my baseline projection. Nevertheless, I am somewhat more comfortable with the prospects for economic activity than I was in April. At the same time, I can't easily dismiss the recent behavior of energy and some other commodity prices. I found the Bluebook's supplemental analysis on oil prices, inflation expectations, and monetary policy to be very useful in thinking about the dilemma that we face. The fact that oil prices have risen so sharply and have been so persistent highlights the risks surrounding the downward projection that I have for core inflation. Without some evidence of less inflationary pressure I don't believe that the fed funds rate can be kept at its current level for very long. But while I do believe that the next policy action will be a rate hike, the potential for the recovery to sputter makes me cautious about embarking on an upward trajectory for the fed funds rate just yet. I believe that the language in alternative B conveys the right sense of direction for the fed funds rate path, with the right amount of caution. Thank you, Mr. Chairman. " CHRG-111hhrg51698--543 The Chairman," Could you pull the microphone a little closer? " Mr. Rosen,"--including reform that will relate to OTC derivatives. Measures are needed to improve regulatory transparency particularly to ensure appropriate capital oversight of professional intermediaries and OTC derivatives whose activities, as we have seen, can have systemic consequences. We look forward to working with this Committee and Congress on broad regulatory reform to address these issues. However, we are deeply concerned that the draft bill could have profound, albeit unintended, adverse consequences not merely for American markets, but for many mainstream American companies. This would contribute to the forces that are driving the current credit crisis. SIFMA's testimony describes the extraordinary extent to which mainstream American companies depend on CDS and other OTC derivatives to manage their risks and obtain access to financing. Direct and indirect limitations on access to these products will increase the risks to which these companies are subject, and in turn increase the risks of loss to which they are subject, the volatility of their earnings, their cost of funds, and thereby reduce their share prices and impair their competitiveness. A number of provisions in the draft bill raise these concerns. The proposed prohibition on purchasing so-called naked CDS protection would essentially eliminate the corporate CDS market. We can think of no traded product that is subject to a restriction of this kind, yet every financial product can be equally used for hedging or to express a positive or negative market view. It is precisely the interaction of these market views that is the essence of price discovery and efficient markets. As a result of this, CDS would become extremely expensive and illiquid in the sense of financial guarantee insurance or a product whose limitations the credit default swap market was specifically developed to address. American companies, including companies in the agricultural sector, would have reduced access to financing, and available financing costs would increase. Bank revenues from lending activity would also be reduced, placing further pressure on the financial strength of the banking sector, which currently depends heavily on public funds. Mandating the clearing of all OTC derivatives with a narrow exception for contracts that are both highly illiquid and highly customized is understandable but impractical, and we think unnecessary. Not all OTC derivatives can be cleared. As this Committee has heard, clearinghouses must be able to obtain reliable current pricing and historical data in order to calculate the appropriate collateral requirements and to model the clearinghouse risk. Also, not all companies have the operational infrastructure to participate. But rather than mandating clearing, we believe it would be far more effective for a prudential supervisor to have authority over all systemically significant market participants, including the authority to require clearing where it is appropriate and/or impose capital charges for the incremental risks represented by uncleared positions. We think this would be an important element in any comprehensive regulatory reform. With regard to carbon offsets, we believe it is clear that off-exchange markets compliment exchange markets. They serve as incubators for developing products, and they enable derivatives to be tailored to companies' risk management needs. Prohibiting them in the case of environmental derivatives will, in our view, only impede the development of a market that is a national priority. Provisions of the bill would impose indirect and potentially direct position limits on OTC derivatives. In our view, off-exchange physical positions have a far greater ability to influence commodity pricing and disrupt markets than purely notional financially settled contracts. In the absence of a perceived need to impose limits on the size of OTC physical positions, we don't see the justification for limits on notional exposures. The restrictive definition of bona fide hedging in the proposed bill would effectively impose a de facto position limit on OTC derivatives that are hedged on futures exchanges. However, the proposed position limit exception for swap dealers does not reflect the way in which companies manage their risk, or the manner in which swap dealers intermediate client risk. The result could be to curtail corporate access to OTC derivatives even for highly desirable risk management purposes. The draft bill also does not recognize that many index and other strategies are not speculative in nature, and would curtail the use of important strategies that are effectively market-neutral and stabilizing, and preclude fiduciaries from protecting retirees and others investing for retirement from protecting their retirement income from erosion due to high rates of inflation. Commercial interests are inherently directionally biased market participants and have the greatest capacity to influence prices and markets. All or virtually all the CFTC energy manipulation cases brought over the last 5 years have involved commercial energy traders. By decreasing the prevalence of directionally neutral participants and increasing the relative dominance of commercial interests, SIFMA is concerned that the draft bill would make the U.S. futures markets far more susceptible than they are today to manipulation. At a minimum, it will increase spreads and the cost of hedging for commercial interests. [The prepared statement of Mr. Rosen follows:] Prepared Statement of Edward J. Rosen, J.D., Partner, Cleary Gottlieb Steen & Hamilton LLP, New York, NY; on Behalf of Securities Industry and Financial Markets AssociationIntroduction Chairman Peterson, Ranking Member Lucas, and Members of the Committee: My name is Edward Rosen \1\ and I am appearing today on behalf of the Securities Industry and Financial Markets Association (SIFMA).\2\ We thank you for the invitation to testify today on the Committee's draft legislation, entitled ``Derivatives Markets Transparency and Accountability Act of 2009''.\3\ My testimony today reflects the views of SIFMA member firms active in both the listed and over-the-counter (OTC) derivatives markets in the United States and abroad.--------------------------------------------------------------------------- \1\ Mr. Rosen is a partner in the law firm Cleary Gottlieb Steen & Hamilton LLP, testifying on behalf of and representing the views of SIFMA and not those of Cleary Gottlieb Steen & Hamilton LLP. \2\ SIFMA brings together the shared interests of more than 650 securities firms, banks and asset managers locally and globally through offices in New York, Washington, D.C. and London. Its associated firm, the Asia Securities Industry and Financial Markets Association, is based in Hong Kong. SIFMA's mission is to champion policies and practices that benefit investors and issuers, expand and perfect global capital markets and foster the development of new products and services. Fundamental to achieving this mission is earning, inspiring and upholding the public's trust in the industry and the markets. (More information about SIFMA is available at http://www.sifma.org). \3\ Draft dated January 28, 2009 (1:08 p.m.).---------------------------------------------------------------------------Overview Preservation of the integrity of U.S. markets must be a paramount concern for the public sector and the private sector alike. SIFMA thus appreciates the Committee's current attention to this objective and commends the Committee for the ongoing leadership role that it has played over many years in sponsoring measures necessary to ensure the integrity of U.S. derivatives markets. SIFMA wholeheartedly endorses a number of the central themes that underpin the draft bill. Specifically, we agree that: Regulatory Transparency. Effective regulatory oversight of commodity markets requires appropriate regulatory transparency that ensures timely CFTC access to relevant position information; OTC Clearing. The clearance of OTC derivatives can and, we think, will play an important role in mitigating operational and counterparty risks for large segments of the OTC derivatives markets and, where appropriate, should be given a high priority by supervisors and the private sector; Speculative Limits. Limits on the size of speculative positions can play an important role in preserving orderly markets; and Global, Linked Markets. Listed derivatives, OTC derivatives and physical commodity markets are global and inextricably linked. We commend the draft bill's focus on these themes. Nonetheless, SIFMA and its members are deeply concerned by a number of provisions in the draft bill. We believe these provisions do not represent the most effective solutions to current market issues. Instead, we believe these provisions would have profound adverse consequences not merely for OTC and listed derivatives markets, but also for mainstream American companies. Specifically, key provisions in the draft bill would: Prohibit the purchase of uncovered CDS protection; Require the clearing of all OTC derivatives, subject to limited exceptions; Authorize the imposition of position limits for OTC derivatives; Prohibit off-exchange trading in futures on carbon credits and emission allowances; and Eliminate position limit exemptions for risk management strategies. We believe these provisions would: Deepen the current crisis by fundamentally undermining both the efficacy and availability of listed and OTC derivatives as risk management tools for large and small American businesses, thereby increasing costs, risks and earnings volatility for such companies throughout the economy; the draft bill's CDS- related provisions in particular would significantly and adversely impact access to, and the cost of, financing for American companies, which could lead to continued job losses; Increase (and not decrease) the susceptibility of commodity markets to manipulation and disorderly trading and enhance the ability of commercial traders with a vested interest in commodity prices to influence such prices; Impede successful development of cap and trade programs by prohibiting non-exchange derivatives on carbon offsets and emission allowances; Preclude pensioners, retirees and those saving for retirement from protecting the real dollar value of their retirement income against erosion from the effects of commodity price inflation through the use of commodity derivatives; and Drive the development outside the United States of markets in energy and other core commodities and financial products that are key to the U.S. economy, with the result that, while these markets would have the ability to inform or drive U.S. prices for the affected commodities and products, the U.S. Congress would have no ability to influence these markets. We believe the potential consequences of these provisions run directly counter to the Committee's own well-intentioned objectives. They also run counter to the efforts of Congress and the supervisory community to address the credit crisis and, if enacted, would almost certainly exacerbate the crisis. SIFMA understands that there is a need for regulatory reform and that such reform will need to address issues such as regulatory transparency and prudential oversight with respect to OTC derivatives. However, SIFMA strongly believes that any statutory changes in the regulation of OTC derivatives, particularly changes that would have such far-reaching consequences as those proposed in the draft bill, should only be undertaken in the context of broader regulatory reform and should focus on decreasing risk and improving transparency and efficiency in the OTC derivatives markets, while maintaining the significant benefits these markets currently provide for mainstream American companies and institutional investors. It is estimated that more than 90% of the 500 largest companies in the world use OTC derivatives.\4\ An even greater percentage (94%) of the American companies in this group use OTC derivatives. More than half of medium-sized American companies are estimated by Greenwich Associates to use OTC derivatives.\5\ These companies rely on access to OTC derivatives for important risk management purposes (some of which may, but many of which will not, fall within the draft bill's proposed definition of bona fide hedging).--------------------------------------------------------------------------- \4\ International Swaps and Derivatives Association, Inc., 2003 Derivatives Usage Survey, http://www.isda.org/statistics/. \5\ Greenwich Associates, http://www.greenwich.com.--------------------------------------------------------------------------- Mainstream American companies in every sector of the U.S. economy, including within the agricultural sector, depend on access to efficiently priced financing in order to make capital investments, purchase inventory and equipment, hire employees and otherwise fund their businesses. The availability of a robust corporate CDS market is essential if lenders are to meet the demand for these borrowings and to be in a position to do so on an efficiently-priced basis. CDS and other OTC derivatives thus not only play an important market function, they also play a critical role in enabling ordinary companies, outside the financial sector, to manage the risks of their businesses and to obtain the financing necessary to expand, and in many cases to sustain, their businesses. And, as the statistics cited above indicate, significantly more than half of the U.S. economy would be directly and adversely affected by the inability of professional intermediaries to make these products available and to utilize them themselves. Against this background and, particularly in the context of the current crisis, it is all the more important that Congress adopt legislative initiatives that preserve the benefits of these products, and access to these products, while carefully targeting those measures that are appropriate to protect the public interest. Our comments with respect to specific provisions of the draft bill are summarized in the following section.Section-by-Section CommentsProhibition of ``Naked'' CDS (Section 16) Section 16 of the draft bill would prohibit the purchase of CDS protection by any person who does not have direct exposure to financial loss should the referenced credit events occur. Very simply, the proposed prohibition would effectively eliminate the corporate CDS market. Although CDS are a relatively recent financial innovation, they have quickly become the most important tool available to banks and institutional investors, such as pension funds, for managing the credit risks arising from commercial loans and corporate bond investments. CDS, which are typically fully collateralized, are the only liquid financial instruments that enable a company exposed to a third party's default risk to manage that credit risk in an efficiently priced market. As such, CDS enable lenders to hedge the credit risks inherent in corporate financing that are essential to economic growth, and, in turn, reduce the cost of funds for borrowers. CDS also free up additional credit capacity, which enables banks to expand credit facilities available to their corporate clients. In addition, CDS provide important benefits for other market participants as well. For example, asset managers and other institutional investors use CDS as a liquid instrument through which to obtain credit exposure to particular companies and to adjust their credit exposures quickly and at a lower cost than alternative investment instruments. In addition, many market participants use CDS pricing to provide a more accurate valuation of credit risk than would otherwise be possible by looking solely to less liquid cash markets. No traded product is subject to a restriction similar to the one proposed to be imposed on CDS by the draft bill. This is not surprising given that the proposal would strictly limit CDS to hedging transactions and would significantly restrict the involvement of professional intermediaries and investors in these products. As a policy matter, the purchase of uncovered CDS protection is no different than buying or selling futures, options, stocks or bonds because the relevant product is perceived to be undervalued or overvalued by the market. These investment activities are critical to liquidity, reduced execution costs and efficient price discovery in these markets and all involve legitimate and, indeed, desirable investment activities. Absent the participation of intermediaries and non-hedgers, CDS would cease to trade in a market, and they would become extremely illiquid and costly--both to enter into and to terminate.\6\ As a direct result, lenders and investors would be left with far more limited and more expensive alternatives for managing the credit risks arising from their lending and investment activities. In turn, American companies, including those in the agricultural sector, would have significantly reduced access to financing, and the financing that would be available would be more costly. Bank revenues from lending activity would also be reduced, placing further pressure on the financial strength of the banking sector.--------------------------------------------------------------------------- \6\ The proposed requirement could also subject CDS to regulation as a form of financial guarantee insurance, thereby subjecting providers of protection to the additional burdens and inefficiencies of regulation by insurance supervisors in each of the 50 states.--------------------------------------------------------------------------- The impact of these effects on the credit crisis, and efforts to reverse the credit crisis, are plain. The OTC derivatives markets in general, and the corporate CDS market in particular, have performed extremely well and have remained liquid throughout the current market turmoil, providing important benefits not only for financial market participants but also for large numbers of mainstream American companies. The corporate CDS market in particular has provided a critical price discovery function for the credit markets, which have otherwise become extraordinarily illiquid during the crisis and, as a result, provide extremely little credit market price discovery apart from corporate CDS. Measures that would interfere with this function would be highly undesirable and would further exacerbate the credit crisis. The segment of the CDS market in which extremely significant losses have been incurred involved the writing of CDS protection on mortgage-related asset-backed securities; in many ways, a very different product than corporate CDS. The market for CDS on asset-backed securities is also a relatively small segment of the overall CDS market; generally less than 2% of the aggregate CDS market.\7\ Losses in this segment led, in part, to the rescue of the AIG insurance conglomerate and the failure or near failure of many monoline financial guarantee insurers subject to oversight by state insurance supervisors. The losses incurred through these products did not result, however, from flaws in the products; in fact, the products transferred the risk of the referenced asset-backed securities as intended by the parties. These losses were directly related to the unexpectedly large losses in the subprime mortgage sector and the leveraging of these exposures through highly structured securities, such as mortgage-related collateralized debt obligations (CDOs--not to be confused with CDS). A number of capital market participants incurred significant losses in the subprime mortgage-related CDS and CDO market.--------------------------------------------------------------------------- \6\ DTCC Deriv/SERV Trade Information Warehouse Reports (data as of the week ending January 23, 2009), http://www.dtcc.com/products/derivserv/data/index.php.--------------------------------------------------------------------------- Although some CDS market participants have incurred large losses in connection with corporate CDS, for example, in the case of CDS referencing financial institutions such as Lehman Brothers, the corporate CDS market nonetheless functioned well as a result of effective bilateral mark-to-market collateral arrangements. The private sector's initiative to establish a clearinghouse for CDS will further reinforce the salutary and stabilizing effects of appropriate bilateral collateral arrangements. The measures proposed in the draft bill would do little to address the regulatory issues actually presented by the failures and near failures resulting from these events; and we see nothing in the events of the recent past that would justify a response in the form of the effective elimination of corporate CDS.Mandatory Clearing of OTC Derivatives (Section 13) Section 13 of the draft bill would require the clearing of all OTC derivatives, subject to a very limited exemptive process in the case of products that are infrequently transacted, highly customized, do not serve a price discovery function and are entered into by parties able to demonstrate their financial integrity. The clearing of OTC derivatives transactions has the potential to provide many important benefits, including the mitigation of operational and counterparty risks and facilitation of regulatory oversight, and should be encouraged where appropriate. However, section 13 of the draft bill would mandate that all OTC derivative contracts must be cleared, including not only CDS but also other OTC derivatives such as interest rate and currency swaps, the markets for which are also significant and have performed well throughout the current credit crisis, with an extremely narrow exception for certain infrequently traded and highly customized contracts. Such a clearing requirement is unworkable as a practical matter and would adversely affect mainstream American companies and reinforce conditions contributing to the current credit crisis. As a threshold matter, not all OTC derivatives contracts are suitable for clearing or can be cleared without presenting unacceptable risk management challenges for a clearinghouse, and not all market participants can participate in a clearing system. In order to mitigate its counterparty risk, a clearinghouse must determine the aggregate risk to which it is exposed as a result of its clearing activities and must collect mark-to-market margin, in cash or liquid securities such as U.S. Treasury securities, every day from each of its members with respect to such members' positions in the clearinghouse. In order to do this, the clearinghouse must be able to model the risks associated with the products it clears and must be able to determine the amount of the market-to-market margin it is to pay or collect each day, a process that requires access to price data. The administrative and financing demands of participating in a clearinghouse on members are significant, and as a practical matter, mainstream American companies that are end users would not participate because they do not have the personnel, operational infrastructure and expertise, nor the cash and securities on hand, to do so. As evidence of this, although exchange-traded interest rate and currency futures are widely available, mainstream American companies are negligible users of such products. Reliable risk modeling requires statistically robust historical price data sets for each cleared product. Reliable mark-to-market margining, in turn, requires (1) products that are both completely standardized and sufficiently liquid (one or the other of these characteristics is not sufficient) and (2) ready access to reliable price sources. Even where these conditions are present, existing clearinghouses must have developed an approved risk modeling approach in order for market participants to clear their positions without subjecting themselves or the clearinghouse to inappropriate market and counterparty risks. Against this background, it is clear that a regulatory model that requires market participants to obtain a prior exemption based on highly subjective criteria before they transact would be utterly unworkable, would inject unnecessary legal uncertainty (potentially subjecting transactions to after-the-fact legal challenges), would interfere with the execution of risk management transactions and would impede new product development. Further, as noted above, limitations on the availability of CDS would directly and adversely affect American companies. While measures to promote standardization can afford risk-reducing benefits, there are many circumstances in which customized solutions will be more appropriate. For example, standardization of products effectively precludes the application of hedge accounting by American companies, as standardization vitiates the ability to structure customized hedges that comply with the requirements of Financial Accounting Standard 133. Without hedge accounting, American companies who do choose to use derivatives would experience significant volatility in their reported earnings, for reasons altogether unrelated to their core businesses. The potential for such volatility in reported earnings would result in less hedging and more risks being borne by companies who are ill-equipped to manage them. Moreover, the proposed provision is unnecessary and exemplifies the pitfalls of addressing the regulation of OTC derivatives outside of an appropriate comprehensive regulatory framework. As a practical matter, the major OTC derivatives intermediaries (at least in financial derivatives) are subject to supervision by Federal regulators, including the Office of the Comptroller of the Currency and the Board of Governors of the Federal Reserve System, as national banks, Federal Reserve System member banks or members of bank (or financial) holding company groups. These supervisors have plenary authority to identify those circumstances in which clearing is appropriate and to require such clearing and/or impose capital charges that address any incremental risks that are associated with transactions not so cleared. Indeed, the industry has been working with the Federal Reserve since 2005 on various voluntary initiatives to reduce risk and improve the infrastructure of the CDS market, including the development of a CDS clearinghouse. We believe a model under which these issues are addressed by a direct prudential supervisor of all systemically significant participants in the OTC derivatives markets is a far more effective approach than, and one that would avoid the significant pitfalls of, a more rigid statutory mandate such as the one included in the draft bill.Imposition of Position Limits on OTC Derivatives (Section 11) Section 11 of the draft bill would authorize the CFTC to impose position limits on ``speculative'' OTC transactions that are fungible with exchange-traded futures. The potential limitation on the scope of permitted OTC derivatives exposures as contemplated by section 11 of the draft bill would have potentially profound ramifications. The potentially adverse implications of such limits for mainstream American companies are significantly exacerbated by the draft bill's proposed categorization of risk management transactions as ``speculative.'' (See the immediately following discussion of section 6 of the draft bill.) The CFTC and the futures exchanges have been able to ensure orderly futures markets through, among other measures, limitations on speculative futures positions without having to limit, for example, off-exchange positions in fungible (i.e., deliverable) physical commodities. It is plain that large physical positions on either side of the market have a far greater potential to disrupt futures markets than do purely notional, financially-settled OTC derivatives. In the absence of such limitations on physical positions, or any perceived need for such limitations, we question the need to impose such limits on purely notional, financially-settled OTC derivatives positions. As noted above, any such proposal for direct and restrictive regulation of OTC derivatives would, in any event, be more appropriately considered in the context of broader regulatory reform.Elimination of Risk Management Exemption (Section 6) Section 6 of the draft bill would limit the availability of position limit exemptions for risk management positions other than those held by commercial entities directly engaged in a physical merchandising chain under a highly restrictive definition of bona fide hedging. The policy rationale for position limit exemptions has historically been based on the inference that a trader who is directionally neutral with respect to the price of a commodity underlying its futures position lacks the motivation to engage in abusive price manipulation. Thus, hedging, arbitrage and spread trading were early examples of cases in which such exemptions were available. As portfolio theory evolved, and financial futures and OTC derivatives became prevalent, a variety of risk management strategies became the basis for similar exemptions. The draft bill would reject this policy rationale and would arbitrarily subject broad ranges of financial hedging and risk management activity to the limitations applicable to truly speculative positions. SIFMA believes that these limitations would have a profound adverse impact on futures and OTC derivatives markets, on retirees and investors, and on companies seeking to manage the commercial and financial risks to which they are subject. These adverse effects are all the more troubling in light of the absence of any rigorous analysis of empirical data indicating that the involvement of noncommercial entities in the futures markets has caused the recent volatility in energy and other commodity prices. Indeed, the only rigorous analysis to date of relevant empirical data by the CFTC has reached precisely the opposite conclusion.Swap dealers and mainstream American companies. Section 6 of the draft bill would severely restrict the ability of swap dealers to provide customized OTC derivatives hedges to commercial end users and corporations. In most cases, swap dealers use a portfolio approach under which they manage price risk using combinations of physical transactions, OTC financially-settled transactions and exchange-traded futures. Thus, when entering into an OTC swap transaction with a counterparty, the dealer does not necessarily hedge that specific transaction with a specific offsetting transaction in the U.S. futures markets or the OTC derivatives markets. Rather than hedge the price risk created by a specific OTC transaction, the dealer might use the U.S. futures markets or the OTC derivatives markets to hedge the net exposure created by multiple transactions conducted contemporaneously or even at another point in time. Known as ``warehousing risk'', a dealer may also enter into numerous or long-dated OTC transactions with a client that is seeking to hedge its price risk. At the time of entering into the transactions, it may not be prudent or possible for the dealer to enter into offsetting transactions in the futures markets or with other OTC dealers. Thus, in warehousing risk, the dealer assumes the price risk from its client and manages it in its trading book using the portfolio approach described above. By requiring that dealers, in order to qualify for the hedge exemption from speculative position limits, be able to demonstrate that any given position in the futures or OTC derivatives markets (hedged by futures) serves as a hedge against a specific OTC transaction with a counterparty that is itself hedging price risk, the draft bill would prohibit useful and risk-reducing hedging, which clearly runs counter to the public policy goals of the draft bill, and would significantly limit dealers' ability to effectively intermediate the risks of their end user and corporate clients which, in turn, would likely significantly reduce liquidity in the futures and OTC derivatives markets, increase hedging costs and leave the markets far more susceptible than they are today to undue influence by commercial interests that have a stake in directional price movements. It would also increase hedging costs for mainstream American companies, leaving them more susceptible to price risk and less competitive.Index strategies. The draft bill's proposed speculative position limit provisions would limit futures trading that is not, in fact, speculative and that does not have a market impact analogous to speculative trading, and, in turn, could potentially interfere with commodity price formation to the detriment of the markets. As an example, pension plans and other investment vehicles hold portfolios whose ``real dollar'' value is eroded by inflation. Investment of a targeted allocation of the portfolio in a broad-based commodity index can effectively ``hedge'' that risk financially. Such a strategy, like ``bona fide'' physical hedging, is undertaken for risk management and risk reduction purposes, is passive in nature (i.e., positions are bought in accordance with the index algorithm and asset allocations and are generally held, not actively traded) and is not speculative in purpose or effect. The strategy does not base trading decisions on expectations as to whether prices will go up or down--the strategy is generally indifferent as to whether prices go up or down. The strategy generally leads to trading in the opposite direction of speculators, offsetting their impact: when commodity index levels rise, portfolio allocations to index strategies are reduced (resulting in selling), when commodity index prices fall, allocations to index strategies are increased (resulting in buying). Over the long term, the strategy acts as a stabilizing influence for commodity prices. These trends were found by the CFTC in its recent study to be consistent with its analysis of relevant trading data. On the other hand, we are unaware of a rigorous analysis of empirical trading data that supports the correlations that have been alleged between index trading and increasing commodity prices. In addition, investing on a formulaic basis in a broad-based commodity index would be the least effective means of ``manipulating'' the market for an individual commodity.Increased susceptibility to manipulation. By restricting the hedge exemption to commercial entities, the draft bill would, in effect, significantly increase the relative market share of these entities and simultaneously reduce liquidity, by reducing the sizes of positions of traders employing risk management strategies that are truly market neutral. Any proposed legislation on this topic must take into account three basic facts. First, although a commercial user's futures position may be offset by a physical position, commercial entities are almost never price neutral. Second, the category of market participant that is best positioned to influence market prices are commercial users controlling large physical positions. Third, significantly increasing the relevant market share of commercial entities increases the ability of such traders to influence prices. As a result, SIFMA believes that the draft bill would make the U.S. futures markets far more susceptible than they currently are to price manipulation by commercial traders with directional biases. Indeed, nearly all of the CFTC energy manipulation cases that have been brought over the last 5 years have been brought against traders at firms that would be considered commercial entities under the draft bill.Carbon Offset Credits and Emission Allowances (Section 14) Section 14 would establish an exchange monopoly for the trading of futures on carbon offset credit and emission allowances and criminalize off-exchange trading in such products. The most successful, liquid and efficient markets are those in which trading is permitted both on-exchange and off-exchange. Indeed, exchange markets are generally enhanced by the success of related off-exchange markets. Off-exchange trading is also essential for a number of reasons. Off-exchange markets serve as the incubators through which trading terms are able to coalesce around agreed market conventions that promote liquidity and efficiency. This process facilitates the evolution of standardized and liquid products that can be effectively exchange traded. Off-exchange trading also enables derivatives to be tailored to the risk management needs and circumstances of individual companies. Off-exchange trading also facilitates the cost-effective execution of large wholesale transactions for which an exchange environment can be inefficient. Finally, the proposed prohibition would eliminate the fundamental salutary market benefits of inter-market competition--a cornerstone of efficient markets and American capitalism. As a result, we believe the proposed prohibition would impair market efficiency and impede innovation and the successful development of these products. As a direct consequence of these effects, the proposed provisions would, in our view, undermine rather than promote the important national policy objective of encouraging the development of successful and efficient trading markets in these important products.OTC Reporting Requirements (Section 5) Section 5 of the draft bill would require the CFTC to impose detailed reporting requirements with respect to OTC derivatives. We note that the CFTC currently has the authority to ascertain information regarding the OTC derivatives positions of large traders holding reportable positions in related futures contracts. SIFMA urges the Committee to avoid the creation of an ongoing detailed reporting regime applicable to OTC derivatives generally, as such a regime has the potential to result in large amounts of, but disproportionately little useful, information, imposing significant costs and burdens on the resources of the private sector and the CFTC alike. SIFMA would not, however, be opposed to a carefully tailored reporting regime (similar to that currently employed by the CFTC) under which the CFTC may require firms to provide upon request targeted information regarding large positions in OTC derivatives that are fungible with exchange-traded futures contracts (or significant price discovery contracts) that are under review by the CFTC as part of its market surveillance function or in connection with any investigation.Reporting Entity Classification (Section 4) Section 4 of the draft bill addresses the classification and disaggregation of large position data and would require disaggregation and reporting of positions of swap dealers and index traders. SIFMA supports the classification of position data into categories that promote the market surveillance function of the CFTC. The distinction between market participants who have directionally biased positions and those that are directionally neutral is a key one in this context. On the other hand, since swap dealers and index traders may fall into either of these categories, it is not clear that the proposed disaggregation would promote the CFTC's surveillance function.Foreign Boards of Trade (Section 3) Section 3 of the draft bill would require the CFTC to impose specific rule mandates on foreign boards of trade. Recognizing that our markets are global and inextricably linked, international coordination and harmonization are important objectives. However, these objectives can be better accomplished without the prescriptive imposition of U.S. rules on foreign markets. In addition to potentially curtailing U.S. access to foreign markets, any such approach would likely be regarded as imperious and may well invite retaliatory measures that could compromise the ability of U.S. exchanges to compete for international business--currently an important growth segment of U.S. exchange markets.Conclusion OTC derivatives markets play a key role in the functioning of the American economy by helping companies, lenders and investors to manage risk and arrange financing. With the limited exception noted above involving the writing of CDS protection on mortgage-related asset-backed securities by AIG and monoline financial guarantee insurers, the OTC markets have performed well and remained liquid throughout the current market turmoil, providing important benefits for a large number and wide range of companies. It must be recognized that the consequences of many of the proposed provisions in the draft bill would not fall solely or even most heavily on the professional intermediaries participating in these markets. Instead, the consequences of these provisions would, if enacted, harm very large numbers of mainstream American companies whose financial strength is critical to the welfare and recovery of our national economy. As noted above, many American companies use OTC derivatives to hedge their cost of borrowing or the operating risks of their businesses. Many of those who do business overseas use OTC derivatives to hedge their foreign exchange exposures. Many companies also hedge their commodity and other price exposures. For many companies, the availability of efficiently priced access to financing and other products depends on access by their counterparties to OTC derivatives such as CDS and interest rate and currency swaps. By limiting or eliminating access to basic risk management tools that American companies routinely use in the day-to-day management of their businesses, the draft bill could have a potentially profound negative impact on these companies and our nation's economic recovery. Recognizing the importance of OTC derivatives, we continue to support efforts to address the risks and further improve the transparency and efficiency of the OTC derivatives markets. Similarly, recognizing the importance of efficient and orderly exchange markets we continue to support tailored measures to improve the efficiency and integrity of listed futures markets. We look forward to working with this Committee, Congress and regulators on initiatives designed to improve oversight of OTC derivatives, while maintaining the significant benefits the OTC derivatives markets currently provide, and to promote orderly and efficient exchange markets. The Chairman [presiding.] Thank you very much, Mr. Rosen. " CHRG-109hhrg22160--12 Mr. Greenspan," Well, Mr. Chairman, I think the first thing that we have to focus upon is this extraordinary shift that is about to occur, starting in 2008, in which roughly 30 million people are going to leave the labor force over the next 25 years and enter into retirement. This creates a very significant slowing in the rate of economic growth. When the rate of growth of the working-age population relative to the total goes down--and even with productivity increasing at a reasonably good clip the rate of growth in GDP per capita must slow down. This is going to cause a confrontation in the marketplace between the desire on the part of retirees to maintain essentially what we call their replacement rate--namely, that a standard of living relative to the standard of living they enjoyed just prior to retirement will be maintained. If that is done, it will put significant pressure on the working-age-population economic growth, and so we have to find a way to get a larger pie to solve both sides of this. The advantage of having individual accounts is over a fairly broad spectrum, but the one that I think is most important actually relates to the issue which your Ranking Member mentioned before. These accounts, properly constructed and managed, will create, as you also point out, a sense of increased wealth on the part of the middle-and lower-income classes of this society, who have had to struggle with very little capital. And while they do have a claim against Social Security system in the future, as best as I can judge, they don't feel as though it is personal wealth they way they would with personal accounts. And I think that is a quite important issue with respect to this. The major issue of personal accounts is essentially economic, in the sense that, confronted with the very large baby boom retirement and the economic difficulties associated with it, the structure of essentially a pay-as-you-go system, which is what our Social Security system is, which worked exceptionally well for almost 50, 60 years, that system is not well suited to a period in which you do not any longer have significant overall population growth, and therefore a very high ratio of workers to retirees. And it is no longer the case, as existed in the earlier years, that life expectancy after age 65 was significant. We have been fortunate in that, for a number of reasons, our longevity has increased measurably. But it does suggest that if we are going to create the type of standard of living that we need in the future for everybody, we are going to need to build the capital stock, plant and equipment, because that is the only way we are going to significantly increase the rate of productivity growth which will be necessary to supply the real goods and services that the individuals who are retired at that point and the individuals who are activity working would sense their right in this economy. And if we are going to do that, we have to have a significant increase in national savings, because even though it doesn't exactly tie one to one because there are other ways in which productivity rises, the central core of productivity increase is capital investment. And to have capital investment you need to have savings. Now, we in the United States have had a very low national or domestic savings rate and have been borrowing a good part of it from abroad to finance our existing capital investment. We are obviously not going to be able to do that indefinitely, which puts even more pressure on building up our domestic savings. And what this means is that whatever type of structure we have for retirement, it has to be fully funded. The OASI has $1.5 trillion in the trust fund at this stage. The required full funding is over $10 trillion. In short, we do not have the mechanisms built into our procedures for retirement and retirement income and pensions which are creating a degree of savings necessary to create the capital assets which are a precondition to get a rate of growth in productivity, given the slow growth in the labor force which we project going forward in order to create enough GDP for everybody. So my major concern is that the current model, which served us so well for so many decades, is not the type of model we would certainly construct from scratch, and we have to move in a different direction. And one of the reasons that I think we have to move toward a private individual account system is they, by their nature, tend to be significantly fully funded, even if they are defined contribution plans, because individuals know what they need for the future and they tend to put monies away adequately to create the incomes they will need in retirement. So I think this is an extraordinarily important problem that exists. And I won't even go on to mention the fact that the Medicare shortfall, so far as the issue of where full funding lies, is several multiples in addition to what we confront in Social Security. " FOMC20080430meeting--207 205,CHAIRMAN BERNANKE.," Thank you all. The discussion was very good as usual, and let me just assure you that I listened very, very carefully. So I'm certainly hearing what you're saying, and I understand the concerns that people have expressed. I play Jekyll and Hyde quite a bit and argue with myself in the shower and other places. [Laughter] Let me first say that I think we ought to at least modestly congratulate ourselves that we have made some progress. Our policy actions, including both rate cuts and the liquidity measures, have seemed to have had some benefit. I think the fear has moderated. The markets have improved somewhat. As I said yesterday, I am cautious about this. There's a good chance that we will see further problems and further relapses, but we have made progress in reducing some of the uncertainties in the current environment. I also think that there's a lot of agreement around the table--and I certainly agree--that we have reached the point where further aggressive rate-cutting is not going to be productive and that we should now be signaling a willingness to sit, watch, and listen for a time, for two reasons. First, risks are now more balanced. That is, there is more attention to inflation risks and dollar risks, and although our output risks remain quite significant, the balance is closer than it has been for some time. Second, given that we have done a lot in a short time and moved aggressively and that we're seeing fiscal actions coming in and perhaps other policy effects as well--lagged effects of our own actions-- it seems to be a reasonable time for us to pause, to watch carefully, and to presume that we're not going to move unless conditions strongly warrant it. So I think that, at least in that broad respect, there's a lot of agreement around the table. The two alternatives that have been discussed by most people are B, which is to move 25 basis points today but to send a fairly strong signal of a preference to pause after this meeting, and C, which is not to move but to keep some elements of the downside risk alive in our risk assessment. Like a number of people, I think both are plausible. Both have appeal. Alternative C, in particular, has the appeal of pushing back against some critics on the inflation side who have criticized us for not being sufficiently attentive to the dollar, to commodity prices, and so on. As I said yesterday, I think that inflation is an important problem. It's a tremendous complication, given what is happening now in the other parts of the economy. In no way do I disagree with the points made by many participants that inflation is a critical issue for us and that we have to pay very close attention to it. As I said yesterday, I do think that some of the criticism that we are getting is just simply misinformed. I don't think there's any plausible interest rate policy that we can follow that would eliminate the bulk of the changes in commodity prices that we're seeing. I think they are due mostly to global supply-and-demand conditions. A small piece of evidence for that is that yesterday the ECB was mentioned favorably as having the appropriate inflation attitudes compared with our attitudes. I would just note that headline inflation in the euro zone is about the same as it is here, despite their stronger currency, because they are being driven by the same global commodity prices that we are. I would also say that, although the inflation situation is a very important concern, I don't see any particular deterioration in the near term. Since the last meeting, oil prices have gone up, which is very high profile, but gold, for example, has dropped about 12 or 13 percent. Other precious metals are down. Some other commodities are down. The dollar is stronger. TIPS breakevens have moved in the right direction. Wages, as we saw this morning, are stable, and I would urge you to compare wage behavior over the past five years with wage behavior during the 1970s. Wage growth then was not only high but also very unstable and responsive to short-term movements in headline inflation. So I think the canary is still getting decent breath here. [Laughter] I want us to be careful not to overpromise. We cannot do anything about the relative price of gasoline, and I don't think that we're on the edge of an abyss of the 1970s type. I do think it's an important issue, and I do think that there is benefit to pushing against the perceptions. In this business, perceptions have an element of reality to them, and we understand that. That's an important part of central banking, and I fully appreciate that point. So again, I see a lot of merit in the alternative C approach. As I think you can conjecture, I'm going to recommend alternative B--25 basis points but with a stronger indication of a pause. Let me discuss why in the end I come down on that side. First is the substance, the fundamentals. I don't think that 25 basis points is irrelevant. For example, one-month LIBOR is up about 35 basis points since our last meeting. These short-run financing costs do matter, particularly in a situation of financial fragility. So it is not just an issue, as President Evans mentioned, of long-term interest rate expectations. Overnight and short-term financing costs do matter for the financial markets, and a lower rate will help the markets to heal. It will affect other rates. To take an obvious example, it affects the adjustable rate that mortgages move to in the economy. So I think there's a case to be made on the substance. I will not add much to the discussion about how we define ""accommodative."" But one way to do it, I guess, is to look at the Greenbook's very thorough analysis, which rather than using rules of thumb attempts to look at a broad forecast conditional on what the staff can ascertain about the financial drags that we're seeing. Their analysis suggests that something around where we are or a little lower is consistent with slow economic growth but also price stability within a relatively short time. That is one way of trying to calibrate. Obviously, there are other ways as well. The second point I'd make, besides just the substance, is the consistency with our own projections. Virtually everybody around the table still thinks that the downside risks to growth are significant, and we've mentioned the same factors--financial conditions, housing, and a few other things. Those remain very serious downside risks. I don't think anybody thinks they are under control at this point. Yes, we also see an increased number of people with upside risks to inflation. But again, in terms of the numbers we'll publish, I think the downside risks are still held by more people than the inflation assessment. That, by the way, suggests why we can't really do what President Plosser suggests--hold and move to the alternative B, paragraph 4, language. Not to move and to say that the risks are balanced would, I think, be clearly inconsistent with the risk assessments that are in the projections. The other issues have to do with communications. We are at an important transition point in our communication strategy. One of the risks that we took when we made the very rapid cuts in interest rates earlier this year was the problem of coming to this exact point, when we would have to communicate to the markets that we were done, that we were going to flatten out, and that we were going to a mode of waiting. It was always difficult to figure out how that was going to work in a smooth way. Whether through luck or design, market expectations have set up perfectly. I mean, basically they're now assuming a flat path going forward, with some increase later; and that appears to be consistent, as Vice Chairman Geithner noted, in the last few days with significant dollar appreciation, declines in commodity prices, and declines in inflation expectations--all the things that we want to see. It appears that we're in a position that had seemed really problematic some time ago, so we are now able to make the transition in a way that will be relatively clear and, I hope, not too disruptive. Now, I want to come back to the issue of disappointing markets. I agree with President Fisher and many others that disappointing markets can be a good thing. It is certainly not always a bad thing, by any means. I think the issue is a little more subtle than that. The issue here is the clarity of what we're trying to say and the way our message is going to be read. Let me make two points about that. If we were to do alternative C, I think there would be essentially two issues. One is that, although we would not be moving, which would be a surprise, we would also not be declaring a pause because of downside risk, which would be another surprise. We'd have a surprise both in the action and in the statement. The risk there is that we confuse the markets about what our intentions are and what would cause us to respond. For example, the Greenbook's projections of Friday's employment numbers are somewhat more pessimistic than those being held in the market. If we took action C today and Friday's numbers were consistent with the Greenbook forecast and with our own projections but worse, significantly worse, than the market expectation, would statement C then lead to the building in of additional ease? I think there would be a lot of confusion there--a lot of uncertainty about what exactly we are saying about when we'd be willing to respond. The other communication issue that I have with alternative C--and this, again, is something President Fisher said yesterday--is that if we don't move and we put C out there, the stock market could go up because it might be read as saying that the Fed has increased confidence, is seeing things looking better, and is feeling stronger about the economy. I'm not sure that really is the assessment we have, and if we then have bad data on the labor markets and the financial markets weaken somewhat, will we be seen as having made a wrong call, as being blindsided by circumstances? This is more discussion than it's worth, but what I'm trying to convey is that it's not just a question of disappointing or not disappointing markets. It's a question of whether or not we're sending a clear message. I think alternative B, while it's consistent with our risk assessments, is also a pretty strong statement. Let me, just for what it is worth, assure you now that data that come in within the general, broad ranges of what we're expecting, even though they will be weak, should not cause us to ease further, given this statement. I believe that this statement will provide us with plenty of cover. No matter what the markets expect, we have said that we have come to a point at which we need to take a pause, we need to see what's happening, and we are going to be watchful and waiting. With respect to the language, I just want to point out how much the language in alternative B has moved from March. It really is a very significant change. First of all, we are acknowledging explicitly how much we have already done--the substantial easing of monetary policy to date plus the measures to foster market liquidity--and expressing a general confidence implicit in that first sentence that we have done a lot; that it is likely to help; and therefore, that we should wait and see what happens. Second, we removed any reference to downside risk to growth, which has been in there for a long time. That's a very strong statement. That says a lot about our inclinations going further. Third, we've added the phrase ""continue to monitor,"" which to me suggests very much a watchful waiting rather than an active approach to developments in the economy. Finally, we have made it clear that we are going to be data dependent and, in particular, though we have done a lot, we are expecting continued weakness, and we'll act as needed. But we have taken out the ""timely manner,"" so the presumption that we'll be responding in a very rapid and aggressive way, I think, has been moderated. I think of alternative B as being a compromise in the sense that it takes a step that is consistent with the fundamentals in terms of the underlying tightness of the financial system and the risks that most of us see to economic growth as well as inflation. At the same time, I think it is a rather strong step in expressing a shift in our strategy--that we are moving from the phase of rapid declines and aggressiveness to a phase of waiting and observing how this economy is going to evolve. Again, with full respect to everyone's comments, I understand. Unlike Governor Mishkin, I wasn't sitting on the fence; I thought that was a little uncomfortable. But I understand the concerns and the arguments. The communication issues did concern me, and largely on that basis, I would advocate B today. Are there any comments? If not, could you please take a roll call? " CHRG-111hhrg53248--27 Secretary Geithner," Chairman Frank, Ranking Member Bachus, and members of the committee, thanks for giving me the chance to come before you today. Let me first begin by commending you for the important work you have already undertaken to help build consensus on financial reform. We have an opportunity to bring about fundamental change to our financial system, to provide greater protection for consumers and for businesses. We share a responsibility to get this right and to get this done. On June 17th, the President outlined a proposal for comprehensive change of the basic rules of the road for the financial system. These proposals were designed to lay the foundation for a safer, more stable financial system, one less vulnerable to booms and busts, less vulnerable to fraud and manipulation. The President decided we need to move quickly while the memory of the searing damage caused by this crisis was still fresh and before the impetus to reform faded. These proposals have led to an important debate about how best to reform this system, how to achieve a better balance between innovation and stability. We welcome this debate, and we will work closely with the Congress to help shape a comprehensive and strong package of legislative changes. My written testimony reviews the full outlines of these proposals. I just want to focus my opening remarks on two central areas for reform. The first is our proposal for a Consumer Financial Protection Agency. We can all agree, I believe, that in the years leading up to the current crisis, our consumer protection regime fundamentally failed. It failed because our system allowed a range of institutions to escape effective supervision. It failed because our system was fragmented, fragmenting responsibility for consumer protection over numerous regulators, creating opportunities for evasion. And it failed because all of the Federal financial services regulators have higher priorities than consumer protection. The result left millions of Americans at risk, and I believe for the first time in the modern history of financial crises in our country, we face an acute crisis, a crisis which brought the financial system to the edge of collapse in significant part because of failures in consumer protection. The system allowed--this system allowed the extreme excesses of the subprime mortgage lending boom, loans without proof of income, employment or financial assets that it reset to unaffordable rates that consumers could not understand and that have contributed to millions of Americans losing their homes. Those practices built up over a long period of time. They peaked in 2006. But it took Federal banking agencies until June of 2007 after the peak to reach consensus on supervisory guidance that would impose even general standards on the sale and underwriting of subprime mortgages. And it took another year for these agencies to settle on a simple model disclosure for subprime mortgages. These actions came too late to help consumers and homeowners. The basic standards of protection were too weak. They were not effectively enforced, and accountability was diffused. We believe that the only viable solution is to provide a single entity in the government with a clear mandate for consumer protection and financial products and services with clear authority to write rules and to enforce those rules. We proposed to give this new agency jurisdiction over the entire marketplace. This will provide a level playing field where the reach of Federal oversight is extended for the first time to all financial firms. This means the agency would send examiners into nonbanks as well as to banks reviewing loan files and interviewing sales people. Consumers will be less vulnerable to the type of race-to-the-bottom standard that was produced by allowing institutions without effective supervision to compete alongside banks. We believe that effective protection requires consolidated authority to both write and enforce rules. Rules written by those not responsible for enforcing them are likely to be poorly designed with insufficient feel for the needs of consumers and for the realities of the market. Rule-writing authority without enforcement authority would risk creating an agency that is too weak dominated by those with enforcement authority. And leaving enforcement authority divided as it is today among this complicated mix of supervisors and other authorities would risk continued opportunities for evasion and uneven protections. Our proposals are designed to preserve the incentives and opportunities for innovation. Many of the practices of consumer lending that led to this crisis gave innovation a bad name. What they claim was innovation was often just predation. But we want to make it possible for future innovations and financial products to come with less risk of damage. We need to create an agency that restores the confidence of consumers and the confidence of financial investors with authority to prevent abusive and unfair practices while at the same time promoting innovation and consumer access to financial products. The second critical imperative to reform is to create a more stable system. In the years leading up to this crisis, our regime, our regulatory framework, permitted an excess buildup of leverage both outside the banking system and within the banking system. The shock absorbers that are critical to preserving the stability to the system, these are shock absorbers in the form of capital requirements, margin, liquidity requirements, were inadequate to withstand the force of the global recession. They left the system too weak to withstand the failure of a major financial institution. Addressing this challenge will require very substantial changes. It will require putting in place stronger constraints on risk taking with stronger limits on leverage and more conservative standards for funding and liquidity management. These standards need to be enforced more broadly across the financial system overall, covering not just all banks but institutions that present potential risk to the stability of the financial system. This will require bringing the markets that are critical to the provision of credit and capital, the derivatives markets, the securitization markets and the credit rating agencies, within a broad framework or oversight. This will require reform to compensation practices to reduce incentives for excessive risk taking in the future. This will require much stronger cushions or shock absorbers in the critical centralized financial infrastructure, so that the system as a whole is less vulnerable to contagion and is better able to withstand the pressures that come with financial shocks and the risk of failure of large institutions. And this will require stronger authority to manage the failure of these institutions. Resolution authority is essential to any credible plan to make it possible to limit moral hazard risk in the future and to limit the need for future bailouts. Alongside these changes, we need to put in place some important changes to the broader oversight framework. Our patchwork, antiquated balkanized segmented structure of oversight responsibility created large gaps in coverage, allowed institutions to shop for the weakest regulator, and left authorities without the capacity to understand and stay abreast of the changing danger of risk in our financial system. To address this, we proposed establishing a council responsible for looking at the financial system as a whole. No single entity can fully discharge this responsibility. Our proposed Financial Services Oversight Council would bring together the heads of all the major Federal financial regulatory agencies, including the Federal Reserve, the SEC, etc. This council would be accountable to the Congress for making sure that we have in place strong protections for the stability of the financial system; that policy is closely coordinated across responsible agencies; that we adapt the safeguards and protections as the system changes in the future and new sources of risk emerge; and that we are effectively cooperating with countries around the world in enforcing strong standards. This council would have the power to gather information from any firm or market to help identify emerging risks, and it would have the responsibility to recommend changes in laws and regulation to reduce future opportunities for arbitrage, to help ensure we put in place and maintain over time strong safeguards against the risk of future crises. The Federal Reserve will have an important role in this framework. It will be responsible for the consolidated supervision of all large interconnected firms whose failure could threaten the stability of this system, regardless of whether they own a depository institution. The Fed, in our judgment, is the only regulatory body with the experience, the institutional knowledge, and the capacity to do this. This is a role the Fed largely already plays today. And while our plan does clarify this basic responsibility and gives clear accountability to the Fed for this responsibility, it also takes away substantial authority. We propose to take away from the Fed today responsibility for writing rules for consumer protection, and for enforcing those rules, and we propose to require the Fed to receive written approval from the Secretary of the Treasury before exercising its emergency lending authority. Now, we look forward to refining these recommendations through the legislative process. To help advance this process, we have already provided detailed draft legislative language to the Hill on every piece of the President's reform package. " FOMC20061212meeting--84 82,MR. PLOSSER.," Thank you, Mr. Chairman. The economic picture in our region has changed little since our last meeting. The coincident indicators in our Business Outlook Survey suggested that economic activity continues to expand at a moderate pace in each of our three states, and the business contacts expect that pace to continue. I’m beginning to feel as though I’m reading the same chapter of the book again. It’s like Yogi Berra—it’s déjà vu all over again. The weakest sector in our region, as in the nation, is of course housing, which continues to decline. Sales and permits continue on a downward trend, and cancellations rose significantly in November; but builders have been able to resell, albeit at lower prices, homes whose initial purchasers have reneged. However, our survey of smaller homebuilders suggests that conditions on average in the housing market in our District seem somewhat better than in the nation as a whole. None of the builders we polled reported low inventories of unsold homes. Interestingly enough, 86 percent of them said their inventories were about right; only 14 percent said inventories were high; and no one reported that they were extremely high. In comparison, across the nation, 51 percent of builders reported that inventories were either low or about right, and 49 percent reported either high or extremely high inventories. Certainly some areas in our District have had a sharp drop in housing activity. The most notable is the Jersey Shore. But generally, based on what I’m hearing from firms in our District, I would continue to characterize the decline in housing in our region as an orderly one. Commercial real estate continues to perform very well. We’ve had some downturn in the value of nonresidential building contracts in the last month, but these data are very volatile, and the revisions tend to be upward as new contracts are reported over time. Our contacts in that sector continue to be among the most optimistic in our region. Office vacancy rates continued to decline in the past few months both in Center City Philadelphia and in the suburbs, and the net absorption of office space continues to be positive. Rents have risen, and the increase in occupancy has led to a scarcity of large blocks of available space, which bodes well for construction. Manufacturing activity in our region has been softening this fall, and we haven’t seen much of an increase since then. After two negative readings in September and October, the general index of economic activity in our business outlook survey turned positive in November, but its level of slightly above 5 suggests that that’s really not much change in the outlook. New orders and shipments were modestly weak. Shipments were actually strong. Orders were a little weaker, but the recent weakness is consistent with softness in national manufacturing and, as we’ve seen, in the purchasing managers’ index. Optimism for future capital spending actually rebounded last month— so the picture there is very mixed. Consumer spending continues to hold up well. Auto dealers and retailers reported strong sales in November and are optimistic about the holiday season. Labor market conditions in the District have changed little. Payroll employment growth in our three states is up at an annual rate of about 0.7 percent, which is slower than the national rate, but that’s just a fact of the population growth in our District. Unemployment rates remain low, near or below the national rates. Business contacts continue to cite difficulty in finding qualified workers, especially for skilled and professional positions. Area employers indicate that, over the past few months, wages have been steadily rising at a pace higher than earlier this year. I also want to mention some anecdotal information that I find interesting. Last week I met with a number of mostly manufacturing CEOs from my District. An observation that one of them made, which many agreed with, was that from their perspective money was almost free. This observation is consistent with what some others have been saying around the table. They thought that there was plenty of liquidity and that interest rates were not limiting them particularly in any way. This observation is also consistent with the views that mortgages rates are still relatively low and that credit spreads show less stress on businesses at this point. I take these observations to indicate that monetary policy is not particularly restrictive at this point. Also on the anecdotal side, the several manufacturers who participate as suppliers to both homebuilding and commercial real estate lamented their housing-related business, whether plumbing, cabinetry, or flooring, which were the three industries represented. On the residential side, the markets were terrible. Business was very bad. However, they all said that the commercial side was booming so much that it more than made up for their weakness on the residential side so that business tended to still be pretty good. In contrast to President Poole’s comment about trucking, I had one trucking CEO who said actually that business was good. It was weak in the Northeast—shipments were down there—but in the South and West their business was picking up and doing pretty well. He also made an interesting comment that I had not really thought about. He said that part of the change in trucking is that, while volumes may be down and they are having trouble finding drivers, there has also been a revolution in packaging. In fact, even though trucking volumes are down, the value of products and goods being shipped is actually up. As an example, they used to ship the big boom boxes that people listened to music on; now they’re shipping iPods. So as packaging has become more efficient and more protective, the truck volume is less, but the value is actually higher. He said that this was an ongoing trend in the trucking industry and that one had to be careful about interpreting volumes. On the inflation front, manufacturers continue to report higher production costs, but these cost increases have been less widespread than recent surveys indicated. Indexes of prices paid and prices received have continued to climb, and they’re still above where we’d like to see them. On the national side, my outlook has changed very little since our last meeting. Compared with earlier this year, growth has weakened, as we all know and have discussed. Housing slowed a little faster than perhaps we anticipated but—I agree with President Lacker—the prospects of spillovers remain relatively low. Again, as Bill applauded Janet’s wonderful one-handed/two- handed presentation, the labor markets are sending a completely different signal. As I said earlier, manufacturers and employers in our region continue to find scarcity in the labor market, both skilled and unskilled. If we thought that the economy were weakening and we expected growth to remain appreciably below potential and weak for a number of additional quarters, it might be important to allow short-term interest rates to move down—but not because I think the Fed can do much to prop up growth in those circumstances, that is, to ride some kind of Phillips curve. After all, businesses say there’s ample liquidity, and mortgage rates remain relatively low. But because equilibrium market rates may be lower over a sustained period, we might want to see a fed funds rate that’s consistent with that. This would be particularly relevant if we were sanguine about inflation. However, in my view, we’re not in that situation yet. As has been alluded to, many market commentators have pointed to the inversion of the yield curve as an indicator that recession is probable, but as suggested by the Chairman and the research that has been done, some of it by the Board staff, the predictive power of changes in the slope of the yield curve depends on why the slope of the yield curve changes. The change in the slope of the yield curve suggested by the research that was alluded to earlier has been about 100 basis points, but about half of that has been in the risk premium associated with long-term rates. At the same time, the predictive content of that risk premium change for recession or GDP growth is much less than absolute changes in real rates. So I take that research to say that the inversion of the yield curve may be forecasting slower growth but not a recession to date. Thus, inflation remains a significant concern to me. Recent readings on headline inflation have shown some encouraging downward movement, and inflation expectations have remained stable. But the level of core inflation continues to be higher than what I consider to be consistent with price stability. Moreover, the forecast does not show us reestablishing price stability in the near future. That’s a reasonable, although unwelcome, forecast to the extent that very accommodative monetary policy over the past five years helped fuel the acceleration of inflation and that monetary policy and financial markets have not tightened much and aren’t expected to tighten much over the coming period. The Bluebook indicates that the current real fed funds rate is within the range of model-based estimates of the equilibrium rate—that is, policy is not terribly tight—and, as I suggested earlier, long rates including mortgage rates are at relatively low levels, suggesting ample liquidity in the market. I’m not convinced that price stability will be achieved without further action on the part of the Fed, and I’d feel more comfortable after seeing a few more months or even another quarter or two of deceleration. The slight deceleration in core inflation that we have seen, coupled with the slower economic growth, has meant that implicit firming of policy even without a change in the nominal funds rate might be in the cards, and that would be a welcome change. I’m not convinced that the recent decline in energy prices will provide the relief we would like to see in core inflation. As suggested by Jeff and my question earlier, I’m concerned that, if oil prices stabilize around $60 a barrel, we will see core inflation begin to creep back up once the temporary benefits of the decline have disappeared. Indeed, gasoline prices have already risen somewhat in the past few weeks from the lows that we saw in late September and early October. As has been mentioned, the sharpest increases in the components of inflation that we’ve looked at over the past few months seem to be in those elements that are least likely to be influenced by energy prices. In addition, as Jeff said, I’m very dubious that the gap measures that we allude to periodically are going to act as much of a constraint on price increases going forward. The bottom line is that I’m not hopeful that energy prices or the output gap will provide us with much of the inflationary relief that we’re looking for. Thank you, Mr. Chairman." FOMC20070628meeting--107 105,MR. MOSKOW.," Thank you, Mr. Chairman. Conditions in the Seventh District have changed little since my last report. Overall activity in the District is lagging the nation, mainly because of the continued difficulties of what we now call the Detroit Three, formerly known as the Big Three, [laughter] and their suppliers. But other sectors of our region are doing better—notably, a number of manufacturers outside autos—and consumer spending is moving forward at a moderate rate. Looking at the outlook for the national economy, the Greenbook baseline forecast has growth recovering to potential and core inflation stabilizing at 2 percent. Our outlook is not much different. We see growth returning close to potential. Assuming that monetary policy maintains its slightly restrictive stance, we think inflation will edge a shade below 2 percent by 2009. That would be a good outcome, and I sure hope we get it. The biggest news since the May FOMC meeting is the adjustment in financial conditions. The change in fed funds futures brings market expectations into better alignment with what I think will be the appropriate path for monetary policy. I’m not sure, however, how much restraint we can expect from the increase in long-term interest rates. As the Chairman heard from our directors last week, the effects can be muted by ample liquidity in the financial markets. One of our directors, who heads a large private equity firm, says that he does not see much of a change in the lending environment. Financing for even high-risk projects continues to be readily available at quite favorable rates and terms. Notably, such loans are being made with few covenants and no automatic default triggers. Of course, the housing market remains a risk. Like the Greenbook, we continue to expect large declines in residential investment through the end of this year, and I remain concerned that builders may need to cut back even more to reduce the high inventory of unsold homes. Our Detroit Branch director, who is CFO of Pulte Homes, noted that two-thirds of their sales usually occur between the Super Bowl and Memorial Day. Sales this year in that period were sluggish and relatively unresponsive to price discounting. Accordingly, he is not looking for a turnaround in housing markets before ’08. Another director, the head of U.S. Gypsum, agreed that it would be ’08 before we could expect a pickup in housing. With regard to consumer spending more generally, some contacts noted the impact of higher gasoline prices. A developer of malls and shopping centers downgraded his expectations for the rest of 2007, but he is not overly pessimistic and is expecting retail sales in the second half to remain near their first-half pace. Both GM and Ford believe that the higher gasoline prices are holding down the overall level of motor vehicle sales in addition to moving the mix of sales away from SUVs and toward cars. At this point, they believe that higher interest rates are having only a marginal effect on demand. Both are predicting that total light vehicle sales will be about 16.5 million units in 2007. That is the same as the pace predicted by the participants in our annual outlook symposium that we held in Detroit earlier this month. But the rest of the manufacturing is doing better than autos. Producers of heavy machinery and agricultural equipment continue to report strong demand. The Chicago purchasing managers’ report, which is confidential until its release this Friday, was 60.2 in June; that reading is down only a bit from its very high one of 61.7 in May. Some of this strength reflects strong growth abroad, which is fueling the demand for U.S. products, as we talked about during the chart show. Indeed, I think that there may be some upside risks to the GDP forecast from faster-than-expected export growth. Labor markets continue to be strong, and we heard the usual stories about selected labor shortages and associated increases in wages. One exception is the soft demand for temporary workers, but this could be normal for a mature business cycle. Turning to prices, our contacts seem to be a bit more pessimistic about the prospects for inflation. We heard concerns that higher energy prices would boost transportation costs and that the demand for food stuffs from abroad and the booming domestic ethanol market are pushing up food prices. In contrast to the anecdotes, the incoming data on core inflation were better than expected. Our indicator models revised down a tenth or two from the last round; they now have core PCE inflation being about 2 percent this year and next and then edging down to 1.8 or 1.9 in 2009. Without any meaningful resource slack, this improvement would require a comparable adjustment in inflation expectations, which may be difficult given a prolonged period of core inflation at or above 2 percent. So I continue to think that the predominant risk remains that inflation will not moderate as expected." FOMC20080430meeting--99 97,MR. BULLARD.," Thank you, Mr. Chairman. The economy of the Eighth District continues to show signs of weakness. The services sector has continued to soften, and sales of both general and big box retailers are down from the same period last year. The residential real estate sector has continued to decline throughout the District. Across major metro areas, sales were about 15 percent below the level from last year, and single-family permits were down about 30 percent. Employment growth has slowed and is estimated to have turned negative in March for many areas. Typically, however, employment growth in the District has been stronger than that for the United States as a whole. Manufacturing has remained roughly flat, despite temporary shutdowns that have affected domestic automobile production. Also, commercial real estate construction remains strong, and vacancy rates are low; however, there are increases in the number of delayed projects. Banks in the District are still in good shape, generally speaking. There have been modest increases in total loans in all categories, including real estate. Contacts in the shipping and trucking industries reported a mixed bag. In some instances, business seems to be holding up, whereas in others it is down substantially. These businesses are being critically affected by increases in energy prices. Similarly, a contact in the fast food industry painted a picture of a business struggling with substantial increases in commodity prices. On the other hand, a contact in a large technology firm indicated that business is holding up quite well, in part because a large fraction of this firm's business is overseas. Contacts in the energy sector reported robust business prospects, as expected. A contact at a large financial firm suggested that the discovery process concerning asset-backed securities, which has been ongoing for many months, has effectively come to a close. The idea that the discovery process--and the considerable macroeconomic uncertainty that attended that process--is over is an important consideration at this juncture. My sense is that expectations of future economic performance are changing rapidly. The probability that the U.S. economy will enter into a debilitating depression-like state has fallen dramatically. In the meantime, other risks have increased markedly--in particular, that the FOMC will lose credibility with respect to its inflation goals. The U.S. economy has certainly encountered a large shock. Monetary policy can mitigate the effects of a large shock but cannot be expected to completely offset exceptional disturbances. Attempts to do too much may create more and moredangerous problems in the future. Best-practice monetary policy would do well, it seems to me, to avoid setting the stage for future problems. The problems with the rate structure, which is too low, are threefold. First, there is the risk of setting up a new bubble. The exceptionally low rates of a few years ago are sometimes cited as providing fuel for today's problems. Some have argued that today's commodity price increases are exactly that new bubble. Second, continued unabated reductions in interest rates will bring the zero bound issue into play with unknown consequences. Third, still lower rates will push the envelope further on inflationary expectations. Those expectations may appear to be reasonably well anchored today, but that is because the private sector expects us to take actions to keep inflation low and stable. Should those expectations become unmoored, it will be too late, and an era of higher and more volatile inflation would be very costly for American households. Much has been done already. A low rate environment has been created and has been in place only for a short time. Marginal moves at this juncture are minor compared with the general thrust of policy over the last nine months. The Committee would do much better at this meeting by taking steps to address eroding credibility. Thank you. " FOMC20080430meeting--91 89,MS. YELLEN.," Thank you, Mr. Chairman. In looking at the latest Blue Chip forecasts for GDP growth, I noted that the range between the highest and lowest is among the largest on record. The 10 most optimistic forecasters are predicting over 2� percentage points faster Q4-over-Q4 growth than the 10 most pessimistic ones. Such forecast dispersion is indicative of the unusually high degree of uncertainty that we are facing. The Greenbook presents one of the most pessimistic economic forecasts; yet I find its recessionary projection quite plausible and see downside risks that could take the economy well below that forecast. Although I found it especially difficult this time to decide on the most likely outcome for the economy, I ended up submitting a forecast that shows somewhat more growth in 2008 than the Greenbook, even though we shared the same assumption concerning monetary policy this year. My forecast projects 2008 growth of � percent. This averages no growth in the first half and 1� percent growth in the second. The unemployment rate increases to just over 5� percent by the end of this year, a bit lower than the Greenbook. In one critical area--namely, the adverse effects of financial sector developments on the real economy--I remain just as pessimistic as the Greenbook. Although the likelihood of a severe financial panic has diminished, the risks are by no means behind us. Moreover, credit conditions have turned quite restrictive. This credit crunch reflects the drying up of financing both for markets that were important sources of business and consumer credit and from banks that are contending with capital-depleting losses and illiquid assets. Among banks, the latest Senior Loan Officer Opinion Survey noted a clear tightening of lending standards, and my own discussions with bankers confirmed this point. They say they are carefully reassessing and significantly curtailing existing home equity lines of credit as well as unsecured consumer loans of all sorts. Banks are also clamping down on the provision of revolving business credit, even to very creditworthy customers. For example, the treasurer of Chevron, a highly rated oil company that, as you can guess given energy prices, has a very strong profit outlook, recently complained to me that banks were reluctant to extend even its credit line. Such reluctance is also evident for lending to students, consumers, and other businesses. The risk of a deepening credit crunch remains as a weak economy--especially with further sharp declines in housing prices--escalates credit losses, harms financial institution balance sheets, and causes them to scale back lending even further. My sense from our business contacts is that their perception of reduced access to credit is causing them to manage their firm's liquidity more carefully and is leading to some deferrals in capital spending projects as a precautionary measure. Certainly the mood is decidedly more pessimistic and cautious. Amid the gloom of the credit crunch, I do see a possible silver lining in that it may amplify the effects of the fiscal stimulus package, and this is part of the reason that my forecasted downturn is a little milder than the Greenbook's. In particular, because of the credit and liquidity considerations, the latest fiscal package could well provide a bigger bang for the buck than the tax rebates in 2001. First, the current tax rebates are more directly targeted at lower-income households, which are more likely to be credit constrained and to spend the cash once it's in hand. Second, given the current tightening of credit availability, households will likely spend an even greater fraction of the tax rebates than they did in 2001. Of course, there is considerable uncertainty about assessing the potential size of these effects. But over the next few months as the checks go out and the retail sales reports come in, we should get a pretty quick preliminary read on how things are shaping up. Regarding inflation, the most worrying developments since we met in March have been the price surges for a wide variety of raw materials and commodities, especially the jump in the price of crude oil. From the U.S. perspective, this run-up in prices represents mainly a classic supply shock, which could threaten both parts of our dual mandate, although the decline in the dollar has slightly exacerbated the severity of the impact. Like the Greenbook, my forecast for inflation does take commodity price futures at face value and foresees a leveling-out of prices going forward. Although I must say, after four years of being wrong, I am beginning to feel like Charlie Brown trying to kick that football. The most recent core consumer price data have shown some improvement, and like the Greenbook, I'm optimistic that core inflation will subside to around 1� percent over the forecast period, assuming that the commodity prices do finally level off and compensation remains well behaved. An interesting analysis by Bart Hobijn of the New York Fed as well as my own staff implies that, in an accounting sense, pass-through from the run-up in oil and crop prices may have boosted core inflation as much as 0.3 percentage point over the past two years. So a leveling-off of these prices could lower not only headline but also core inflation. My core PCE inflation forecast is a tenth or two lower than the Greenbook this year and next also because we assume lower passthrough of the dollar depreciation to non-oil import prices. We have been reexamining the data on this issue and find the evidence quite convincing that pass-through has been quite low recently-- lower, for example, than embodied in the FRB/US model. With respect to inflation expectations, market-based measures have now edged down. We took little comfort from this fact, however, because we had viewed the uptick in inflation compensation in recent months mainly as a reflection of a higher inflation risk premium and not a reflection of higher inflation expectations. I am also somewhat concerned that the median expectation for inflation over the next five to ten years in the Michigan survey has ticked up. " FinancialCrisisReport--43 A third problem, exclusive to state regulators, was a 2005 regulation issued by the OCC to prohibit states from enforcing state consumer protection laws against national banks. 91 After the New York State Attorney General issued subpoenas to several national banks to enforce New York’s fair lending laws, a legal battle ensued. In 2009, the Supreme Court invalidated the OCC regulation, and held that states were allowed to enforce state consumer protection laws against national banks. 92 During the intervening four years, however, state regulators had been effectively unable to enforce state laws prohibiting abusive mortgage practices against federally- chartered banks and thrifts. Systemic Risk. While bank and securities regulators focused on the safety and soundness of individual financial institutions, no regulator was charged with identifying, preventing, or managing risks that threatened the safety and soundness of the overall U.S. financial system. In the area of high risk mortgage lending, for example, bank regulators allowed banks to issue high risk mortgages as long as it was profitable and the banks quickly sold the high risk loans to get them off their books. Securities regulators allowed investment banks to underwrite, buy, and sell mortgage backed securities relying on high risk mortgages, as long as the securities received high ratings from the credit rating agencies and so were deemed “safe” investments. No regulatory agency focused on what would happen when poor quality mortgages were allowed to saturate U.S. financial markets and contaminate RMBS and CDO securities with high risk loans. In addition, none of the regulators focused on the impact derivatives like credit default swaps might have in exacerbating risk exposures, since they were barred by federal law from regulating or even gathering data about these financial instruments. F. Government Sponsored Enterprises Between 1990 and 2004, homeownership rates in the United States increased rapidly from 64% to 69%, the highest level in 50 years. 93 While many highly regarded economists and officials argued at the time that this housing boom was the result of healthy economic activity, in retrospect, some federal housing policies encouraged people to purchase homes they were ultimately unable to afford, which helped to inflate the housing bubble. Fannie Mae and Freddie Mac. Two government sponsored entities (GSE), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), were chartered by Congress to encourage homeownership primarily by providing a secondary market for home mortgages. They created that secondary market by purchasing loans from lenders, securitizing them, providing a guarantee that they would make up the cost of other requirements, the rules prohibited lenders “from making loans based on collateral without regard to [the borrower’s] repayment ability,” required lenders to “verify income and obligations,” and imposed “more stringent restrictions on prepayment penalties.” The rules also required lenders to “establish escrow accounts for taxes and mortgage related insurance for first-lien loans.” In addition, the rules “prohibit[ed] coercion of appraisers, define[d] inappropriate practices for loan servicers, and require[d] early truth in lending disclosures for most mortgages.”). 91 12 CFR § 7.4000. 92 Cuomo v. Clearing House Association , Case No. 08-453, 129 S.Ct. 2710 (2009). 93 U.S. Census Bureau, “Table 14. Homeownership Rates by Area: 1960 to 2009,” http://www.census.gov/hhes/www/housing/hvs/annual09/ann09t14.xls. any securitized mortgage that defaulted, and selling the resulting mortgage backed securities to investors. Many believed that the securities had the implicit backing of the federal government and viewed them as very safe investments, leading investors around the world to purchase them. The existence of this secondary market encouraged lenders to originate more loans, since they could easily sell them to the GSEs and use the profits to increase their lending. FOMC20080916meeting--146 144,MR. FISHER.," Mr. Chairman, it may surprise you that President Yellen and I agree, [laughter] at least with the recommendation, as I do with the majority. I also agree firmly with President Hoenig. David wanted to know a little more about Houston, so I will start out with that, and then I'll quickly go to the policy matter. The storm devastated Galveston and Beaumont. Their combined population is 650,000. The population of the greater Houston area is 6.5 million. The damage to Houston was moderate. The overall effect on the Texas economy should be relatively mild. We still expect employment growth this year of 1� percent or so, plus or minus, even though the storm really hit hard an area that accounts for 26 percent of our employment and 30 percent of our output. In terms of the national impact, I think it's important to understand that the energy infrastructure took minor losses. The short-term functioning of that infrastructure is hampered by power losses and water problems. Gasoline prices have gone up because 3.9 million barrels a day, or roughly 22 percent of the U.S. refining capacity, has been shut down. By the way, that affects the spot market--I think that's some of the reason you've seen this weakness recently--and maybe the near-term futures market. If you look at the gasoline price market, the gasoline price went up another 13 cents yesterday, but the near futures market is down 19 cents. I think it reflects expectations that, once power is restored, the refineries will come back on line about a week later. So we will likely have a temporary bump-up in inflation due to the gas prices. But I think it is important to realize that this, unlike Katrina, didn't shut down the Mississippi, and the effect on other commodity prices is likely not to be significant, with one exception. If you look, you'll see that prices of soybeans and soybean oil have spiked recently. Clearly, the weather has an impact, but I think that's more supply�demand imbalance-- something that I'm watching carefully. The silver lining, if there is a silver lining to human tragedy, is probably twofold. One is, if you notice, that lumber prices are actually up this year, which is kind of odd in terms of lumber trading. Of course, lumber producers are probably pretty happy with the devastation in our state. Second, Mexican laborers will be very happy if we let them into the country because the Hispanics build most of our buildings in the United States. But I would say that the storm should not have any effect on nor should it alter our preferred policy direction, and I would like to talk about that very quickly. I have been affected in my thinking about economic growth and inflation by what I'm seeing overseas. I'm globally oriented. I do expect that we're going to have less impetus from exports, which were significant in carrying our growth. Our numbers show that, and your numbers, David, show that, and all of our conversations have revolved around that. We were surprised on the upside by it. Now I think weakening economic growth elsewhere is likely to subdue that effect. We have also had an appreciation of the dollar. Oil prices have declined. I dove deep in my anecdotal explorations with the majors and also with all supply companies. For whatever it's worth, they are convinced that OPEC now has $100 rather than $70 as their benchmark. Most of them expect prices to slide down to somewhere in the $80 range. But over the longer term, whatever that term may be, we're going to talk about $100-plus oil. Then, of course, many commodity prices are off their peaks. They have retraced significantly--some entirely. That said, in my anecdotal interchanges, I am still hearing about the likelihood, as I think President Pianalto mentioned, that people are seeking to preserve their margins. They've been stung for many years, and I'll just give you one case because I think it tells us something. If you talk to the CEO of Wal-Mart USA, what they are pricing to be on their shelf six to eight months from now has an average price increase of 10 percent. Now, of course, you might have this reversed as we go through time. My biggest disappointment, incidentally, was that the one bakery that I've gone to for thirty years, Stein's Bakery in Dallas, Texas, the best maker of not only bagels but also anything that has Crisco in it, [laughter] has just announced a price increase due to cost pressures. But I do think we have a mitigation of inflation, and we also have a mitigation of the impetus to economic growth. As to the current financial predicament, I want to go back to a comment I made a long time ago. This is not the first for me. I like to tease President Stern about his maturity--I don't go back to the Panic of 1890, but to Herstatt, 1974; New York City's failure, 1975; 1987; and what happened in Japan. Incidentally, you see the same pictures repeated in every newspaper. It's always the trader holding his head or looking up at the board. Now it's in color; it used to be black and white. I think it comes from the same archive, and it is repeated throughout time. [Laughter] All of that reminds me--forgive me for quoting Bob Dylan--but money doesn't talk; it swears. When you swear, you get emotional. If you blaspheme, you lose control. I think the main thing we must do in this policy decision today is not to lose control, to show a steady hand. I would recommend, Mr. Chairman, that we embrace unanimously--and I think it's important for us to be unanimous at this moment--alternative B. Thank you, Mr. Chairman. " CHRG-111shrg51290--32 STATEMENT OF SENATOR SCHUMER Senator Schumer. Thank you, Mr. Chairman. Thank you for holding this hearing, and unfortunately I got here a little late, so I am going to take a little bit of my time and read my opening statement, if you don't mind. And I want to thank you and Senator Shelby for holding this hearing. I think this hearing is really important. We have a great economic crisis in our country and it extends from one end to the other. We have had an explosion of consumer debt. Now we have 12 million households that owe more on their mortgages than their house is worth. The average American family has over $8,000 in credit card debt. Mortgages and credit cards are ordinary features of middle-class life and now they are at the heart of our financial crisis. Something went awry, seriously awry. During the 1980s, I worked to pass legislation that would require disclosure on credit card terms, the ``Schumer box,'' and it had a real effect. But it doesn't do enough now, because disclosure isn't enough, and when you hear of banking institutions just raising the rates, boom, for some small almost induced mistake, you say, well, we need more, and I know that Senator Dodd, Senator Menendez, and I have been working on credit card legislation. But the deceptive practices, the predatory practices, we have seen them in the mortgage industry. The Federal Reserve was in charge of all this and did nothing. Home buyers were enticed and misled, sometimes by banks, sometimes by independent mortgage brokers, more often by the latter, but there is a serious problem. And so I would say complexity ultimately stacks the deck in favor of the financial experts who peddle the products at the expense of the consumer. So again, I am not trying to point fingers of blame here. I am trying to correct the situation. In the early 1900s, Congress created the Food and Drug Administration to protect consumers from peddlers of medicinal concoctions whose miracle elixirs did more harm than good. In today's world, we need a comparable response to peddlers of unfair and deceptive financial practices and services. And I would just say to Mr. Bartlett that all too often, they don't come only from major banking institutions or financial institutions. They come from everywhere. So this week Senator Durbin and I plan to introduce legislation to create a new regulator to provide consumers with stronger protection from excessively costly and predatory financial products and practices. The idea for a Financial Product Safety Commission was first proposed by Elizabeth Warren, professor at Harvard, in 2007. She recognized that substantial changes in the credit markets have made debt far riskier for consumers today than a generation ago and that ordinary credit transactions have become complex undertakings. Consumers are at the mercy of those who write the contracts, and simple disclosure--it is never simple anymore because the terms are so complicated--it doesn't do the job. So consumers deserve to have someone on their side, a regulator that will watch out for the average American, who will review financial products and services to ensure they work without any hidden dangers or unreasonable tricks. So the time is right for a financial services regulator with consumer focus. Professor Warren and consumer groups--CFA, Consumers Union, Public Citizen, Center for Responsible Lending--have been instrumental in helping develop the objectives and responsibilities of such a regulator and I appreciate their efforts. I also think we have got to think beyond regulatory reform of the financial system. We need to think about a new way to live, because what has happened basically over the last decade and a half is we became a country that consumed more than we produced, borrowed more than we saved, and imported more than we exported. Something has to give. And I would say the greatest challenge President Obama has after he gets us out of this financial mess is to figure out how we get back to those traditional values. We have seen it up and down the line. There are the CEOs and their salaries. We all know about that, excessive, huge, based on the short-term. We have seen it here in government with all the deficits. And we have seen it with individuals who get into debt far beyond their means. So it has been a whole societal problem that we have to do something about. The proposal that Senator Durbin and I are making is one part of that, but there are lots of other parts, and I thank you all for listening. I particularly want to thank both Ellen Seidman and Professor McCoy for arguing for this kind of thing. Do I have time for one question, Mr. Chairman? Is that OK? " FOMC20081007confcall--39 37,CHAIRMAN BERNANKE.," All right. I'm going to read the joint statement by central banks, which has been negotiated with the other central banks. So we really can't edit this one because of the negotiations that have already taken place. However, you should already have the FOMC statement. So here's the joint statement by central banks: ""Throughout the current financial crisis, central banks have engaged in continuous close consultation and have cooperated in unprecedented joint actions such as the provision of liquidity to reduce strains in financial markets. Inflationary pressures have started to moderate in a number of countries, partly reflecting a marked decline in energy and other commodity prices. Inflation expectations are diminishing and remain anchored to price stability. The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability. Some easing of global monetary conditions is therefore warranted. Accordingly, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, Sveriges Riksbank, and the Swiss National Bank are today announcing reductions in policy interest rates. The Bank of Japan expresses its strong support of these policy actions."" So that would be the joint statement. Then we would issue separately on our website the FOMC statement. Let me stop there and open the floor for comments on the action, on the general situation, on the statement, or whatever you would like to talk about. Would anyone like to speak? President Yellen. " FOMC20080318meeting--138 136,MR. KOHN.," Thank you, Mr. Chairman. I also support your proposal, both the action and the language of alternative A. I think it's an appropriate response to the developing situation, and I do think that the language will help us on the inflation front. Let me elaborate a bit. We've had a marked deterioration in the outlook, as everybody around the table has seen and has agreed with. I do think, as President Yellen and others have said, that a decline in the federal funds rate will be helpful in mitigating the recessionary tendencies in the economy. The decline of 75 basis points is not as much as the Greenbook r* decline, but I think it's appropriate and reasonable to await more evidence about whether at some point we need to go further. The resulting real federal funds rate would be approximately zero using core inflation, and I think that's a reasonable place to be, given the weight of the constraining factors in the economic outlook, particularly from the credit markets. I use core in thinking about the real funds rate because I do think that even a zero real funds rate under these circumstances, at least for a time, will be consistent with inflation coming down as commodity prices level out and as resource utilization goes down. I agree with Brian that there could be a bit of an adverse reaction in financial markets because it's not quite as much as they're expecting, but with that risk sentence in paragraph 4, it shouldn't be too bad. I do think it's consistent with heightened attention by the Committee to inflation and inflation expectations for the reasons you gave, Mr. Chairman. It's less than the market expects, and both paragraph 3 and paragraph 4 increase the attention to inflation and inflation risk. Thank you. " FOMC20061025meeting--242 240,CHAIRMAN BERNANKE.," Thank you. Well, thank you all very much for a very useful, very informative discussion. My bottom line is that we have not had a great deal of information in the past five weeks on which to base a sharp change either in policy or in this statement. Therefore, I would propose that we make no change in the federal funds rate target today. Many of the issues that were raised yesterday were in some sense prospective. Will the housing market decline further or stabilize? Will labor markets strengthen or weaken? Will growth slow or return to potential? Over the next six or seven weeks, until the next meeting, we’ll be seeing the employment cost index, the third-quarter GDP, two employment reports, and a raft of data on housing prices and other key indicators. So I think it would be sensible to think very hard in December about whether a course adjustment is necessitated both in terms of policy and in terms of the statement. I would just say that Governor Warsh’s comment about the markets was one that I’ve thought about myself. If the markets disagree with you, do you try to persuade them or not? I think the ideal thing is, again, to convey strongly what our views are—in particular, both our objective function and our outlook—but in general not to try to directly influence the position of the yield curve because doing so makes us lose an important source of information about the economy. However, in the intermeeting period we can continue with our verbal tightening in the sense that we can emphasize our ongoing concern about inflation and the pace of change in inflation, and we can convey, those of you who believe this, that the risks to lower growth seem to have been at least somewhat moderated. With respect to the language, I’ve been trying to keep track here, [laughter] but I think I have a clear majority in the third section to strike “and of the prices of energy and other commodities.” I heard no disagreement there. The Kohn amendment seems to have a majority. Governor Warsh raised some of the issues that I thought about in trying to distinguish the third quarter from the fourth quarter. I guess I’m okay with Governor Kohn’s suggestion. Is there anyone who would like to re-enter this discussion after hearing the whole thing? If not, I take the general thrust to be in favor of making that change." FOMC20070131meeting--174 172,MS. BIES.," Thank you, Mr. Chairman. Like several of you, I’m going to focus on housing and what we’re seeing in the banking sector and in mortgage performance. Since the last meeting, I am feeling better about the housing market in the aggregate. It looks as though home sales are stabilizing for the fourth quarter. On the whole, home sales actually did go up a bit. The inventory of new homes for sale has now fallen for five months through December, and mortgage applications for home purchases continue to move above the levels of last summer, when they hit bottom. The National Association of Realtors is estimating that existing home sales have already bottomed out, and homebuilder sentiment improved in three of the four past months. But even if sales really have stabilized, the inventory of homes for sale still must be worked down before construction and growth resume in this market. Given that some existing homes have likely been pulled off the market in light of slower sales and moderating housing prices, this inventory correction period will probably continue into 2008. I think this is particularly true in markets such as Florida, as First Vice President Barron mentioned, where a large amount of speculative investment occurred during the boom period—with three to five years of excess construction from the investor side. So those homes still have to be worked through. Asset quality in the consumer sector as a whole is very good. We have come through one of the most benign periods. The exception, as Bill mentioned in his presentation earlier today, is the subprime market. When you dissect it, you see that prime mortgage delinquencies are flat and subprime mortgages at a fixed rate are flat. The whole problem is in subprime ARMs, which are running into difficulties. The four federal regulatory agencies are looking harder at some of these subprime products. We started reviewing 2/28 mortgages, and now we’re looking at and testing some other products. We’re finding that the issues are getting more troublesome the further we dig into these products. To put the situation in perspective, subprime ARMs are a very small part of the whole mortgage market. As Vincent mentioned, subprime is about 13 percent, and the ARM piece of the subprime is about half to two-thirds, so we’re talking perhaps around 8 percent of the aggregate mortgages outstanding. We’re seeing that the borrowers who got into these during the teaser periods now are seeing tremendous payment shocks. For example, 2/28s that are going from the fixed two-year period to the adjustment period basically had their interest rates double, so they’re going from a 5 percent handle to a 10 percent handle, and the borrowers don’t have the discretionary income to absorb that. This type of mortgage was sold to a lot of subprime borrowers on the idea that they are lending vehicles to repair credit scores. You will show that you are going to pay during the early period, and then you can refinance and get a lower long-term rate, so you’ll never pay the jump. But we’re finding that some of these mortgages have significant prepayment penalties, and so to refinance and get the better terms, some borrowers are getting into difficulty. Because of the moderation in housing prices, these borrowers haven’t built up enough equity to absorb the prepayment penalty. So the problem stems from a combination of factors. There are a lot of spins on these products, but we’re trying to take an approach based on principles in looking at what’s really happening. I also want to mention that, although the ownership of the mortgages is very diffuse and so we’re not seeing any real concentrated risk, particularly in banking, we do need to pay more attention to where the mortgage-servicing exposures are. The servicing of these mortgages that are securitized is concentrated in certain institutions. Clearly, when you have such a high level of delinquencies and potential defaults, all profitability in servicing is gone. So there could be some charge-offs in these securitized mortgages. Also, I think all of you have noticed the number of mortgage brokers that have closed up shop in the past six months because they couldn’t get enough liquidity or capital to repurchase the early defaults of these recent pools. That is really shrinking the origination pocket. I should also say that, with the exception of the subprime ARM mortgages, we feel very good about overall credit quality. When I look at the economy as a whole, I also see that except for housing construction and autos, the rest of the economy is sound. The recent growth in employment and the strong wage growth give me comfort that the income growth of consumers is there to mitigate some of the wealth effects that we may have with moderating housing prices. But I also share the concerns that some of you mentioned here, and that President Yellen spoke of in a speech, about the issue regarding productivity trends and wage growth, and determining how fast the economy is growing. Productivity is going to have to grow faster to absorb the higher wage growth, particularly as employment growth continues strong, and I think the slack in the skilled labor force is getting very, very limited. When I think, in aggregate, about the data since our last meeting, I feel a little better about inflation because it appears to be moderating, but I’m not jumping for joy because we need a few more months. However, the growth information has been, instead of mixed as at the last meeting, generally stronger, and that does make me feel better. In net, then, based on the recent information, I’m even a bit further along on the side that the risks have moved higher for inflation than on the side of the risk of a slowdown in the economy. Thank you, Mr. Chairman." CHRG-111shrg61513--15 Mr. Bernanke," Well, we believe that the underlying trend of inflation, given stable expectations, given a very weak economy, looks to be subdued. Of course, we monitor energy and commodity prices very closely and they can vary substantially depending, for example, on the strength of the global recovery. Recently, energy prices have been roughly stable and futures prices don't indicate an expectation of sharp increases in the near term. So, again, we will continue to monitor energy prices, but currently, at least, they are not presenting a major inflationary threat. The very high vacancy rates in rental properties are keeping rents down, as well as vacancies in homes, as well, and our anticipation is that shelter costs are going to remain quite subdued for some time. Senator Johnson. Senator Shelby. Senator Shelby. Thank you. Chairman Bernanke, this Committee continues, as you well know, to wrestle with financial reform and the role of the Fed has been a significant part of that debate, as you are well aware. Chairman Dodd has previously proposed stripping the Fed of its regulatory authority, allowing you and your colleagues to focus on your monetary policy, lender of last resort, and payment systems functions and so forth. On the other hand, some on the Committee have argued in favor of allowing the Fed to retain some type of regulatory authority over the largest institutions, perhaps some of the others. What do you see--how do you see such an approach, as a net positive or a net negative here, and what would you do as Chairman of the Board of Governors of the Fed if the will of the Congress was to give the Fed another opportunity to be a regulator? What would you change, considering all the problems that were had in the last 7 years in the regulatory process? " CHRG-111hhrg51698--432 Mr. Morelle," Well, thank you Congressman. I just would point out, as I mentioned in my testimony, that if you look at AIG from the perspective of the state-regulated companies, AIG has many state-regulated insurance subsidiaries. In New York alone, the property and casualty companies that come under AIG have roughly a $20 billion surplus that is robust, policyholders have been protected, and the experience has been similar in other states. And to Congressman Marshall's point earlier about regulatory arbitrage, I will respond in writing and I appreciate the question because it is an important one. But I do note that the experience was similar across other states in the countries that have subsidiaries of AIG. You contrast that with the financial services arm of AIG, unregulated, and by virtue of the Commodity Futures Modernization Act unregulated by the states and by the Federal Government. Their great exposure to credit default swaps in particular and their inability to manage risk, as Mr. Pickel indicates, the lack of ability to be able to quantify risk, and obviously other mark-to-market rules, et cetera, exacerbated their problem. To me that serves as a great contrast between those that take seriously the notion of financial guaranty and underwriting standards, et cetera, and the unregulated marketplace. I would just say in closing, it is also noteworthy that under state regulations, we would not allow in New York, for instance, or any other state, the surpluses at the regulated subsidiaries to flow upward to provide support for AIG's financial services company, because it would have jeopardized the financial commitments that they had made to policyholders, and we hold that very dear at the state level. " FinancialCrisisReport--33 Conflicts of Interest. Credit rating agencies are paid by the issuers seeking ratings for the products they sell. Issuers and the investment banks want high ratings, whether to help market their products or ensure they comply with federal regulations. Because credit rating agencies issue ratings to issuers and investment banks who bring them business, they are subject to an inherent conflict of interest that can create pressure on the credit rating agencies to issue favorable ratings to attract business. The issuers and investment banks engage in “ratings shopping,” choosing the credit rating agency that offers the highest ratings. Ratings shopping weakens rating standards as the rating agencies who provide the most favorable ratings win more business. In September 2007, Moody’s CEO described the problem this way: “What happened in ’04 and ’05 with respect to subordinated tranches is that our competition, Fitch and S&P, went nuts. Everything was investment grade.” 50 In 2003, the SEC reported that “the potential conflicts of interest faced by credit rating agencies have increased in recent years, particularly given the expansion of large credit rating agencies into ancillary advisory and other businesses, and the continued rise in importance of rating agencies in the U.S. securities markets.” 51 Mass Downgrades. The credit ratings assigned to RMBS and CDO securities are designed to last the lifetime of the securities. Because circumstances can change, however, credit rating agencies conduct ongoing surveillance of each rated financial product to evaluate the rating and determine whether it should be upgraded or downgraded. Prior to the financial crisis, the numbers of downgrades and upgrades for structured finance ratings were substantially lower. 52 Beginning in July 2007, however, Moody’s and S&P issued hundreds and then thousands of downgrades of RMBS and CDO ratings, the first mass downgrades in U.S. history. From 2004 through the first half of 2007, Moody’s and S&P provided AAA ratings to a majority of the RMBS and CDO securities issued in the United States, sometimes providing AAA ratings to as much as 95% of a securitization. 53 By 2010, analysts had determined that over 90% of the AAA ratings issued to RMBS securities originated in 2006 and 2007 had been downgraded to junk status. 54 48 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 18-19. (See Chapter V below.) 49 “Revenue of the Three Credit Rating Agencies: 2002-2007,” chart prepared by the Subcommittee using data from http://thismatter.com/money, Hearing Exhibit 4/23-1g. 50 9/10/2007 Transcript of Raymond McDaniel at Moody’s MD Town Hall Meeting, Hearing Exhibit 4/23-98. 51 1/2003 “Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets,” prepared by the SEC, at 40. The report continued: “[C]oncerns had been expressed that a rating agency might be tempted to give a more favorable rating to a large issue because of the large fee, and to encourage the issuer to submit future large issues to the rating agency.” Id. at 40 n.109. 52 See, e.g., 3/26/2010 “Fitch Ratings Global Structured Finance 2009 Transition and Default Study,” prepared by Fitch. 53 See “MBS Ratings and the Mortgage Credit Boom,” Federal Reserve Bank of New York Staff Report no. 449, May 2010, at 1. 54 See, e.g., “Percent of the Original AAA Universe Currently Rated Below Investment Grade,” chart prepared by BlackRock Solutions, Hearing Exhibit 4/23-1i. See also 3/2008 “Understanding the Securitization of Subprime Mortgage Credit,” Federal Reserve Bank of New York Staff Report no. 318, at 58 and chart 31 (“92 percent of 1st- CHRG-111hhrg51698--309 Mr. Pickel," Thank you, Chairman Peterson, Ranking Member Lucas, and Members of the Committee. Thank you again for asking us to testify before this Committee, this time regarding the Derivatives Markets Transparency and Accountability Act of 2009. It is worth noting at the outset that OTC derivatives have continued to perform their important risk management function during the current market turmoil. It is our hope that policymakers will keep in mind the relative health of OTC derivatives throughout the market downturn as you consider measures which might profoundly change the way these markets function. As I noted before this Committee in December, the roots of the current global financial crisis lie in imprudent decisions, particularly with respect to residential housing. OTC derivatives were not the cause of the current financial crisis. OTC derivatives have remained available, despite the recent market turmoil. This has enabled companies to hedge risk that would have had a significant adverse financial impact on them, but for a well-functioning OTC derivatives market. Parties to OTC derivatives have received the benefit of their bargain, and the legal certainty provided by the Commodity Futures Modernization Act is a big reason for this. OTC derivatives serve a very valuable purpose. They allow companies to manage risks like interest rate risk, foreign exchange risk, commodity price risk and credit risk. The financial system and the economy as a whole are stronger and more resilient because of OTC derivatives. OTC derivatives are a way for businesses to obtain protection against market events that they cannot control. Despite many claims to the contrary, it is also worth remembering that the overwhelming majority of OTC market participants use collateral to protect themselves against loss. The Agriculture Committee has a great deal of experience with the OTC derivatives market. Going back to the earliest days of OTC derivatives, this Committee helped create the framework for legal certainty which underpins the health and success of the U.S. OTC derivatives business. This legacy of leadership has helped create a thriving, vibrant risk management industry, which even today, amidst the global financial meltdown, continues to employ thousands of Americans and provide tax revenue to states and the Federal Government. However, portions of this bill would severely harm these markets and prevent them from functioning properly in the United States, while also impairing the ability of American companies to hedge their risk. More importantly, the consequences of certain of the provision of this bill would harm many mainstream American corporations. Many American corporations use OTC derivatives to hedge their cost of borrowing or the operating risks of their business. Many of those who do business overseas need to hedge their foreign currency exposure. Some American corporations may also hedge their commodity or credit exposure. The current wording of the bill would have a disastrous effect to the large majority of these corporations by taking away risk management tools that American corporations use in the day-to-day management of their business. Regarding some specific provisions of the legislation, let me make the following comments: Section 6 would effectively eliminate the hedge exemptions for entities which use the futures market to gain exposure to certain asset classes, or which facilitate risk management by other entities which cannot or choose not to use the futures markets. The effect of this provision would be to severely limit the use of the hedge exemption and thus access to the futures markets. This would likely result in more costly hedging, increased volatility, reduced liquidity and a deterioration in the price discovery function of futures markets. Section 11 of the bill authorizes the CFTC to impose position limits on OTC transactions if the agency determines that transactions have a potential to disrupt a contract traded on a futures markets or the underlying cash market. There is a lack of credible evidence or academic studies to support the proposition that derivatives markets cause imbalance in cash markets. In addition, this provision allows the CFTC to order otherwise regulated institutions such as banks and broker dealers to terminate their privately negotiated contracts. This provision effectively gives the CFTC the authority to cancel OTC derivative contracts. We have also concerns about the mandatory clearing provisions of section 13. Clearing can provide benefits and in appropriate cases should be encouraged. However, it is not clear what justification there is for a requirement that all OTC contracts should be cleared. To the contrary, since the advent of the OTC derivatives market, bilateral credit arrangements have been used to settle contracts smoothly and efficiently. There is simply no evidence suggesting anything other than the bilateral credit arrangements contained in standard ISDA documentation work extremely well. Finally, section 16 makes it unlawful to enter into a credit default swap unless the person entering into the transaction would experience a financial loss upon the occurrence of a credit event. This provision would effectively eliminate the credit default swap business in the United States. This provision would mean that a dealer could not hedge its risks. Therefore, the only participants in the CDS market would be counterparties which each had perfectly matched risk which they had sought to hedge. The number of such persons is likely to be extremely small. In conclusion, OTC derivatives markets play an important role in the U.S. and world economy. Despite exaggerated reports to the contrary, they did not cause the market meltdown and, in fact, have helped mitigate the effect of the downturn for many institutions. OTC derivatives remain an essential element in returning our financial system to full health, and harming these markets is not in keeping with that goal. This Committee is to be commended for addressing these questions and seeking answers to help set right our economy. But to the extent oversight of OTC derivatives markets need review and reform, it should be part of a larger dialogue on reform of the financial system in general. I look forward to your questions, and I thank you for inviting us today. [The prepared statement of Mr. Pickel follows:] Prepared Statement of Robert G. Pickel, Executive Director and CEO, International Swaps and Derivatives Association, New York, NY Mr. Chairman and Members of the Committee: Thank you very much for allowing ISDA to testify at this hearing regarding the ``Derivatives Markets Transparency and Accountability Act of 2009''. We are grateful to the Committee for seeking a broad range of views as it considers legislation addressing the bilaterally negotiated or OTC derivatives industry. It is worth noting at the outset that these markets have continued to perform their important risk management function during the current market turmoil. It is our hope that policymakers will keep in mind the relative health of OTC derivatives throughout the market downturn as you consider measures which might profoundly change the way these markets function.About ISDA ISDA, which represents participants in the privately negotiated derivatives industry, is the largest global financial trade association, by number of member firms. ISDA was chartered in 1985, and today has over 800 member institutions from 56 countries on six continents. These members include most of the world's major institutions that deal in privately negotiated derivatives, as well as many of the businesses, governmental entities and other end users that rely on over-the-counter derivatives to manage efficiently the financial market risks inherent in their core economic activities. Since its inception, ISDA has pioneered efforts to identify and reduce the sources of risk in the derivatives and risk management business. Among its most notable accomplishments are: developing the ISDA Master Agreement; publishing a wide range of related documentation materials and instruments covering a variety of transaction types; producing legal opinions on the enforceability of netting and collateral arrangements; securing recognition of the risk-reducing effects of netting in determining capital requirements; promoting sound risk management practices; and advancing the understanding and treatment of derivatives and risk management from public policy and regulatory capital perspectives. ISDA continues to provide clarity and certainty to the risk management industry through our collaborative initiatives with market users and policymakers worldwide.OTC Derivatives and the Current Market Turmoil As I noted before this Committee in December, the roots of the current global financial crisis lie in imprudent lending decisions, particularly with respect to residential housing but also extending to other areas including consumer receivables, auto finance and commercial development. These imprudent decisions were reinforced by credit ratings of securities composed of these loans which proved to be grossly overconfident, and by faulty risk management practices of some of the institutions investing in those securities. These securities should not be confused with derivatives. One thing that should by now be clear is that OTC derivatives were not the cause of the current financial crisis. In fact, had the Commodity Futures Modernization Act of 2000 (CFMA) not been passed we would find ourselves in exactly the same financial crisis we are in today. Indeed the crisis might be worse, as the CFMA created legal certainty for OTC derivatives and thus allows market participants to hedge risk through privately negotiated risk management contracts. It is worth noting that the OTC derivatives market has continued to function despite the recent market turmoil. This has enabled companies to hedge risks that, without a well functioning OTC derivatives market, would have had a significant adverse financial impact on them. The derivatives markets have remained open and liquid and fulfilled their hedging purposes while other asset prices have collapsed. OTC derivatives serve a very valuable purpose: they allow companies to manage risks, like interest rate risk, foreign exchange risk, commodity price risk and credit risk. The financial system and the economy as a whole are stronger and more resilient because of OTC derivatives, and those that disparage their use, or confuse them with asset backed securities and collateralized debt obligations (or CDOs, an acronym that leads to some confusion with the straightforward credit derivative instrument CDS) which have proved illiquid and difficult to value in the current crisis, threaten to damage a sector of the financial services industry that remains healthy. Some point to the large outstanding notional value of OTC derivatives as somehow representing a source of concern. It is important to understand first that notional values represent an underlying quantity upon which payment obligations are calculated. For example two parties may agree to an interest rate swap with a notional value of $10 million. Under that contact one party will pay to the other a fixed rate of interest on that $10 million, while the other will pay a floating rate of interest on that same amount. At no point do the parties exchange $10 million, and at no point is $10 million dollars at risk. Nevertheless, when referring to notional amounts of OTC derivatives, that is precisely what people are doing: notional amount refer to hypothetical amounts of money, not money that is actually at risk. However there is an even more fundamental point to be made about notional amounts: to the extent they represent actual money at risk, they are representing risk that is being hedged. Notional figures indicate how much protection parties have purchased against some underlying, uncontrollable risk. In general policymakers have concluded that encouraging risk management is sound public policy, and so it would seem to still be the case today. OTC derivatives are a way for businesses to obtain protection against market events that they cannot control. It is also worth remembering that the overwhelming majority of OTC market participants are collateralized to protect themselves against loss. Standard industry practice requires counterparties to secure one another against the possibility that the other party will fail to make its required payments. The ability to access this collateral in the event of default is protected under Federal law, and this has proved to be an important way to minimize the fallout of insolvency in the current market.The Draft Bill The Agriculture Committee has a great deal of experience with the OTC derivatives market. Going back to the earliest days of OTC derivatives this Committee helped create the framework for legal certainty which underpins the health and success of the U.S. OTC derivatives business. The Futures Trading Practices Act of 1992 gave the CFTC exemptive power and directed the agency to use this authority to exempt swap agreements. When the Commission acted in ways which called into question the viability of that exemption this Committee adopted an amendment in the 1999 Agricultural and related agencies appropriations act which reinforced the enforceability of OTC derivatives and prevented the CFTC from challenging their exemption under the law. In 2000, of course, this Committee led the way in adopting the Commodity Futures Modernization Act which most clearly established the legal framework for the U.S. OTC markets. And as recently as last year this Committee reaffirmed that framework when it passed the CFTC Reauthorization Act of 2008. This legacy of leadership has helped create a thriving, vibrant risk management industry which even today, amidst the wreckage of the global financial meltdown, continues to employ thousands of Americans and provide tax revenue to the states and Federal Government. However portions of this bill would severely harm these markets and prevent them from functioning properly in the United States while also impairing the ability of American companies to hedge their risks. More importantly the consequences of certain of the provisions of this bill would harm many mainstream American corporations. Many American corporations use OTC Derivatives to hedge their cost of borrowing or the operating risks of their business. Many of those who do business overseas need to hedge their foreign currency exchange rate exposure. Some American corporations may also hedge their commodity or credit exposure. The current wording of the bill would have a disastrous effect for the large majority of these corporations by taking away basic risk management tools that American corporations use in the day to day management of their of business. Below are a few selected provisions of the legislation which bear particular mention:Section 6: Trading Limits This section requires the CFTC to establish position limits for all commodity futures contracts traded on an exchange or exempt commercial market which offers significant price discovery contracts. These position limits would be required to be established for all commodities, including financial commodities. As an initial matter we question whether it is necessary to establish position limits for financial commodities given that the markets are broad, liquid and have an effectively limitless supply. The section would effectively eliminate the hedge exemption for entities which use the futures market to gain exposure to certain asset classes, or which facilitate risk management by other entities which cannot or choose not to use the futures markets. The effect of this provision would be to severely limit the use of the hedge exemption and thus access to the futures markets. This would likely result in more costly hedging, increased volatility, reduced liquidity and a deterioration in the price discovery function of futures markets. It is also of note that this provision is based on the unproved, and if several credible studies are to be believed disproved, theory that speculation creates higher prices.Section 11: Over-the-Counter Authority This provision authorizes the CFTC to impose position limits on OTC transactions if the agency determines that the transactions have the potential to disrupt a contract traded on a futures market, or the underlying cash market. As stated above, there is a lack of credible evidence or academic studies to support the proposition that derivatives markets cause imbalances in cash markets. Supply and demand inexorably determine prices. In addition, this provision allows the CFTC to order otherwise regulated institutions such as banks and broker/dealers to terminate their privately negotiated contracts. This seems to represent an unwarranted intrusion into the jurisdiction of other Federal regulators. Lastly, as OTC derivatives contracts are privately negotiated agreements between two counterparties this provision effectively gives the CFTC the authority to cancel private contracts. This fundamentally undermines legal certainty, would make it difficult for parties to calculate how much capital to hold against such contracts and would likely cause a significant decrease in OTC activity.Section 13: Clearing This section requires that all currently exempted and excluded OTC transactions must be cleared through a CFTC regulated clearing entity, or an otherwise regulated clearinghouse which meets the requirements of a CFTC regulated derivatives clearing organization. The provision gives the CFTC the authority to provide exemptions from this requirement provided that the transaction is highly customized, infrequently traded, does not serve a significant price discovery function and is entered into by financially sound counterparties. Clearing can provide benefits and in appropriate cases should be encouraged. However it is not clear what justification there is for a requirement that all OTC derivatives should be cleared. To the contrary, since the advent of the OTC market bilateral credit arrangements have been used to settle contracts smoothly and efficiently. These arrangements have been supported by Federal law and policy, which promotes netting and close-out of bilateral agreements in the event of the bankruptcy of a counterparty. These arrangements have been tested both in the market and in the courts and have been successfully used to settle thousands of OTC trades. During the current market turmoil we have witnessed the failure or default of a major OTC dealer (Lehman Bros.), two of the largest issuers of debt in the world (Fannie and Freddie), and a sovereign country (Ecuador). Indeed, on an almost weekly basis there are failures which call into action the carefully crafted settlement provisions of ISDA documentation. In every case the contracts have settled according to their terms and according to market expectations, with net settlements changing hands being much smaller than media pundits had anticipated (in Lehman's case, approximately $5bn changed hands in respect of CDS contracts). There is simply no evidence suggesting anything other than that the bilateral credit arrangements contained in standard ISDA documentation work extremely well. While clearing should be encouraged, and market participants continue to work with Federal and international regulators to create a viable clearing solution for OTC derivatives, mandating clearing of all OTC derivatives is unwarranted.Section 16: Credit Default Swaps This provision makes it unlawful to enter into a CDS unless the person entering into the transaction would experience a financial loss upon the occurrence of a credit event. This provision would effectively eliminate the CDS business in the United States. As written the provision would make it impossible for sellers of protection to hedge their own risks. Most dealer firms, which by and large are federally regulated banks, run a hedged portfolio which seeks to minimize their losses in the case of a loss on a particular contract. Thus for CDS, a dealer firm will seek to ensure that if it has to pay out protection under a CDS contract it will within its own portfolio have a hedged position to minimize its loss. This provision would mean that a dealer could not hedge its risks. Therefore the only participants in the CDS market would be counterparties which each had perfectly matched risks which they sought to hedge. The number of such persons is likely to be extremely small. This provision would also have the effect of turning all CDS into insurance contracts as it requires parties to a CDS to show a loss. As such under most state insurance statutes a party to a CDS would be required to be regulated by state insurance law, thus bringing federally regulated institutions under the authority of local state authorities. As noted above this provision would effectively end the CDS business in the U.S. As noted in this testimony and elsewhere the credit derivatives market has continued to function throughout the downturn, providing a way for market participants to hedge credit risk and express a view on market conditions. Limiting access to credit derivatives would create disincentives to lending at a time when Federal authorities are seeking to promote lending in order to restart the economy. It is difficult to see what public purpose would be served by destroying these currently healthy and important markets.Conclusion OTC derivatives markets play an important role in the U.S. and world economy. Despite hyperbolic reports to the contrary they did not cause the market meltdown, and in fact have helped mitigate the effect of the downturn for many institutions. To the extent some participants in the markets have suffered losses related to derivatives, or failed to adequately secure themselves or their counterparties against the possibility of losses, this reinforces the need for sound risk management practices and a careful review of the actions of regulators charged with overseeing these institutions. OTC derivatives remain an essential element in returning our financial system to full health, and harming these markets is not in keeping with that goal. This Committee is to be commended for addressing these questions and seeking answers to help right our economy. But to the extent oversight of OTC derivatives markets needs review and reform it should be part of a larger dialogue on reform of the financial system in general. Acting hastily is likely to have unintended consequences and prove counterproductive. " FinancialCrisisInquiry--62 In the consumer area—and there are other people here who have consumer businesses— clearly, all that’s been written about origination and Jamie referred to stated income without tests, and I’m sure he can pick up that cudgel and talk about on the consumer side. On the more corporate side, I would say it had to do with leverage and it had to do with terms, covenants, conditions. The markets got more competitive. There was a sense that the world had a lot of liquidity. And so the commodity of money got less scarce and people paid less attention to it. BLANKFEIN: And as a consequence, people were lending to support transactions, which is a business that we’re very familiar with, that had more multiples of debt for the equity and the conditions that applied—the covenants, the maintenance, the things that allowed a lender to intervene in the company became more and more lax, and so you could intervene less. So that lack of rigor on the—on the transactional side I think had its counterpart in the consumer side and in the commercial lending side, which others here are more familiar with. HOLTZ-EAKIN: Were you aware of this at the time? Did you see the standards going down? And if so, how did you highlight this in your risk management? BLANKFEIN: In all honesty, we did—we did know. You cannot miss the fact that the covenants are getting a little lighter and that the leverage is getting bigger. With the benefit of hindsight, I wish I weren’t in the position of having to explain it. But at the time, I know we all rationalized the way a lot of people—other people—have rationalized. “Gosh, the world is getting wealthier. Technology has done things. Things are more efficient. Interest—there’s no inflation. Things belong low. These businesses are going to do well.” And I think we talked—much of the world did—talked yourself into a—into a place of complacency, which we should not have gotten ourselves into and which, of course, after these events, will not happen again in my lifetime, as far as I’m concerned. CHRG-111shrg50814--105 Mr. Bernanke," Well, inflation is primarily the responsibility of the Federal Reserve and we consider that to be a critical element of our mandate. Our view is that over the next couple of years, inflation, if anything, is going to be lower than normal, given how much commodity prices have come down, given how much slack there is in the economy. When the economy begins to recover, it is important that we raise interest rates and do what is necessary to prevent an overheating that would lead to inflation down the road, and as I have mentioned, we are confident that we can do that. Every time we use our balance sheet to try to support the economy, we are thinking about how can we unwind that in a way that will be kindly and allow us to take the actions we need to take. That is a somewhat separate issue from the debt issue. It seems to be, at least for now, that the dollar and U.S. debt are still very attractive around the world and there is a lot of demand for holding our Treasuries. That said, it is self-evident that we can't run trillion-dollar deficits indefinitely. It is going to be very important, as we emerge from the crisis and begin to go into a recovery stage, that we get control of the fiscal situation and begin to bring down the deficit to a sustainable level. So I agree with you that we do need to address that issue. For the moment, foreign demand for U.S. securities is strong, but you are absolutely right. If we don't get control of it, eventually, they are going to lose confidence. Senator Hutchison. Let me shift to the issue that many of us have talked about and that is getting credit into the marketplace. Because the balance sheet of the banks has gone up so much now, holding their reserves in the Fed, and you are still paying interest to the banks, do you think that is having an impact on banks leaving their money in the Fed to get interest and having the reverse effect on what we all want, which is getting credit out into the marketplace? " FOMC20080916meeting--151 149,MR. KOHN.," Thank you, Mr. Chairman. I think that, even before the recent intensification of financial market turmoil, there were trends becoming increasingly evident over the summer, since late June, that suggested that the economy was on a substantially slower path than it had been before. Resource utilization was falling appreciably, and the expected downward path of inflation in the future had much better odds of occurring. Indeed, I think that the expected weakness in the economy and the financial markets are interacting. We have one of these feedback loops in play. There has been a lot of concern not only in the United States but in other countries as well, as I heard in Basel last weekend, about a spillover--that the problems were not confined to the mortgage markets but were spilling into the loan books of the banks. That was related to the weakening in economic activity and was tightening up credit conditions, which would, in turn, further weaken economic activity. So this feedback loop was at work certainly in the United States and was beginning to be felt a little more in other countries as well. Since late June we have come to know a couple of things a little better. One is that consumption is not immune to soft labor markets, increases in energy prices, declining housing wealth, and tighter borrowing conditions. Even if we can't parse out the effects of each of these factors, consumption has weakened substantially. We have had three months in a row of declines in the retail control component and very weak auto sales. Although recent declines in oil prices will support disposable incomes and consumption, I think the other sources of restraint on households-- declining house prices and tighter credit conditions--are more likely to intensify than to abate in coming quarters. Another thing we know is that businesses have not gotten ahead of their need to shed labor, and they continue to trim staff in response to actual and expected weakness in demand. The decline in employment shows no signs of abating. Initial claims are running more than 50,000 higher than they were at the end of June, and they have remained elevated past the time that the introduction of the temporary extended benefits should have been felt. The unemployment rate is already � percentage point higher than anyone around this table predicted for the end of the year. The household survey, along with national income statistics, could be signaling greater softness in activity and higher output gaps than is evident in the GDP and spending data. Another thing we have learned, as Nathan emphasized, is that foreign economies have not decoupled from the United States, and their prospects have been revised down substantially. They're absorbing the effects of weaker U.S. domestic demand on their exports, and growing risk aversion in financial markets is spreading abroad. The latter, the growing risk aversion, is beginning to have, as Chris Cumming was noting, effects on a number of emerging-market economies, where capital inflows show signs of abating or even reversing; and indicators of financial stress have risen as a consequence of all this. Because of the stronger dollar, we will be able to rely less on exports going forward than we did before. We never expected a rapid return to more normal financial market functioning, but the adjustment in the financial sector now looks to be more severe and to take longer than we thought before. Financial firms need to bolster profits to offset losses and track capital. They need to delever by reducing debt relative to equity. They need to consolidate, and above all, they need to protect themselves against the possibility of a run. All of this implies a prolonged period of very cautious lending and a high cost of capital for borrowers relative to benchmark interest rates. If the current severe financial situation persists, I think the flight to safety and liquidity could dry up credit to a broad array of all but the very safest borrowers and reduce asset prices with feedbacks on spending, and that feedback loop could intensify if these market conditions pertain. I think that's a substantial downside risk to the growth outlook. Not all news affecting spending has been negative. Capital goods orders have held up. The decline in interest rates and commodity prices that respond to the markdown in global growth will help support domestic demand, and actions to stabilize the GSEs are helping the mortgage market. Activity is more likely to stagnate than to decline. But I think that we can be more certain than we were, say, at the end of June that the economy will move substantially away from our high employment objective over the next several quarters and that the downside risks to that are larger. On the inflation side, incoming data have been disappointing, a little worse than anticipated, perhaps suggesting greater pass-through. The rise in import prices at the beginning of the third quarter was higher than anticipated. But we've also learned over the last couple of months that oil and other commodity prices can go down as well as up. The drop in retail energy prices helped to reverse much of the run-up in inflation expectations at the household level and reduced inflation compensation in financial markets at least over the next five years. Weaker economies, along with lower commodity prices, are expected to reduce inflation in our trading partners, and that along with the dollar should lower import price inflation. The broadest measures of labor compensation available through the second quarter continue to suggest no upward pressure on the pace of increases in nominal labor costs. Despite elevated headline inflation, surprisingly good growth of productivity is holding down unit labor costs. Taking all of this together, I think that, despite the incoming inflation data, we can have greater confidence in our forecast that inflation will decline late this year and run much lower in the next few years than in the past year or so, though the risks to that still lie on the upside until we actually see the decline in headline inflation persist. On policy, Mr. Chairman, I support alternative B, keeping the funds rate at 2 percent. I think that, at least for now, is consistent with lower inflation and a slow return to full employment in the future over time. We need to assess the effects of the financial turmoil. If asset price declines accelerate and the tightening of financial conditions is large and likely to be sustained, I would be open at some point in the future to a lowering of interest rates. Thank you, Mr. Chairman. " CHRG-111hhrg74855--329 Mr. Markey," Thank you so much. We appreciate it, Mr. Duane. The chair will now recognize himself for some questions. Ms. Moler, your position is that FERC should have exclusive authority over RTO products and services. That is a much more aggressive position then Mr. Waxman and I and Mr. Upton and Mr. Barton have taken. We basically say lets preserve FERC's authority and where there is overlapping authority, let the FERC and the CFTC work it out. Why is your approach better in your opinion? Ms. Moler. My concern is born of the language in the bills that have gone through the two other committees. Under the Commodity Exchange Act, if the CFTC has jurisdiction over a transaction, it supplants other agencies' jurisdictions. They have exclusive jurisdiction and I do not understand having negotiate a number of Memoranda of Understanding when I was at FERC and when I was Deputy Secretary of Energy how one agency that has preemptive authority over transactions that are currently regulated by another agency, how those two agencies can successfully negotiate a Memorandum of Understanding. So if you give the CFTC authority over or if they claim authority over things like Financial Transmission Rights, that trumps FERC's authority and FERC's ability, at least arguably, and FERC's ability to allocate transmission rights and the like, and I worry about that. I understand that they have under the Energy Policy Act of 2005, authority to look at fraud and manipulation but they wouldn't have anything to do with those transactions. That is why I am not as comfortable with the MOU approach. " Mr. Markey," OK, great. Mr. English, what would be the practical impacts on consumers and your members if FERC's authority over Financial Transmission Rights and other RTO products were eliminated as a result of the pending bill? " CHRG-110hhrg44901--25 Mr. Bernanke," Congressman, I couldn't agree with you more that inflation is a tax and that inflation is currently too high, and it is a top priority of the Federal Reserve to run a policy that is going to bring inflation to an acceptable level consistent with price stability as we go forward. I would make one distinction, which is that what the Federal Reserve can control is the increase in prices on the average, over the overall basket of consumer goods and services. The enormous jumps in oil prices and other commodity prices are to some extent at least due to real factors out of the control of the Federal Reserve. The Federal Reserve cannot create another barrel of oil. It is the global supply and demand conditions which are affecting those particulars things to the most significant extent, but to the extent that the Fed does have influence on the overall inflation rate, you are absolutely right that it is very important to maintain price stability, and I take that very seriously. Dr. Paul. But if the oil prices were going up for another reason other than monetary reasons, other prices would have to come down because there would be a limit in the money supply. I think--and the prices are going up today, like I indicated in my opening statement, not necessarily because of the monetary policy of the last year but maybe for the last 15 or 20 years and the fact that we were able to export, so to speak, our inflation. Now it is coming home. Those people who have been holding these dollars are not wanting to buy them as readily. Fortunately, foreign central banks are still not dumping them but even the other central banks might not be as cooperative. So I still see tremendous pressure. I don't see any signs that you are able to do very much because all we hear about is more inflation. You know, it is not so much that they are too big to fail. It just means that everybody needs to be propped up. Congress participates in it. And all the pressure is put on the dollar. It is a dollar bubble. And I think what we are seeing is the unraveling of a dollar bubble that had been building for more than 35 years. " FOMC20080318meeting--38 36,MR. SHEETS.," The global economy has likewise seen some extraordinary developments during the intermeeting period. Notably, the spot price of WTI has surged more than 15 percent, briefly reaching $110 per barrel, and many nonfuel commodities prices have moved up by similar magnitudes. The exchange value of the dollar, which had been relatively stable since November, has returned to a depreciating path, falling more than 5 percent against the major currencies since midFebruary and reaching a post�Bretton Woods low. The global financial stresses that began last summer have further intensified. Also, as Dave has outlined, recent data suggest that the U.S. economy has continued to weaken. Nevertheless, not all the news from the foreign sector has been grim. Indeed, given the shocks that have materialized, the foreign economies appear to be showing somewhat more resilience than we would have expected. Total foreign real GDP growth in the fourth quarter of last year stepped down to 3.2 percent from the rapid 4.5 percent rate that had prevailed through the previous three quarters, as the pace of activity slowed in both the advanced economies and the emerging market economies. This fourth-quarter out-turn, however, was about � percentage point stronger than we had expected, reflecting an upside surprise in the emerging markets. Available indicators of first-quarter activity paint a mixed picture. In the euro area, economic sentiment fell in February for the ninth consecutive month, but the purchasing managers index for the services sector and the German IFO index of business conditions picked up. In addition, industrial production and retail sales posted stronger readings in January. The ECB's bank-lending survey indicates a tightening of lending standards, but measures of bank credit to the corporate sector have continued to expand. Indicators of activity in the United Kingdom have also been mixed. Consumer confidence in February slid to a five-year low, but business confidence and conditions in the services sector have been more upbeat. In emerging Asia, while the impetus from external demand is clearly diminishing, Chinese retail sales have continued to grow robustly; industrial production in Korea, Singapore, and Taiwan moved up in January; and domestic consumption in the ASEAN countries has remained solid. Taken together, these data seem to indicate that growth abroad has cooled but has not stalled. Our forecast thus seeks to balance several offsetting considerations. On the one hand, the projection for U.S. growth this year has been cut by a sizable 1� percentage points; this has particularly stark implications for countries like Canada, Mexico, and some in emerging Asia that have close trade ties with the United States. The further deterioration in global financial conditions should also weigh on activity abroad. On the other hand, the incoming data suggest that the foreign economies are not yet following the United States into recession, and the red-hot commodities markets also lead us to believe that activity is holding up in some corners of the world. Weighing these factors, we have cut our forecast for total foreign growth in 2008 to 2.3 percent, down from 2.9 percent in the last Greenbook, with much of this markdown reflecting softer growth in Canada and Mexico. Our projections for emerging Asia have also been reduced, but we see these economies still expanding at a moderate pace. Clearly, there are both upside and downside risks around this forecast. On the downside, the adverse spillovers from the U.S. slowdown and continued financial stresses may be more severe and more broadly felt than we envision. On the upside, the apparent resilience in foreign demand to date suggests the possibility that growth abroad may hold up better than we now expect. In 2009, foreign growth is projected to rebound to 3� percent, in line with the expected easing of global financial stresses and economic recovery in the United States. With commodities prices increasing sharply, foreign inflation has continued to rise. Notably, in the euro area, 12-month headline consumer price inflation climbed to 3.3 percent in February, well above the ECB's 2 percent ceiling, driven up by food and energy prices. In China, 12-month inflation in February surged to 8.7 percent, at least in part reflecting sharp increases in food prices due to severe winter weather. In an effort to temper these pressures, the Chinese authorities have introduced temporary price controls for some basic necessities and this morning announced plans to raise reserve requirements another 50 basis points. We now see average foreign inflation in 2008 as coming in at around 3� percent, up � percentage point from the last Greenbook. Central banks have responded to this cocktail of slowing growth and higherthan-desired inflation in divergent ways. To date, the ECB has held its policy rate firm at 4 percent, citing the level of headline inflation, possible second-round effects from commodity price increases, and risks from ongoing wage negotiations. Given these concerns, we now expect the ECB to remain on hold a while longer but, in response to a projected further slowing of activity, to cut rates 50 basis points later this year. The Bank of England, in contrast, has reduced its policy rate 50 basis points since the fall--and we expect another 75 basis points by year-end--in an effort to cushion the economy against financial headwinds and slowing in the housing and commercial real estate sectors. Finally, the Bank of Canada has reduced rates 100 basis points since the autumn, in response to downdrafts from the United States and the strong Canadian dollar, and the Bank has indicated that ""further monetary stimulus is likely to be required."" Thus we see another 50 basis points of easing in the second quarter. As noted earlier, the dollar has depreciated more than 5 percent against the major currencies since mid-February as the widening divergence between the path of policy rates in the United States and other industrial countries, particularly the euro area, has weighed on the dollar. As a related factor, the tone of the recent U.S. economic data has been much softer than for most other advanced economies. In broad real terms, the path of the dollar in our current forecast is about 2� percent weaker than in the January Greenbook. Going forward, our forecast calls for the broad real dollar to decline at a 3 percent annual rate, with this depreciation expected to come disproportionately against the currencies of the emerging market economies. I conclude with a few words regarding the performance of the U.S. external sector. The January trade data showed exports continuing to rise at a healthy pace while nonpetroleum imports contracted. Imports of consumer goods were particularly soft. For 2008 as whole, we now expect the external sector to contribute a substantial 1.2 percentage points to growth, about twice as much as in our previous forecast. To be sure, much of this larger arithmetic contribution from net exports reflects a contraction in imports caused by the slowdown in U.S. demand. However, part of the reduction in imports is also due to the decline in the dollar. Exports this year are seen to grow at a pace of nearly 7 percent, just a touch less than in the last Greenbook, as the effects of the weaker dollar almost offset the markdown in foreign growth. In 2009, imports rebound as the U.S. economy recovers, and the positive contribution from net exports accordingly shrinks to about percentage point. Finally, yesterday the BEA reported that the current account deficit narrowed to 4.9 percent of GDP in the fourth quarter, its smallest share of GDP since 2004. We had expected the rise in oil prices to drive up the deficit, but this was more than offset by a marked improvement in net investment income, partly as earnings received by foreigners on their investments in the U.S. financial sector declined, reflecting the effects of the ongoing financial turmoil. We will now be happy to take your questions. " FOMC20080130meeting--276 274,MR. ROSENGREN.," Thank you, Mr. Chairman. I support alternative B, though I think a case can be made for alternative A. The Boston model indicates that even after a 50 basis point reduction, we still need more easing to return to an economy with both full employment and inflation below 2 percent. Taking out insurance against more-severe downside risks would imply even more easing than our baseline forecast. Given our recent move and the additional easing in alternative B, I am comfortable waiting to take more aggressive action only if incoming data warrant it. However, I will not be surprised if we find further action is indeed needed. What would be the arguments against taking an aggressive tack? Certainly, one argument might be that elevated oil and commodity prices and core inflation currently above 2 percent warrant a more restrained approach. However, I would note that in previous recessions the inflation rate has declined significantly, even in the 1970s, in the midst of historic surges in energy and food prices. Whether we skirt a recession or experience a recession, I expect core inflation to trend down. A potential second argument is that we have responded too slowly to the need for tighter policy in the past, so we should be more reluctant to ease in the present. While it may be true that we raised rates too slowly at the onset of previous expansions, I see no reason for this Committee to behave in a manner that it believes is suboptimal. As a Committee, we seem to have consensus on the importance of maintaining low inflation rates, and I am confident we have the will to raise rates with the same alacrity that we reduced them, should economic conditions warrant such action. " FOMC20070509meeting--158 156,MS. YELLEN.," Thank you, Mr. Chairman. I support the Bluebook’s alternative B, both the policy and the language as it stands. With respect to the language, I strongly support the view that you, Governor Kohn, and others expressed—that a change today would be a mistake, given the significance that the markets would attach to it. I think the language is completely acceptable and we should stick with it. If we were to move, I wouldn’t have a problem with the language in C about inflation and uncertainty, but I would also want to add something about uncertainty with respect to growth, and I see no need to make this change today. It seems to me that we do need considerable flexibility at this point to respond to emerging data. The intermeeting developments have strengthened the case for a soft landing, but there is significant risk on both sides with respect to inflation and growth. I’m still comfortable stating that the predominant policy concern is the risk that inflation will fail to moderate as expected. I am worried about labor markets that remain fairly tight, oil and commodity prices that are higher, and the dollar, which has fallen. At the same time, the recent favorable inflation data have reinforced my view that a substantial part of the uptick in inflation last year was transitory. I think that the discussion we have had so far reinforces the point that going forward we are going to have trouble crafting policy and a statement if we don’t clarify— at least within the Committee, if not publicly—what our ultimate inflation objective is. I’m not going to weigh in again at this point on the merits, but it is obvious that we will have increasing difficulty. I am happy today to say that core inflation remains “somewhat elevated on balance.” But if we get more readings of core PCE inflation that are in the neighborhood of 2 percent and they continue, we really will have to revisit the debate about what we want to achieve and how we can reflect that decision in our statement." CHRG-111shrg57322--202 Mr. Tourre," Yes. Senator Coburn. OK. Mr. Chairman, my time is up. Senator Levin. Thank you very much, Dr. Coburn. Senator McCaskill. Senator McCaskill. I want to make clear that I understand that for most of these transactions we are talking about today you considered yourself a market maker. And by that, you were trying to allow clients to bet on a certain outcome. And for purposes of my questions today, I would like to limit this to synthetic CDOs because I think they are the best representative of why most of America does understand what happened. We are not talking about a farmer trying to get certainty on a commodity. We are not talking about an airline company trying to get certainty on jet fuel, which is the societal reason that we have market makers to put predictability into a business model that will allow more informed risk taking as it relates to a business model. But the synthetic CDOs were really about somebody just wanting to place a bet, and so I want to try to continue with the analogy of you being the house or the bookie. Most people in America understand about a football bet. I have usually bet on MU versus KU because I went to MU and I care about MU. But the line is important. Obviously, if you are going to be a serious bettor, you have got to know what the line is. You have got to know how many points you are going to get or how many points you are going to give. And that is, I think, where we can start drawing the analogies to your jobs. You were trying to make a market, and staying close to home was trying to get the line right. Staying close to home was to not be too far out on one side or the other. When the bookie gets too many bets on MU, if MU is getting points, it gives fewer points to MU to move more bettors over to KU and vice versa. The bookie moves the line in order to even out the bets. So the perfect bookie who makes a lot of money is somebody who just gets the vig. And depending on whether you are betting in an office pool that is illegal or whether you are betting in Las Vegas, the vig is going to vary anywhere from 5 to 10 percent. I do not know who the right person is to ask this--what is your vig, Mr. Sparks, on these deals? What is the vig you make, assuming all you are doing--not playing in the market, but all you are doing is trying to stay close to home like a bookie would try to do in order to minimize their risk? " FOMC20050503meeting--59 57,MR. STOCKTON.," The result of that exercise suggests, if anything, a little surprise that we didn’t get a touch more pass-through. Actually, I was surprised when I first saw those results but not after I sat back and thought more carefully. Certainly, if you had told me in late 2003, when oil prices were $25 to $28 a barrel, that they were going to be something north of $50, that the markets would perceive that as being very largely a permanent change, that we would see an ongoing depreciation of the dollar and a very significant acceleration in intermediate materials prices, I think I would have said core consumer price inflation now of just 1¾ percent would be a pretty good outcome. So, as I thought more about it, I was more comfortable with the results that we presented yesterday. Now, as we indicated in the Greenbook in an alternative simulation, while we are comfortable with our inflation forecast, we could certainly understand it if you were less comfortable with our assessment of the pass-through to core inflation, given that this has been an area where we have made persistent errors. It’s very hard to estimate these pass-through effects. I know of work done over the years at the Board and by Reserve Bank staff aimed at trying to estimate indirect energy price effects or import price effects. Sometimes the coefficients are zero and sometimes they May 3, 2005 22 of 116 could simply be a function of the fact that many of those variables were relatively stable over a long period of time. It’s just very hard to estimate precisely what the effects are. Our alternative simulation, where we doubled the size of those pass-through effects, is intended to give you a sense of how far things could get out of line if we made a rather big error in the size of the pass-through. And, as we noted, there would be a very noticeable effect going forward. So, it does seem reasonable to wonder not only about whether we have the underlying forecast right for oil, imports, and other commodities but also whether we have the pass-through of that correct." CHRG-111hhrg53246--54 Mr. Kanjorski," No, no. Just timeframe. First of all, the relationship between the two of you is something we should compliment, and I do. And I anticipate that because of this good relationship we are going to have very positive things. I understand because of prior meetings and other testimony that you have made that you have worked out and harmonized a great deal of the conflict between the two agencies but that you have not resolved all of those conflicts. And you are down to what really I would like to ask, what are the remaining disagreements between the SEC and the CFTC that have not yet been harmonized and are still open in the air, and do you have a suggestion where they are going to come down and are they resolvable at a given time? Ms. Schapiro. Let me take the first crack at that and then ask Gary obviously to fill in. I think you point out correctly that we have tremendous agreement around most issues. There is a very narrow area where we are not in full accord, and that is with respect to whether broad-based indices, OTC derivatives or swaps on broad-based indices should be regulated by the SEC or the CFTC. Our view is that securities-related derivatives ought to be under the SEC's jurisdiction. The Commodity Futures Modernization Act, while exempting these products broadly from regulation, did retain with the SEC antifraud authority over anything securities based. As Gary will point out, under the Shad-Johnson Accord reached quite a few years ago, there was a drawing line between narrow-based and broad-based indices. Broad-based went to the CFTC and narrow-based went to the SEC for the purposes of options and futures. I would say that is the one area that we still are trying to work through. As we go through our harmonization process, and as Gary said, we are going to hold joint hearings to get public input on this, we will discover there are lots of areas where our rules approach things differently. And on those I don't even know that we will have particular disagreement. Some won't be able to be harmonized because the nature of the markets and the products is quite different. But that is what we are working through right now. " FOMC20070321meeting--105 103,MR. LOCKHART.," Thank you, Mr. Chairman. Thank you for the earlier welcome. Over the intermeeting period, aggregate economic activity in the Sixth District showed signs of slowing. Manufacturing activity appeared to soften, with the majority of reports suggesting declining orders. Retail reports pointed to a slowing pace of sales. The BLS employment data revisions for 2006 supported the view that Florida’s economy has decelerated considerably in the wake of the housing downturn. Sales tax data suggest that retail spending in Florida actually declined in late 2006. Recovery on the Gulf Coast of Mississippi and Louisiana continues to proceed more slowly than hoped. The immediate post-hurricane boost to spending has waned, and the problems of housing and insurance availability remain largely unresolved. The biggest concern for the Sixth District continues to be in real estate markets. As stated at the last meeting, it appears to be too early to suggest that the region’s housing situation has stabilized or that the housing sector’s drag on the District has ended. Reports indicate that many areas in Florida are experiencing dramatic declines in sales of single-family homes and condos, even while new product continues to come onto the market. As a result of this oversupply, construction plans have been cut back. In January, permit issuance for single-family homes in Florida was 57 percent lower than a year earlier. For the rest of the United States the decline was 25 percent. Permits for multifamily development declined 40 percent versus a 7 percent decline nationally. This situation is most extreme in Florida. Interestingly, we do hear anecdotal reports of improved potential buyer traffic in Florida, but that improvement is not translating into sales. Buyers appear to be expecting lower prices. In the other states in the District, single-family permits were down 19 percent in January, less than the decline nationally. Regarding the region’s exposure to nonprime and subprime mortgages, the concern is again mostly in Florida. According to the Mortgage Bankers Association, over 9 percent of mortgages serviced in Florida in the fourth quarter of 2006 were subprime ARM loans; this exposure was second only to Nevada, which was at 13 percent, and compares with 6½ percent nationally. In contrast, the exposures of the other states in the District were all at or below the national level. Reports from banking contacts suggest that delinquency rates on nonprime ARM loans in Florida will continue to trend higher this year. Reduced access to credit for nonprime borrowers will slow the absorption of the current oversupply of housing product and will put downward pressure on house prices. Also, the boom in condo conversions and condo construction in 2005 and 2006 drained the supply of apartments in many areas in the District, and landlords have been able to increase rental prices as a result. Turning to our perspective on the country as a whole, much of the slowdown in real activity that occurred in the second half of 2006 reflected weakness in the housing sector. If weakness remains contained within the housing sector, the outlook, although subdued, is acceptable in our view. Much of the recent moderation in real activity is consistent with what we had forecast several months ago. Realization of this moderation does not in itself imply that we should revise our outlook. Some professional forecasters continue to anticipate that real GDP growth will rebound to close to its trend rate of 3 percent for the rest of 2007, in effect discounting any drag from prolonged weakness in residential investment. The Atlanta Fed staff forecasts for real GDP growth are consistent with these optimistic commercial forecasts. The current Greenbook forecast implies a slightly weaker outlook from extended weakness in residential investment and weaker growth of consumer expenditures, perhaps incorporating some signal from the recent financial distress in subprimes. Despite slight differences in these forecasts, the outlooks do not suggest recession at this point. Measured core inflation remains in excess of 2 percent. Our staff consensus forecast sees core inflation continuing in the range of 2 to 2½ percent for all of 2007. This forecast is a bit less favorable than the Greenbook forecast, but we have no sense that the inflation outlook has deteriorated significantly. The implications of the outlook for real output and inflation are that current policy is set about where it should be. The U.S. economy has performed about as expected. Financial market turbulence and subprime mortgage distress raise potential concerns that should be monitored, but for now it seems that the outlook has not substantially changed. Thank you, Mr. Chairman." FOMC20050809meeting--180 178,CHAIRMAN GREENSPAN.," Further questions for Brian? If not, let me add my thoughts, wherever they may go. [Laughter] I thought it was quite interesting to hear the tone of this Committee’s view that the inflation rate is gradually moving up and that’s not particularly worrisome, except that basis points keep getting added to basis points and before you know it, the rate of inflation is higher than we want it to be. The undertone of resistance to that I thought was rather impressive and, I must say, it’s a view that I share as well. The rate is being boosted by a thousand little hits which eventually get you, and suddenly you say, “How in the world did we get here?” There are general concerns in the sense that the costs of national defense, homeland security, and the like are really quite substantial. But they don’t seem to have impacted the cost August 9, 2005 81 of 110 know, have considerable concern that the rate of productivity growth in the second quarter was going to slow appreciably and that in the third quarter it wasn’t going to move very much from that reduced pace. We thought that structural productivity might well be revised down and that, therefore, structural unit labor costs would increase, suggesting an acceleration in inflation. That apparently is not happening. That is, we are getting upward revisions in productivity on a month-by-month basis, so that concern is something we can basically put aside for the moment. On the other side, there was a general tone in the comments around the table of concern about the acceleration in economic activity. But I think we ought to be a little careful in making a judgment on that, given that the pause in the second quarter was to a very large extent reflective of inventory investment falling away at a fairly significant pace, though the extent of that was not something of which we were aware until after the fact. Currently, we’re seeing the reverse. Now, even though industrial production is not all that big a chunk of GDP, it is a significant aspect of the change in GDP. And the combination of motor vehicle output and non- motor vehicle inventory change suggests, as David pointed out, an automatic pop in the numbers. And that is what we’re seeing. Is it an implication of an acceleration in economic activity? I would say “not necessarily.” Were that the case, we would be seeing a tightening in markets. We’d see it in commodity prices, but we do not. We’d see it in delivery lead times, but we’re seeing only a marginal increase there. In other words, the anecdotal reports and other usual evidence of markets tightening up are not there. We’re not seeing the consequences of what inevitably has to be the case—that is, the loss of effective capacity as a result of increasing oil and natural gas prices. That’s going to happen at some point, but it’s not evident anywhere we August 9, 2005 82 of 110 increasingly of a tightening nature. But those changes are not showing up in any form that creates a sense of urgency to address them. There are two areas of the outlook about which I think we know a great deal less than we’d like. One is oil and the other is housing prices. On the oil side, the futures markets, as you know, show a flattening out of crude prices. But when any commodity price is going up, futures prices always show a flattening out. The reason is that futures markets, while they may be the best estimate that exists of the market’s expectation of prices in the future, are nonetheless a mechanism in which the demand in the immediate period is essentially spread out over the whole futures spectrum. And it’s reflected in the fact that the upper end of futures prices relative to the spot price cannot be more than the carrying charges. If it is, what happens is that the spot price gets pulled up in the process. So, at this stage what we’re looking at is the market’s best forecast of the longer-term outlook for oil prices. But as a quick look at history will tell us, the futures price has a terrible record as a forecast. Therefore, it’s not all that useful, especially when we’re looking at very odd underlying fundamentals here. If one looks at the production numbers and demand as currently measured, we’re running into a big increase in inventory accumulation in the second half of the year. And one would presume, as I guess Lee Raymond does, that that implies the markets are going down. But we also have the other side of this problem where all of the proved reserves are in areas with nationalized oil industries and, therefore, the ability to bring to bear financing from the international oil companies is very significantly limited. Indeed, in the case of Mexico, it is constitutionally prohibited. And as the populations in these oil-producing areas are growing August 9, 2005 83 of 110 welfare needs. So even though the prices are going up and the revenues and cash flows are going up, there appears to be a shortage of cash available to convert the proved reserves into effective operating capacity, meaning drilling and infrastructure. Even though the numbers look reasonably good, what we have had in the last few years, after a long period of very small increases in world oil demand, is that demand has suddenly tilted up as China and India have come on the scene. And after a fairly significant amount of non-OPEC production, which turns out to have been largely Russian, now we’re getting some evidence of nationalism in the Russian oil industry, and production growth there has slowed very materially. Hence, the outlook for any slack we generally might have is questionable. And one of the serious questions is: Are we underestimating long-term demand growth so that even though there may be production out there, the gap is closing from the demand side? But most of the concern, as Karen pointed out, is on the supply side because one can list a number of fragile oil-producing areas and a whole series of possible supply interruptions. Anything can go wrong. Indeed, one indication of how sensitive the market is can be seen in the reaction to every flicker of a potential hurricane in the Gulf of Mexico. That is not the biggest oil-producing area of the world, but when there’s even a hint of a hurricane in that region, crude prices pop. As a consequence, we may have a sense that we’re looking at a short-term glut, but the prices are seeing through the glut. That’s, indeed, the convergence of the long-term 6-year futures price to the spot price. For a long period of time we had a big surge in the spot price and the 6-year futures dragging along barely, with the gap opening up. In the last year that gap has closed very dramatically, which suggests that there’s a fundamental concern in the marketplace that the long-term capabilities of this market are not sufficient and that a price of $60 or $65 a August 9, 2005 84 of 110 today’s prices of $90 for WTI back in the 1970s. All we can say that’s fortunate about that comparison is the fact that the amount of oil used per unit of GDP is down very significantly. So, there is no basic long-term concern, but there is a short-term concern here, which I think raises questions about inflation and about the contractionary characteristics of oil price increases. So it’s a very difficult mixture. On the housing area, the real problem is not actually the boom or how far it’s going or whether it is a bubble or the like. The real issue is this: When it diffuses, as it will one way or the other, what are the implications? The serious problem that will arise when that happens relates to the question of what is the marginal propensity to consume out of housing wealth. The problem that I think we have is that the impact from a slowing or decline in house appreciation— or more explicitly the effect of housing capital gains on the one hand and of stock capital gains on the other—would be a far greater contraction in consumption than indicated by a standard reduced form system, which we currently have in our models—namely, the wealth effect. What bothers me is that we may, in fact, be looking at much higher marginal propensities to consume from housing capital gains. And, as housing turnover slows, cash-outs will slip and the amount of equity extraction will fall quite significantly. In fact, implicitly the Greenbook has a very substantial fall in equity extraction, as you know. Mortgage debt is shown to slow down very materially. The key question is: Is the marginal propensity to consume from equity extraction actually 0.3, which is the figure indicated in our surveys of cash-outs and other surveys? If one assumes that that’s the impact on consumption, that accounts for virtually all of the decline in the saving rate, and it would imply a reversal—a very significant rise—in the saving rate. And that is the other side of the question of what kind of consumption pattern we August 9, 2005 85 of 110 Implicitly our existing model, which endeavors to differentiate the marginal propensity to consume from wealth creation from stocks and wealth creation from housing, is incapable of distinguishing any difference in the marginal propensity to consume from those two sources. And instead of 0.3, the implicit number is well under 0.1. As a consequence, even though the Greenbook forecast has a significant implicit decline in mortgage debt expansion, we do not get the type of marginal slowdown in personal consumption expenditures—and I might add modernization expenditures—that is implicit in the survey data. The trouble is that we cannot know the answer at this stage to the question about the marginal propensity to consume out of housing wealth. International data are more suggestive of a higher propensity to consume. Australia’s PCE slowed down very dramatically with the slowing in house price appreciation there. The same was true in the United Kingdom. And that’s an issue about which I’m fearful we will not know the answer for the United States until we see it—when we find that equity extraction suddenly falls with a flattening of house prices and retail sales somehow begin to disappear. I’m not sure we can make judgments in advance as to how that will come out, but how it comes out may be the most difficult problem that we will be confronting. It doesn’t seem likely to be imminent. It’s certainly not the case that housing starts are falling off dramatically. Indeed, the backlog the large builders have on starts is still very high. It is flattening out a bit but is showing no signs of weakness. Conceivably, in the event of a weakening in prices, a lot of that backlog will disappear. That may occur without our knowing where it’s coming from, but people will just pull away from the housing market. So, we do have problems out there, and I don’t think we really have a great deal of August 9, 2005 86 of 110 impressive expansion in the economy. I’m certainly not arguing that I wish it were otherwise. This is as good an economy as one can get. It’s just that we have to look down the road and see what’s out there. And what I see are a couple of possibilities that should make us want to exercise some caution, although none of the potential problems, as best I can judge, is imminent, There’s nothing out there that indicates that something is about to fall apart. But as we get into 2006, I feel that the tranquility we are forced to exhibit—because the forecast is a point estimate in all of our projections—may be a bit overdone. In summary, I think we’re on the right path. I don’t think there’s any urgency to consider accelerating the path nor, of course, pulling it back. I share the view expressed by a number of you around this table in that I’m delighted that the futures markets have jacked up the implicit longer-term projection of the funds rate quite significantly, and I think certainly to the right dimension. And as I’ve said here before, my impression basically is that when the economy starts to change, the markets are going to be moving ahead of us and probably will conclude pretty much as we would conclude when we meet. If that is indeed the case, as I mentioned earlier, the most probable outlook is that the markets are going to tell us when we have finally reached the point where this program of increasing the funds rate is over and a pause is implied. It is conceivable that we may have to change the language abruptly, which will change the market’s expectations and cause some disruption. I think that probably will not happen. Judging from the way we and the markets have interacted, we’re all looking at essentially the same play book, and I think we are likely to come out with the same conclusions. If that’s the case, the period of about six weeks that we’re going to have between one meeting and another at the point we’re going to change is probably going to be enough time for the markets to adjust August 9, 2005 87 of 110 FOMC meeting.” And that, indeed, is likely to be what we’re going to want to do. We’re going to change the language. We’re going to change, in fact, the way we produce our statement. And hopefully we will have phased into the next stage of monetary policymaking in a less disruptive way than we probably fear—or at least that I fear. But that’s for the future. For now, I think the appropriate action is a move of 25 basis points and pretty much the alternative B statement that is shown in Brian’s table. So I’d like to put that proposal on this table and get your reactions. President Poole." FOMC20060131meeting--104 102,MR. POOLE.," Thank you, Mr. Chairman. What strikes me from my conversations with my contacts is the growing confidence that they do not see major risks on either side, that there are reduced standard errors around their projections. Very few had comments or concerns about inflation outside of energy, which, of course, is on everybody’s mind. I’d like to make an analytical point that actually comes from my UPS contact. I think I mentioned at an earlier meeting that UPS is moving its business off the mixed rail—the piggyback. That move is a consequence of the fact that the railroads are unable to speed up delivery times, which in turn is a consequence of the railroads’ decision that it is not worth the capital investment that would be necessary for what for railroads is a relatively low-yielding business. UPS is also working to maximize the return on its own capital. The company is very disciplined about adding capital and is planning to price low-yielding business out of its network. That is, for the low-yield products, they’re going to raise prices expecting that the business will go away. My contact at UPS said that he thought that the strategy would not really be successful and that they will probably be looking at substantial increases in capital spending in ’07, once they find that they have optimized their existing plant, that the volume doesn’t go away when they try to raise the prices on it, or that not enough of it goes away. And I think that this phenomenon might be more general in our economy. Companies are very disciplined about their capital investment. But as the economy continues to expand, they’re going to run out of ways to optimize the existing capital plant, and we will see investment coming in stronger over the next couple of years. That’s an observation that may have more general application. I support the Greenbook’s forecast, plus or minus a quarter of a standard deviation. [Laughter] Not worth worrying about. Instead, what I’ve been trying to do is to make lists—and these could be much longer—of risks on the high side and the low side. On the high side, I would point to commodity prices, which are high and have gone up a lot, and growing strength—as I just commented—in business fixed investment. I mention high money growth, because I don’t think that the rapid money growth is fully explained, and it certainly has frequently been a precursor of higher inflation. Some indicators on the other side—we talked about housing, the possible reversal of the unusually low saving rate, the behavior of the yield curve, the risk of oil supply disturbances. Most of oil has been demand-driven, but supply disturbances because of the problems in the Middle East primarily—Africa as well—could certainly produce a significant downward shock on economic activity and upward shock on prices. No doubt these lists could be amplified, and I think it’s probably worth spending more time thinking through the risks and how to respond to various events than it is trying to optimize the forecast and get that last quarter of standard deviation exactly right. Mr. Chairman, many around the table have commented about their experience serving here. I will, of course, echo those. I would like to put a little different angle on it. Of the people who have had a major impact in my life, you are certainly one. I mark on the fingers of one hand the people who have had extraordinary influence on me. You have influenced me mostly in my professional life but also in many aspects of leadership that go beyond economics and policy in a narrower sense. So I thank you for that. I am also looking forward to continuing to learn from you. I understand that you have some books, at least in your head. And given my interest in making sure we have clear communication, I have a suggestion for a title for your first book. And it is in line with some books by your predecessors. So I suggest “The Joy of Central Banking.” [Laughter] And I suggest that your second book be “More Joy of Central Banking.” [Laughter]" FOMC20080916meeting--118 116,MR. HOENIG.," Mr. Chairman, I see no reason to focus on the details of the forecast. Clearly, the economy is under stress, both as we look at the economic growth forecast and as we look at the inflation forecast. So I recognize the amount of stress we are under here. I would say to you, in dealing with that stress, I am fully supportive of the actions that we take in terms of liquidity--the TAF and the other efforts to provide liquidity into the market. These are tools that we can and should use for these kinds of shocks in a short-term context. On the other hand, I would encourage the Committee to resist the impulse to ease policy in a sense of doing something. The issue is not the level of our policy rate at this time. It is the dysfunctioning of the markets that we hope our liquidity efforts will help address. To begin to talk about easing or even to put language in there that suggests easing is to cause people, on the expectation that we might ease at some point even if we hold off now, to delay decisions that they would otherwise make that would benefit the economy. I also encourage us to look beyond the immediate crisis, which I recognize is serious. But as pointed out here, we also have an inflation issue. Our core inflation is still above where it should be. Headline inflation has been up, even though there are some signs that commodities and energy are backing off. But the businesses themselves are saying, ""How do I recover my margin?"" So there is no impulse to pass along those reductions. We talk about wages and labor backing off. But they are holding off, they are not backing off, and in negotiations they are much more antagonistic. Those kinds of pressures will emerge at some point. Those are the longer-run issues that I think we need to keep in mind as we deal with this immediate crisis. So I would strongly encourage us to leave rates where they are, to be very careful with our language, not to encourage the expectation of further rate decreases, and to continue to be aggressive in our liquidity provisions as we have been the last several weeks and months. Thank you. " FOMC20060920meeting--148 146,MR. KROSZNER.," Thank you very much. Unfortunately, I think we find ourselves in an uncomfortable position like that of six weeks ago, with a continuing mix of inflationary pressures and decelerating economic growth at the same time. I think the fundamentals are in place for a continued moderation of growth but not a contraction, much as the Greenbook describes. Obviously, housing is a risk that everyone has talked about. But the key, as many people have also mentioned, is maintaining contained inflation expectations, and that comes down to thinking about whether some of the factors that we’ve been seeing have been more transitory or more persistent. Let me first talk about growth and go through the C plus I plus G plus net exports. I would agree with the staff’s characterization that world economic growth is not quite as strong as some others have put forward. I don’t think we’re going to be seeing an enormous export boom. Also, as briefly mentioned, I see very little on the government stimulus side. Tax revenues, as Governor Warsh mentioned, were very high. Spending is being kept relatively tight. On investment, we’re seeing some strength in capital spending. My concern is, if consumption goes as low as the Greenbook suggests, what the return on this capital spending will be. Is it going into the right areas? I was a little concerned when President Poole mentioned that the air freight company is expanding rapidly but the on-the-ground delivery company is not expanding at all. So are they going to have to invest in parachutes to get these in? [Laughter] But that is precisely the concern that I have—that capital spending may not conform perfectly to what consumption demand is going to be. We certainly saw this in the late 1990s and early 2000s. I’m just a bit worried about that now, especially given the potential tension between slowing consumption and robust investment growth. Now, regarding consumption—we’ve talked about the potential support from lower energy prices and some positive wealth effect from stronger equity markets, but obviously housing is one key here. It’s a key partially in overall investment but also in the uncertainty that it causes in consumers’ minds. Housing is one of the worst areas for data. It’s very difficult for us to have any concept of what prices are doing because it’s not a market like any other. We do have the Case-Schiller index, and we do have some better indexes that people are now betting on, but they’re still very poor indicators of prices relative to the indicators we have in other markets. We also know that there can be queues and that extras can be thrown in, so there’s a lot of uncertainty with respect to where prices are going. That concerns me quite a bit because I think we just don’t have a good handle on it. Permits and starts have continued to come down from where they were at our last meeting and are now at levels of the beginning of 2003 or even starting to slip into 2002. If they flatten out there, the housing sector is still historically reasonably good. But there’s no indication that we’re necessarily at a turning point and that things are going to flatten out. There is the wealth effect, the direct effect on people’s consumption behavior of lower wealth going forward, and also the confidence effect. We don’t have a perfect analogy with the previous times in which we’ve seen these housing downturns— we have a different context in that the economy is broadly more robust—and so I think it’s less likely that we’re going to see a major housing problem. But I think it is a real risk, and we have to be sensitive to it. On the inflation outlook, we have to come back to transitory versus more-persistent components, as many people have mentioned in the discussion. Obviously, people are heartened that energy prices have come down, but I certainly would not put the same bet on the energy markets that one trader did in a hedge fund that got into a little trouble recently because we know that energy prices can move in ways we don’t expect. So I don’t want to take too much from that. I think it’s appropriate in the Greenbook to use the market’s expectations. What measure do we have other than market expectations? If we did have a better measure, then we’d be running one of those hedge funds. However, there’s a lot of uncertainty around that measure. So I certainly don’t want to bet on better inflation going forward just because we’ve suddenly seen a 15 percent decline in oil prices over the past six weeks. That said, it’s heartening that energy prices are unlikely to lead to greater inflationary pressures going forward than those when we paused six weeks ago. The rise in compensation is obviously troublesome—not if you are an employee receiving the higher compensation, but from our point of view. However, a lot of tension is in those data because we have the compensation numbers versus the ECI. There’s a big statistical discrepancy between gross domestic income and gross domestic product. It’s possible that some of the increase in compensation will be revised away, and we’ll see actually higher productivity growth. We just don’t know, and it may be a while before we see it. Also, as we discussed a lot last time but not this time, the continuing fairly wide margins that businesses are experiencing may come under more pressure and may absorb some of the increases in labor compensation. How much is uncertain, but that may be one potential offset. As many people have said, we can’t become complacent. Inflation expectations have behaved reasonably well since we paused at the last meeting, which is heartening in that the markets believe that inflation is reasonably under control in the near to medium term and even in the longer term. It’s hard to find evidence of increases in inflation expectations, but as many people have said, that does not mean that we don’t have to worry. We have to worry a lot because the key is keeping those expectations well contained. I think we’re in a situation in which we can do that. Slowing growth is not going to give us more of a benefit. The flatness of the Phillips curve, which people have talked about, is what the data have been over the past ten to fifteen years in the United States and most other countries. So even if there is a bit more slowdown, we are not necessarily going to get the potential benefit in significantly lower inflation pressures—maybe a little but not very much. So we still have to worry about the upside on inflation, and that’s why maintaining our credibility is of utmost importance." CHRG-111hhrg55811--13 Mr. Hensarling," Thank you, Mr. Chairman. As I look at all the root causes of our economic turmoil, I haven't quite convinced myself that the derivatives market is among them. We all certainly know what happened to AIG's Financial Products Unit with the credit default swaps. I am sure not sure that wasn't a symptom as opposed to a cause. Now, clearly, their behavior in retrospect was reckless, and I for one do not agree that the taxpayer should have been asked to pick up the tab. Be that as it may, it is important to know as we go forward what the history is, and the history is that the relevant regulator did not lack regulatory authority. They may have lacked regulatory expertise, but they did not lack regulatory authority. Now, as we look at the new draft of the derivatives bill, I would like to commend the chairman for significantly improving the Administration's bill. It is only 10:20 in the morning, and I find myself in the unusual position of having agreed with my chairman 3 times now, and the day is early. It probably won't happen again any time soon. But, nonetheless, I think that it is important that all of us realize that ultimately derivatives have a very important function in our market. Many of us have received correspondence from the Coalition for Derivatives End-Users. I would like to quote from that letter, which includes 170 of the largest job creators in America, ``Business end-users rely on OTC derivatives to manage risk, including currency exchange, interest rates and commodity prices by insulating companies from risk; customize OTC derivatives; provide businesses with access to lower capital, enabling them to grow, make new investments and retain and create new jobs.'' We should be very, very loathe to ruin that. Thank you. I yield back. " FOMC20080805meeting--113 111,MR. BULLARD.," Thank you, Mr. Chairman. Economic activity in the Eighth District has remained roughly stable during the summer. Activity in the services sector has increased slightly, and except for the auto industry, manufacturing activity is also stable to slightly higher. Automotive contacts reported a variety of plans to lay off workers or to idle production, and at least three automotive parts suppliers will close plants in the District. Contacts in the auto industry are not optimistic that production will increase in the short term. Retail and auto sales have softened in recent weeks, and some District retail contacts have expressed concerns about summer sales. Many contacts continue to emphasize commodity price levels as a key factor in business decisions. They are concerned both about the necessary business adjustments, given the new pricing structure, and about the implications for the overall level of inflation going forward. The residential real estate sector continues to decline. Across four of the main metropolitan areas in the District, home sales through May declined about 18 percent compared with 2007, whereas single-family construction permits declined about 40 percent. The number of foreclosures in the St. Louis area in the second quarter increased to about 6,300 filings, up about 77 percent from last year. I am impressed, however, with the regionalism in the foreclosure situation, as some areas of the nation continue to have far higher foreclosure rates than others. In contrast with the generally positive reports in commercial real estate activity for the earlier part of 2008, recent reports have indicated more uneven conditions in the nonresidential real estate sector across the District. Turning to the national outlook, I was encouraged by the recent GDP report for the second quarter, which showed growth at an annual rate of 1.9 percent. Real final sales increased at an annual rate of 3.9 percent. It now appears that the worst quarter associated with the current episode of financial turmoil was probably the fourth quarter of 2007, when the economy abruptly stalled. The slow- or no-growth period was through the winter, with the economy gradually regaining footing through the spring and summer. If there were no further shocks, I would expect the economy to grow at a more rapid rate in the second half of this year. But there has been another shock--namely, substantial increases in commodity and energy prices. I think it's important to be careful not to confuse the effects of this latter shock with the effects of the housing-sector shock. My sense is that the level of systemic risk associated with financial turmoil has fallen dramatically. For this reason, I think the FOMC should begin to de-emphasize systemic risk worries. My reasoning is as follows. Systemic risk means that the sudden failure of a particular financial firm would so shock other ostensibly healthy firms in the industry that it would put them out of business at the same time. The simultaneous departure of many firms would badly damage the financial services industry, causing a substantial decline in economic activity for the entire economy. This story depends critically on the idea that the initial failure is sudden and unexpected by the healthy firms in the industry. But why should this be, once the crisis has been ongoing for some time? Are the firms asleep? Did they not realize that they may be doing business with a firm that may be about to default on its obligations? Are they not demanding risk premiums to compensate them for exactly this possibility? My sense is that, because the turmoil has been ongoing for some time, all of the major players have made adjustments as best they can to contain the fallout from the failure of another firm in the industry. They have done this not out of benevolence but out of their own instincts for self-preservation. As one of my contacts at a large bank described it, the discovery process is clearly over. I say that the level of systemic risk has dropped dramatically and possibly to zero. Let me stress that, to be sure, there are some financial firms that are in trouble and that may fail in the coming months or weeks depending on how nimble their managements are at keeping them afloat. This is why many interest rate spreads remain elevated and may be expected to remain elevated for some time. These spreads are entirely appropriate for a financial system reacting to a large shock. But at this point, failures of certain financial firms should not be regarded as so surprising that they will cause ostensibly healthy firms to fail along with them. The period of substantial systemic risk has passed. Of course, we have also endured a bout of systemic risk worries stemming from the operations of the GSEs. However, my view is that the recent legislation has addressed the systemic risk component of that situation as well. Because of these considerations, my assessment is that the chances of unchecked systemic risk pushing the U.S. economy into a severe downturn at this point are small, no larger than in ordinary times. Unfortunately, while the threat from this source is retreating, another threat is upon us-- namely, a substantial shock from increased energy and certain commodities prices, which is leading many to forecast slower growth during the fall. Real automotive output subtracted 1.1 percentage points from real GDP growth in the second quarter. Many contacts seem to attribute this largely to consumer reaction to increased gasoline prices. If this is true, then it seems to me that some of the most visible reaction to this shock may have already occurred, being pulled forward into the second quarter. Labor markets have been weak, but I am not as pessimistic as most on this dimension. So far this year, the U.S. economy has shed about 387,000 nonfarm payroll jobs as compared with a drop in employment of 402,000 jobs during the first seven months of 2003 or 315,000 during the first seven months of 2002. Neither of these latter two episodes is associated with the recession label. These two years might provide better historical guides to the behavior of today's economy than those associated with the recession label, such as 2001, 1990�91 or 1980�82. This is one reason that I think the labeling game can mislead us in our thinking about the economy. The main contribution that the FOMC can make to the economy is to keep inflation low and stable. The headline CPI inflation rate is running close to 5 percent measured from one year earlier. The University of Michigan survey of inflation expectations one year ahead reflects this reality with the most recent reading at 5� percent. The June CPI annualized inflation rate was a 1970ssounding 13.4 percent. Of course, much of this is due to energy prices. Still, with these kinds of numbers we're going to have to do more than talk about inflation risks. Thank you. " FOMC20070321meeting--79 77,MR. HOENIG.," Mr. Chairman, I’ll spend a little time on the District. I think you can describe it as almost robust, recognizing that we are a District that exports a lot of raw materials and byproducts of raw materials. We have had solid job gains led by further tightening in our labor markets, and recent revisions suggest that 2006 job growth was stronger than we had previously thought. Mining led the job growth, but we also saw strong gains in professional and business services and in leisure and hospitality. In fact, our ski season this year was a record, as the snow was also a record. Besides shortages of skilled labor, of which we are constantly getting reports, we are seeing also shortages of some lower-skilled workers as well—in the temporary employment area, for example. It is also noteworthy that our manufacturing activity has been strengthening. We have received good reports from our directors and advisory council members that it actually strengthened in February. Lower inventories of finished goods led to a surge in order backlogs, and most industries reported robust activity led by machinery and high-tech equipment production. In addition, plant managers expressed greater optimism about the outlook for employment and capital spending as they look forward, not as they’re looking right now. Turning to real estate, housing activity may have stabilized. We have suffered like the rest of the country in that area, especially in our Denver market, where we have had record levels of foreclosure. But beyond that—and even there—we have seen some stabilizing in our housing market, and our commercial activity remains really quite solid. Housing permits and the value of new residential construction held steady in February. In addition, the buildup of home inventories has actually slowed, and District contacts expect inventories to decline gradually in the coming months, as they are now seeing things turn. Nonresidential construction remains strong, with absorption of office space increasing in most cities and vacancy rates continuing to decline throughout our region. Commercial real estate contacts expect more new construction in the months ahead. They are actually seeing it come on the drawing board. They also reported that office prices and rents increased further, even though sales were somewhat flat over the last month or so. Farm financial conditions have improved overall, with increased crop prices that are being driven by the expanded ethanol production. USDA forecasts that net farm income will rise about 10 percent this year. Strong income prospects have boosted land prices—significantly, I might add, in some parts—and solidified farm balance sheets. One piece of information I would note is that ethanol is a boom industry right now in the region—not in just our region but in the area around Nebraska and Iowa. In that area, 100 plants are producing; there are 50 on the drawing boards, but we are seeing some backing away from that. Three projects have been pulled back in Oklahoma recently, and one more in Kansas. But still, a lot are going forward, and it gives me some pause because it has the tone of too much, too quickly, and the real economy will suffer if it backs away from that development. Anyway, on balance, the regional economy is very strong right now. Turning to the national outlook, I would say that, on balance, although I have revised my outlook down somewhat in 2007, I still have it projected as growing on the whole for the year better than 2½ percent. So my outlook is more optimistic than that of the Greenbook. There are some reasons for that, at least that we’re thinking through. Like others, we see housing stabilizing, perhaps taking a little longer to come back, but inventories seem to have stabilized. As those inventories are worked off through the first half of this year, we think housing should improve through the rest of the year, at least given where the fixed interest rates lie. We’re also seeing that the secondary effects of the slowing of the housing market seem contained at the moment, so that slowing is not spilling over, and the containment is being strengthened by the facts that personal incomes are actually continuing to improve and that we have a good labor market. So those factors are important. Also, as we discussed earlier, foreign demand is strong, and the outlook seems to be good. Finally, federal spending—the fact is that we’re fighting a war, and you tend to spend more over the course of a war—is picking up I think. Coffers are strong, and states are spending at a fairly rapid rate. So a lot of factors are affecting demand, and therefore I think that this economy will pick up as the year goes on. I recognize very clearly that there are some risks to keep in mind. One is that the housing market could worsen, and there could be further spillovers. I’m very mindful of that. But on the other side, I do share some of the concerns raised by others in terms of the inflation outlook. Inflation has not come down as much as we had hoped, although I’m still projecting that it will so long as we keep the rates at their current levels. But there are some upside risks with the tighter labor market and strong demand, and we could see energy prices putting more pressure on it. So it’s a mixed bag perhaps with, on balance, some upside risk as well as downside risk to this economy. Thank you." CHRG-111hhrg51592--2 Chairman Kanjorski," This hearing of the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises will come to order. Pursuant to committee rules, each side will have 15 minutes for opening statements. Without objection, all members' opening statements will be made a part of the record. Today we meet to examine the operations of credit rating agencies and approaches for improving the regulation of these entities. Given the amount of scrutiny that these matters have garnered in recent months, I expect that we will have a lively and productive debate. The role of the major credit rating agencies in contributing to the current financial crisis is now well documented. At the very best, their assessments of packages of toxic securitized mortgages and overly complex structured finance deals were outrageously optimistic. At the very worst, these ratings were grossly negligent. In one widely reported internal e-mail exchange between two analysts at Standard and Poor's in April of 2007, one of them concludes that the deals ``could be structured by cows and we would rate it.'' I therefore fear that in many instances the truth lies closer to the latter option, rather than the former possibility. Moreover, if we were to turn the tables today and rate the rating agencies, I expect that most members of the Capital Markets Subcommittee would agree that during the height of the securitization boom, the rating agencies were AA, if not AAA failures. Clearly, they flunked the class on how to act as objective gatekeepers to our capital markets. Along with the expressions of anger, outrage, and blame that we will doubtlessly hear today, I hope that we can also explore serious proposals for reform. Unless we can find a way to improve the accountability, transparency, and accuracy of credit ratings, the participants in our capital markets will discount and downgrade the opinions of these agencies going forward. One could hope that the agencies would do a better job in policing themselves. But if past is prologue, we cannot take that gamble. This time their failures were not in isolated, case-by-case instances. Instead, they were systemic problems across entire classes of financial products and throughout entire industries. Stronger oversight and smarter rules are therefore needed to protect investors and the overall credibility of our markets. As a start, the rating agencies must face tougher disclosure and transparency requirements. For example, investors receive too little information on rating methodologies. The financial crisis has illustrated the danger flawed methodologies pose to the system. If methodologies remain hidden, there exists no check by which to expose their weaknesses. In addition to establishing an office dedicated to the regulation of rating agencies within the Securities and Exchange Commission, oversight must also focus more intently on surveillance of outstanding ratings. The industry has done an inadequate job of downgrading debt before a crisis manifests or a company implodes. Moreover, we must examine how we can further mitigate the inherent conflicts of interest that rating agencies face. In this regard, among our witnesses is a subscriber pay agency. This alternative model is worthy of our consideration. At one time, all rating agencies received their revenues from subscribers, but they evolved into an issuer pay model in response to market developments. I look forward to understanding how a subscriber pay agency succeeds in today's marketplace. Additionally, the question of rating agency liability is of particular interest to me. The First Amendment defense that agencies rely upon to avoid accountability to investors for grossly inaccurate ratings is generally a question for the courts to determine, but Congress can also have its say on these matters. Much like the other gatekeepers in our markets, namely lawyers and auditers, we could choose to impose some degree of public accountability for rating agencies via statute. The view that agencies are mere publishers issuing opinions bears little resemblance to reality, and the threat of civil liability would force the industry to issue more accurate ratings. In sum, the foregoing financial crisis requires us to reevaluate how rating agencies conduct their business, even though we enacted the Credit Rating Agency Reform Act just 3 years ago. As this Congress considers a revised regulatory structure in a broader context, this segment of our markets also needs to be examined and transformed. By considering proposals aimed at better disclosure, real accountability, and perhaps even civil liability, we can advance that debate today and ultimately figure out how to get the regulatory fit just right. Now, I will recognize the gentleman from New Jersey for 5 minutes. " FOMC20080318meeting--51 49,MR. ROSENGREN.," Thank you, Mr. Chairman. Since our last meeting, the economic data have continued to indicate a very weak economy and that, in all likelihood, we have entered a recession. Like the Greenbook, my outlook is particularly influenced by indications of significantly weaker labor markets and a housing market that is as yet showing no signs of reaching bottom. Private payroll employment fell 101,000 in February, and the sum of the downward revisions in December and January was about the same magnitude. Not only have we had three months of declining private payroll employment, but also the decline has been widespread across most industries. The Blue Chip economic forecast, the Greenbook forecast, and our own forecast have the unemployment rate peaking somewhere between 5� and 6 percent. While most analysts are in the process of downgrading their forecasts from skirting to actually having a mild recession, the risk of a more severe downturn is uncomfortably high. A major determinant of the severity of a downturn will be the housing market. Because recent developments in the housing market are so different from most postwar history, I remain very concerned that the effects of substantial declines in housing prices will be difficult to capture in statistical models based on historical data. The Case-Shiller index indicates that housing prices fell approximately 10 percent in 2007, and a decline of similar magnitude this year would mean that many homes purchased in the past several years are in a negative equity position. Elevated foreclosures and large inventories of unsold properties are providing abundant opportunities to purchase homes at heavily discounted prices financed at low interest rates by historical standards. But widespread concerns that prices will continue to fall have resulted in many prospective buyers deferring purchase decisions. To date, the housing market has been quite weak, despite relatively low unemployment rates. But if our forecasts are right, job losses this year are likely to exert a significant further drag on housing prices as rising unemployment rates force additional home sales or foreclosures. Falling housing prices are likely to have a collateral impact on consumption. Perhaps reflecting this risk, the credit default swap rates on retailers have been rising, and we are increasingly hearing of retailers that are closing stores or postponing expansions. Retailers, like consumers, are aware that high oil prices, increasing job losses, and losses of wealth in the stock and housing markets are not likely to be conducive to robust consumption. Exacerbating the negative economic news is the continued deterioration in financial markets. Credit spreads have widened significantly over the past six weeks, with many spreads more than 50 basis points higher than at the last meeting. Hedge fund and money managers that I talk to are acutely aware of the counterparty risk and are very carefully managing their collateral. Most firms with excess collateral are in the process of managing that position down. The deleveraging that is going on has reduced the willingness of banks and other financial intermediaries to finance their positions. In addition, as concerns with liquidity rise, we are once again seeing renewed pressure on the asset-backed commercial paper market. The rise in credit default swaps for companies like Washington Mutual and Lehman Brothers indicates increased concerns for the solvency of other large financial institutions with large exposures to mortgages. The potential for a further episode of financial market dysfunction and for runs on additional financial firms is significant. My primary concern at this time is that we could suffer a severe recession. Falling collateral values and impaired financial institutions can significantly exacerbate economic downturns. Some indicators of inflation are higher than we want, but during previous recessions, commodity prices and inflation rates fell. Given my forecast for the economic outlook, I expect substantial excess capacity to significantly reduce inflationary pressures going forward, and I see little evidence that higher commodity prices are causing upward pressures on wages and salaries. " CHRG-111hhrg48874--16 Mr. Polakoff," Good morning, Chairman Frank, Ranking Member Bachus, and members of the committee. Thank you for the opportunity to testify on behalf of OTS on finding the right balance between ensuring safety and soundness of U.S. financial institutions and ensuring that adequate credit is available to creditworthy consumers and businesses. Available credit and prudent lending are both critical to our Nation and its economic wellbeing. Neither one can be sacrificed at the expense of the other, so striking the proper balance is key. I understand why executives of financial institutions feel they are receiving mixed messages from regulators. We want our regulated institutions to lend, but we want them to lend in a safe and sound manner. I would like to make three points about why lending has declined: number one, the need for prudent underwriting. During the recent housing boom, credit was extended to too many borrowers who lacked the ability to repay their loans. For home mortgages, some consumers received loans based on introductory teaser rates, unfounded expectations that home prices would continue to skyrocket, inflated income figures, or other underwriting practices that were not as prudent as they should have been. Given this recent history, some tightening in credit is expected and needed. Number two, the need for additional capital and loan loss reserves. Financial institutions are adding to their loan loss reserves and augmenting capital to ensure an acceptable risk profile. These actions strain an institution's ability to lend, but they are necessary due to a deterioration in asset quality and increases in delinquencies and charge-offs for mortgages, credit cards, and other types of lending. Number three, declines in consumer confidence and demand for loans. Because of the recession, many consumers are reluctant to borrow for homes, cars, or other major purchases. In large part, they are hesitant to spend money on anything beyond daily necessities. Also, rising job losses are making some would-be borrowers unable to qualify for loans. Steep slides in the stock market have reduced many consumers' ability to make downpayments for home loans and drain consumers' financial strength. Dropping home prices are cutting into home equity. In reaction to their declining financial net worth, many consumers are trying to shore-up their finances by spending less and saving more. Given these forces, the challenges ensuring that the pendulum does not swing too far by restricting credit availability to an unhealthy level, I would like to offer four suggestions for easing the credit crunch: Number one: Prioritize Federal assistance. Government programs such as TARP could prioritize assistance for institutions that show a willingness to be active lenders. The OTS is already collecting information from thrifts applying for TARP money on how they plan to use the funds. As you know, the OTS makes TARP recommendations to the Treasury Department. The Treasury makes the final decision. Number two: Explore ways to meet institutions' liquidity needs. Credit availability is key to the lending operations of banks and thrifts. The Federal Government has already taken significant steps to bolster liquidity through programs such as the Capital Purchase Program under TARP, the Commercial Paper Funding Facility, the Temporary Liquidity Guarantee Program, and the Term Asset-backed Securities Loan Facility. Number three: Use the power of supervisory guidance. For OTS-regulated thrifts, total loan originations and purchases declined about 11 percent from 2007 to 2008. However, several categories of loans, such as consumer and commercial business loans, and non-residential and multi-family mortgages increased during this period. The OTS and the other Federal banking regulators issued an ``Inter-agency Statement on Meeting the Needs of Creditworthy Borrowers'' in November 2008. It may be too soon to judge the effectiveness of the statement. And, number four: Employ countercyclical regulation. Regulators should consider issuing requirements that are countercyclical, such as lowering loan to value ratios during economic upswings. Conversely, in difficult economic times, when home prices are not appreciating, regulators could permit loan to value ratios to rise, thereby making home loans available. Also, regulators could require financial institutions to build their capital and loan lost reserve during good economic times, making them better positioned to make resources available for lending when times are tough. Thank you, Mr. Chairman. I look forward to answering your questions. [The prepared statement of Mr. Polakoff can be found on page 163 of the appendix.] " FOMC20080430meeting--108 106,MR. STERN.," Thank you, Mr. Chairman. Well, for some time I have been using the headwinds period of the early 1990s as a frame of reference for thinking about credit conditions, economic growth, and inflation prospects for the next several years. I won't belabor that comparison much this afternoon, except to say that I continue to find it helpful. With that, and given that the information we have received since our March meeting hasn't caused me to change my views about financial conditions or about growth, let me just say that I continue to expect financial headwinds of some intensity to persist well into next year. I think that the economy will decline--contract in this quarter and in the next quarter--before growth resumes, and that the resumption will initially be fairly mild. So my outlook for economic growth next year is below that of the Greenbook. It is a pretty modest outlook. Recent anecdotes from business contacts and from people in financial services firms have not been what I would call overly negative. If I were to give those anecdotes more weight, I would probably be somewhat more optimistic about the economic outlook than I am. But I am guessing that those anecdotes are underestimating the weight of the credit constraints that are in train, and people--at least people that I have talked to--don't fully appreciate that yet. Turning to inflation, on average it seems to me that the inflation situation and its prospects are no better, and possibly worse, than I had been anticipating. To be sure, the core measures of inflation have not accelerated recently and look to be what I might call close to acceptable, looking at their recent performance. But we have been warned that some of that better performance is likely to prove transitory. Meanwhile, headline inflation has been elevated and has tended to surprise on the upside. Moreover, I worry that the persistence of sizable increases in energy and general commodity prices will have a more pronounced effect on core inflation going forward than they have in the recent past. Further, I have the sense, both from some estimates of inflation expectations and from the comments and questions I have been getting about inflation and the foreign exchange value of the dollar, that the public's conviction about monetary policy's willingness and ability to maintain low inflation is starting to waver. Thank you. " FinancialCrisisReport--494 The CDO valuation project undertaken in May provided clear notice to Goldman senior management at the highest levels that its CDO assets had fallen sharply in value, and that despite their lower value, the Mortgage Department planned to aggressively market them to customers. In an earlier draft of the presentation, the Mortgage Department had also stated that it expected Goldman’s CDO and CDO 2 securities “to underperform”: “The complexity of the CDO^2 product and the poor demand for CDOs in general has made this risk difficult to sell and the desk expects it to underperform.” 2096 Mr. Sparks reviewed that draft language and made comments about other items on the same page, but did not change the phrase, “the desk expects it to underperform.” 2097 The same phrase appeared 011057632 (mortgage credit business shared with SPG Trading Desk “a fairly lengthy list of accounts that are considered to be ‘key’”). In December 2006, the Correlation Trading Desk drew up a list of target customers for 2007: the “proposed top 20 correlation customer list.” 12/29/2006 email from Fabrice Tourre, “Last call–any other comments on the proposed top 20 correlation customer list, ” GS MBS-E-002527843, Hearing Exhibit 4/27-61. Mr. Tourre issued a “last call” for comments on the list and suggested focusing on “buy-and-hold rating-base buyers ” who might be more profitable for the desk than more sophisticated and demanding hedge fund customers: “[T]his list might be a little skewed towards sophisticated hedge funds with which we should not expect to make too much money since (a) most of the time they will be on the same side of the trade as we will, and (b) they know exactly how things work and will not let us work for too much $$$, vs. buy-and-hold rating- based buyers who we should be focused on a lot more to make incremental $$$ next year. ” The proposed top 20 list identified a number of European accounts, as well as customers who had purchased asset backed security products from Goldman in the past. The reference to “buy and hold, ratings-based buyers ” was to conservative financial institutions, often insurance companies or pension funds, that tended to hold their investments indefinitely or until maturity, some of which were limited to holding investments with AAA or other investment grade credit ratings. Many of these buyers tended to rely on the AAA rating as a “seal of approval ” signaling that the rated instrument offered predictable, safe returns. Many viewed the AAA rating as, in effect, all these buyers thought they needed to know about the CDO securities they were purchasing. See, e.g.,11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined Comments,” GS MBS-E-010135693-715 at 713) ( “Investors in subprime related securities, especially higher rated bonds, have historically relied significantly on bond ratings particularly when securities are purchased by structured investing vehicles.”). But as one press article explained: “CDO ratings may mislead investors because they can obscure the risk of default, especially compared with similar ratings for bonds, says Darrell Duffie, a professor of finance at Stanford Graduate School of Business in California, who ’s paid by Moody ’s to advise the company on credit risk. ‘You can ’t compare these CDO ratings with corporate bond ratings, ’ Duffie says. ‘These ratings mean something else – entirely.’” See 5/31/2007 email to David Lehman and others, “CDO Boom Masks Subprime Losses, ” GS MBS-E-001865723 at 733. The article pointed out that the lowest grade of corporate bonds rated by Moody ’s had a default rate of 2.2%, while the default rate for CDOs with the same rating was 24%. Id. 2096 5/19/2007 Goldman presentation, “Mortgages CDO Origination – Retained Positions & W arehouse Collateral, May 2007,” GS MBS-E-010951926. 2097 5/19/2007 email from Daniel Sparks, “Mortgages CDO Origination Presentation,” GS M BS-E-010973174 (Mr. Sparks: “p. 5 again ‘marked to securitization exit’ [re marked to model language] ... some A and BBB were sold on the deals [re demand only for the supersenior tranche language] ”). in several earlier versions of the presentation as well, but was removed from the final version sent to fcic_final_report_full--20 Veteran bankers, particularly those who remembered the savings and loan crisis, knew that age-old rules of prudent lending had been cast aside. Arnold Cattani, the chairman of Bakersfield, California–based Mission Bank, told the Commission that he grew uncomfortable with the “pure lunacy” he saw in the local home-building market, fueled by “voracious” Wall Street investment banks; he thus opted out of cer- tain kinds of investments by .  William Martin, the vice chairman and chief executive officer of Service st Bank of Nevada, told the FCIC that the desire for a “high and quick return” blinded people to fiscal realities. “You may recall Tommy Lee Jones in Men in Black, where he holds a device in the air, and with a bright flash wipes clean the memories of everyone who has witnessed an alien event,” he said.  Unlike so many other bubbles—tulip bulbs in Holland in the s, South Sea stocks in the s, Internet stocks in the late s—this one involved not just an- other commodity but a building block of community and social life and a corner- stone of the economy: the family home. Homes are the foundation upon which many of our social, personal, governmental, and economic structures rest. Children usually go to schools linked to their home addresses; local governments decide how much money they can spend on roads, firehouses, and public safety based on how much property tax revenue they have; house prices are tied to consumer spending. Down- turns in the housing industry can cause ripple effects almost everywhere. FOMC20070807meeting--107 105,CHAIRMAN BERNANKE.," Thank you for the useful discussion. As usual, I am going to very briefly summarize what I heard. I will be happy to take any comments on that. Then I just want to make a few short points. Again, most of the key points have been made. Most participants expect growth to remain moderate over the forecast period. Despite lower household wealth resulting from weaker house and stock prices, consumption is likely to continue to grow as labor markets remain strong, real incomes increase, and gasoline prices moderate. Business investment should also grow moderately, although lower productivity and higher volatility could be drags on investment. Commercial real estate, in particular, may be slackening, but it retains good fundamentals. The global economy is strong. Industrial production is expanding at a reasonable pace. However, downside risks to growth were noted and perhaps received somewhat greater emphasis than at past meetings. Most notably, housing appears to have weakened further, with sales of new and existing homes declining and inventories of unsold homes remaining high. Homebuilders are experiencing financial strains, and there is downward pressure on home prices. Spillover on consumption spending is not yet evident but is a possible risk. In this regard, developments in credit markets received considerable attention. On the positive side, the repricing of risk and the reevaluation of underwriting standards seem appropriate. Liquidity still exists, credit is still being extended, and markets may work out their problems on their own. A lower dollar and lower long-term Treasury rates also tend to offset financial tightening. However, higher risk premiums, tougher underwriting, and greater uncertainty may constrain housing and investment spending, leading to broader macroeconomic effects. In more-pessimistic scenarios, dislocations in credit markets may last awhile and have a more substantial effect on credit availability and costs for businesses as well as for homebuyers. The possibility of contagion or severe financial instability also exists. Many participants took note of the NIPA revisions and their implications for productivity growth, consumer saving, and unit labor costs. Meeting participants tend to put potential growth at higher rates than the Greenbook. Views on inflation are similar to those in previous meetings. Recent readings are viewed as reasonably favorable. However, risks to inflation remain, including the possible reversal of transitory factors, tight labor markets, the high price of commodities, and higher unit labor costs resulting from lower productivity growth. In all, the risks to inflation remain to the upside. That is my summary of what I heard. I’m sure a lot more could be said. Any comments? If not, let me just make a few additional comments. There have been two very important developments since the last meeting. The first was the downward revision to the NIPA growth numbers. It’s not obvious yet, of course, how much of that reflects a permanent decline in productivity and how much is transitory. But certainly the best guess is that some of it is more long term in nature. I think the main point I’d like to make is that the implications of this downward revision for inflation and monetary policy, except perhaps in the very short run, are not obvious. The question is, What is the effect of the lower productivity growth on aggregate demand? We have examples of both types of phenomena. In the late ’90s, the pickup in productivity growth stimulated a very strong boom working through the stock market, consumption, and investment, so it led to an overheating economy, whereas in the earlier part of this decade, productivity growth picked up again but with weak aggregate demand. We had a jobless recovery associated with that. So it remains to be seen exactly how aggregate demand will respond to these developments. I do think that perhaps that in the very short run, given wage behavior and unit labor costs, if I had to choose, I would say that there is a slight bias toward higher inflation and tighter money. In the longer run, you would expect to see lower long-term rates because of slower growth. The second issue that has been widely discussed around the table is the financial market. It is an interesting question why what looks like $100 billion or so of credit losses in the subprime market has been reflected in multiple trillions of dollars of losses in paper wealth. So it’s an interesting question about what is going on there. I think there are three reasons that the financial markets have moved in the direction they have. First, there has been a widespread repricing of risk. That is, obviously, a healthy development, particularly if there is no overshoot, which is a possibility. But all else being equal, it is restrictive in terms of aggregate demand, and it makes our policy tighter than it otherwise would be. The second reason for the changes in markets is that there has been a loss of confidence in the ability of investors to evaluate credit quality, particularly in structured products. There is an information fog, as I have heard it described. This is very much associated with the loss of confidence in the credit-rating agencies. I think one of the implications of this is that some of the innovations we have seen in financial markets are going to get rolled back. We are going to see more lending taken out of originate-to- distribute vehicles and put back onto portfolio balance sheets. So the question is how much effect this adjustment process will have on the availability of credit. The third reason that I think the markets have reacted as much as they have is concern about the macroeconomic implications of what is happening. In particular, there is a fear that subprime losses, repricing, and the tightening of underwriting standards will have adverse effects on the housing market and will feed through to consumption, and we will get into a vicious cycle. That certainly is reflected in the expectations of policy. I am not going to go through all the things that are going on now in the markets. You have had very good reviews of that. Obviously, the markets right now are not functioning normally. Some conduits of credit are simply closed or frozen. A number of companies are having difficulties with short-term finance, and so, per President Fisher’s comment, we are watching those things very carefully. We are prepared to use the tools that we have to address a short-term financial crisis, should one occur. In the longer term, of course, our policy should be directed not toward protecting financial investors but, rather, toward our macroeconomic objectives. That is very important. Then the question is what the long-run implications of the financial market adjustment will be for the economy. I think the odds are that the market will stabilize. Most credits are pretty strong except for parts of the mortgage market. But even so there will be notably tighter credit, tighter standards, probably some loss of confidence in markets, and higher risk premiums that will on net be restrictive. This restrictive effect could come in various magnitudes. It could be moderate, or it could be more severe, and we are just going to have to monitor how it adjusts over time. Again, there is a bit of a risk—and tail risk has been mentioned not only in a financial sense but also in the macro sense—that, if credit is severely restricted so that we get feedback from lower house prices, for example, into the financial markets, that situation would be difficult to deal with. Those are the two major issues that people have talked about. Just very briefly on the overall assessment—on the output side, economic growth looks a little softer to me, mostly because of housing. There are also some slightly worrying developments in terms of automobile demand, which suggest some weakening in consumer spending. But there are some strong elements as well. Also the labor market has marginally softened. The unemployment rate is about 25 basis points above its recent low; so there has been some movement, and I still expect to see some reduction in construction employment. So I think there is a bit more softness and there are a few more downside risks to output than at our last meeting. Like others, I think the recent inflation data are moderately encouraging. I continue to see risks. If you’re not satiated with risks, I’ll add one more, which is that if the housing market really weakens and people go back to renting, we could get the same phenomenon that we saw last year, by which rents are driven up and we get an effect working through shelter costs. So I agree with those who still view the risk to inflation as being tilted to the upside. If there are no comments or questions, let me turn now to Brian to discuss the policy action." FOMC20060510meeting--93 91,MR. FISHER.," Mr. Chairman, at the last meeting, I reported the comments of a CEO of a big box retailer who said the economy was “amazing.” I suppose the best summary of what I’m about to report to you in terms of my readings in the field—this time I assiduously talked to twenty-five CEOs and COOs, and I’ll give you that list separately so I won’t bore you with the details—the economy is even more amazing than it was before. That is, we see a shift taking place from consumption-driven to business-investment-driven growth, but also, unfortunately, we see evidence that inflation is raising its ugly head and that inflation expectations are higher as we go through time. Let me give you some specifics. According to reports from shippers that I’ve talked to, the shipping market for bulk and containers is stronger in the second quarter than it was in the first quarter. Karen, there is a report, which is why I would like to see a more definitive version, of fleet utilization running well over 90 percent and waiting time in ports increasing significantly. My rail contacts report that rail traffic as of April 22 is up 4½ percent for the year. They expect higher growth in the second quarter than in the first quarter. UPS is planning for “some moderation in volume” but “hasn’t seen any sign yet of a slowdown, discounting for the late Easter.” An airline with 80 million passengers reports very strong advance bookings through July in every region of the country. Some pressure from gas going over $3 at the pump has been reported, particularly in the past two weeks, by the retailers at every price point; and yet there’s an interesting shift taking place. For example, JCPenney now runs a billion dollars worth of sales through the Internet. That growth rate is increasing; it’s 23 percent. This way of presenting their products to the market helps to offset the oil price effect. In the IT sector, the book-to-bill ratio of the large semiconductors is still greater than 1. Companies like EDS and other “productivity enhancers” are seeing increased demand for their products, which they interpret as a vote of confidence. We’re also seeing increased demand for storage capacity, which many would interpret as a vote of confidence going forward in the business picture. From the largest bank in our District, the report is that volume is “so good you’re able to eat it.” They report, by the way—I don’t want to give offense to any sector of our economy—that the only people having credit problems are personal injury lawyers in Texas because of the reform that has taken place there. But other than that, the credits, as reported by banks, look to be in very, very good shape. In terms of the housing market, you may recall my last report from a large house builder who built 400,000 homes thus far. I’ve expanded that to another builder of similar size. The cancellation rate now, David, is up to 40 percent—a key indicator. However, it has shifted around the country, and in our state they report that you’d have to be a princess on a pea to feel any discomfort with the Texas housing market. It is booming, unlike the Florida market—which, as you know, is cascading. As far as cost-cutting capital expansion, it continues. Fluor reports a remarkable first-time-in- history statistic, which is that every single sector that they deal with, and every one of their product lines, is on the uptick. I want to report one particular project in summary that just puts things in perspective. Texas Utilities is about to announce a $10 billion coal-processing plant. This is conversion from coal to electricity. It will generate 40,000 jobs in our state to construct and 21,000 permanent jobs. But here’s the interesting statistic. It’ll take 12 million manhours and womanhours to construct. The CEO reports that ten years ago all those jobs would have been American jobs. Only 4 million of the manhours and womanhours to construct this project will be American jobs; the rest of the construction will be done in China or in Germany. Five years ago, it would have taken six years to build. According to the CEO, they’ll build it in three years, and to go to President Moskow’s point, yesterday the CEO of a large—as we used to say—“underwriting house” in New York offered to assume all the financing. They will finance at 100 percent nonrecourse. There’s a lot of liquidity in the system. We are concerned about prices. We see pricing power creeping upward in the reports we’re getting from the CEOs. As you know, our compass in Dallas is the trimmed mean PCE. It’s running at a rate of about 2.3 percent. At some point in the future, Mr. Chairman, I would like to provide a memo on that particular measure of inflation, which we consider to be a more reliable indicator of future inflation. But the point is that, in all of our soundings among these operators of businesses, they are feeling increasing price pressure, both at the intermediate level and at the consumer level. There are two little indicators that I found interesting. One is that Texas Instruments, which usually has 200 or 300 jobs maximum outstanding and looks for highly trained engineers, is now trying to fill 1,000 of those jobs and having trouble filling them. Second, at the other end of the range, 7- Eleven reports that in Florida, the Great Lakes District, and the Chesapeake Bay area, they cannot find $7- to $8-an-hour sales clerks. They are having to raise their prices. In short, we view this economy to be something like a 2006 BMW Z4 Roadster—Bluetooth- enabled, by the way. It’s complex, it’s highly integrated, it’s a technically advanced machine that apparently cannot help itself from exceeding the speed limit. [Laughter] Thank you." FOMC20061025meeting--231 229,MR. KROSZNER.," I support no change at this time. As many people have said, we’ve had very little new information to change our views from the last meeting, and I think that the position that we’re in is consistent with growth a tad under trend potential, whatever word we might want to use. I share Rick’s caution about being too explicit about that because I think there’s a lot of controversy about what that precisely means, and I don’t think we want to get into that in this statement or at least not at this point. Also, we have seen some inflationary pressures come off. Inflation has been evolving a bit as I expected. I was talking about the temporary factors versus the more-permanent factors. The key temporary factor seems to have been a temporary elevation in owners’ equivalent rent and the way we put that into our core CPI and PCE; so some of it is a measurement issue. Some of it is a transition in the housing market away from purchases toward rental. That seems to have come off a bit, and so going forward, it does seem as though we’re unlikely to have that continuing at elevated levels. My concern, as I mentioned yesterday, is that I don’t understand the path or the dynamics going forward. Certainly we have some simulations in the Bluebook which are very, very sticky. Inflation seems to evolve very slowly, or very little seems to affect it. Part of that seems to be, if we look at the data, that the energy price run-up appears not to have pushed much on inflation, so I don’t think we can rely on the energy price decline to give us much benefit in terms of core. Recent data on output gaps don’t seem to suggest that there’s much empirical evidence that a change in the cyclical behavior of the economy is going to have an important effect on inflation. Expectations certainly potentially have a very important effect, and I think we have seen a reduction in inflation expectations and inflation compensation, both in survey measures and in TIPS spreads or other market-based measures. But as I mentioned yesterday, that is a very fragile thing. The process is something that I don’t fully understand. Obviously, our credibility is very important, and our statements are very important. But it does seem as though the minutes and speeches have helped to clarify what our position is. If you look at the evolution of the expected fed funds rates in Vince’s exhibit 1, you see that not much change has been expected over quite a bit of time now and maybe 25 basis points is expected a year hence. That position is different from our position a few months ago. I think it’s an appropriate position given our discussions. It leaves us a lot of flexibility to respond either to surprisingly strong growth, to surprisingly strong inflation numbers, or to surprisingly weak housing. So I think that market expectations are in a reasonably good position in the near term. We do have to think about the longer-term issues that President Lacker has raised and that may come up in our discussions of communications. Speaking of communications, in particular the statement—we’ve been talking a lot about how the Committee is focused on data and the role of data and our forecasts. Because not much data have come in and our views have not changed a lot, I think we should not be changing the statement much. That is consistent with our view that we are really focusing on the data. In particular, I don’t like speculating about a particular number, especially when that number is going to be revealed in a few days, for three reasons. One is the potential embarrassment factor if we’ve missed the number. The second is that, even if we have very high confidence that we have gotten the number roughly right, getting it right only feeds the view that a lot of market participants have— and I’m sure you’ve all heard this—that we know something the rest of the world doesn’t, that we know these data before the rest of the world. I don’t—maybe some of you guys do [laughter]—at least the staff has not revealed any of that to me. Third, what we’ve been trying to say is that we look at a mosaic of data; we don’t look at any one piece, and to emphasize one piece is problematic. So that said, obviously the type of approach that Don was discussing is one that I would support. But I do think it is very important to make sure that we have a good understanding, in the context of that statement, of what “moderate” would be interpreted as. Obviously it will be very important in the minutes to make very clear what that is, and obviously with our blackout period, it will take us a while before we can make explicit statements if there’s confusion in the market. So I do think we need to think about the interpretation of “moderate.” However, I like the idea of conveying that the economy is likely to be coming back, perhaps not at the robust pace that we’ve seen in the past but at a reasonable or moderate pace. Given that energy prices and commodity prices have come down, we should be taking out that energy prices and commodity prices are pushing up inflation or seem to be sustaining inflation pressures. Also given that we have not seen much change in the data or have not made much change in our approach, there’s really no reason to change the assessment-of-risk discussion, particularly as the markets seem to be interpreting our assessments roughly where we think is reasonable considering the risks going forward. If the markets were interpreting things as they had been interpreting them a month or two ago, we may have wanted to change our statement, but I see no reason to do that now." FOMC20070131meeting--172 170,MR. KOHN.," Thank you, Mr. Chairman. In preparation for submitting my forecast, I looked at my previous forecasts—a humbling but instructive experience usually. [Laughter] Going back a year, I found that, based on the staff’s estimate for 2006, inflation and growth had each turned out within a quarter point of my projections. I’m quite certain that this is not a consequence of any particular expertise on my part. Rather, it is indicative that, in a broad sense, the economy is performing remarkably close to our expectations. President Poole was making this point. Even going back a few years to when we started to remove accommodation, despite large fluctuations in energy prices in recent years, huge geopolitical uncertainties, and a housing boom and bust the dimensions of which we really didn’t anticipate three years ago, the economy is in the neighborhood of full employment, and core inflation is at a fairly low rate by historical standards. Now, the surprises last year were the surge of inflation in the spring and early summer. That has not been entirely reversed. The extent of the slowdown in productivity growth, both in terms of trend and of actual relative to the lower estimated trend, and the related decline in the unemployment rate suggest that we are entering 2007 with a higher risk of inflation than I had anticipated a year ago. Given this risk, it is especially important that economic growth be no greater and perhaps a little less than the growth rate of potential, and that is my forecast—a small uptrend in the unemployment rate. The issue I wrestled with was how fast the economy will be growing when the drag from housing abates. In early December, the debate might have been about whether demand would be sufficient to support growth as high as potential. But given the stabilization of housing demand, the strength of consumption, and ongoing increases in employment, I asked myself whether we might not find the economy growing faster than its potential beginning in the second half of 2007 and in 2008, thereby adding to inflation pressures. A couple of forces, however, gave me a little comfort in supporting my projection of only moderate growth. One is the modest restraint on demand from the recent rise in interest rates, especially the restraint on the housing market, and the dollar exchange rate. Another is the likelihood that consumption will grow more slowly relative to income and will lag the response to housing as housing prices level out and as energy prices begin to edge higher. Consumption late last year was probably still being boosted substantially by the past increases in housing wealth and by the declines in energy prices, which combined with warm weather to give a considerable lift to disposable income. On the housing wealth factor, I think our model suggests that it takes several quarters for a leveling out in housing wealth to build into consumption. In fact, the data through the third quarter suggest that prices were really just about leveling out in the third quarter. So it may be a little early to conclude that, just because we’re not seeing a spillover from the housing market to consumption, there isn’t going to be any. I expect some, though modest, spillover. Moreover, some of the impulse in the fourth quarter was from net exports. These were spurred in part by a temporary decline in petroleum imports and an unexpected strength in exports. Those conditions are unlikely to be sustained. In addition, business investment spending has been weaker than we anticipated. Now, I suspect this is, like the inventory situation, just an aspect of adapting to a slower pace of growth, and investment will strengthen going forward. But it does suggest that businesses are cautious. They are not anticipating ebullient demand and a pressing need to expand facilities to meet increases in sales, and their sense of their market seems worth factoring into our calculations. Finally, the fact that I would have been asking just the opposite question seven weeks ago suggests that we’re also putting a lot of weight on a few observations, [laughter] whether regarding the weakness then or the strength more recently. I do continue to believe that growth close to the growth rate of potential will be consistent with gradually ebbing inflation. For this I would round up the usual suspects, reflecting the ebbing of some temporary factors that increased inflation in 2006. One factor is energy prices. Empirical evidence since the early 1980s to the contrary notwithstanding, the coincidence that President Lacker remarked between the rise and fall in energy prices in 2006 and the rise and fall in core inflation suggests some cause and effect. The increase in energy prices into the summer has probably not yet been completely reversed in twelve-month core inflation rates, so I expect some of that to be dying out as we go into the future. Increases in rents are likely to moderate as units are shifted from ownership to rental markets. The slowdown in growth relative to earlier last year seems to have made businesses more aware of competitive pressures, restraining pricing power. When we met last spring, we had a lot of discussion about businesses feeling that they had pricing power—that they could pass through increases in costs. I haven’t heard any of that discussion around the table today. The recent slowdown in inflation is encouraging but not definitive evidence that the moderation is in train. The slowdown could have been helped by the decline in energy prices, and that decline won’t be repeated. Goods prices might have been held back by efforts to run off inventories, and that phenomenon, too, would be temporary. As I already noted, the initial conditions—the recent behavior of productivity and the relatively low level of the unemployment rate—suggest upward inflation risks relative to this gentle downward tilt. To an extent, the staff has placed a relatively favorable interpretation on these developments. They haven’t revised trend productivity down any further. They expect a pickup in realized productivity growth over this year. They see a portion of the strength in labor markets as simply lagging the slowdown in growth—a little more labor hoarding than usual as the economy cools, along with some statistical anomalies. Thus, in the Greenbook, the unemployment rate rises, and inflation pressures remain contained as activity expands at close to the growth rate of potential. President Yellen at the last meeting and Bill Wascher today pointed out two less benign possibilities. One is that demand really has been stronger, as indicated by the income-side data, and that the labor and product markets really are as tight as the unemployment rate suggests. In this case, the unemployment rate wouldn’t drift higher with moderate growth. Businesses might find themselves facing higher labor costs and being able to pass them on unless we take steps to firm financial conditions. The second possibility is that trend productivity is lower. In this case, actual productivity growth might not recover much this year. Unit labor costs would rise more quickly. Given the apparent momentum in demand, we might be looking at an even further decline in the unemployment rate in the near term. Now, my outlook is predicated on something like the staff interpretation, but I think these other possibilities underline the inflation risks in an economy in which growth has been well maintained. Thank you, Mr. Chairman." CHRG-111shrg50814--8 Mr. Bernanke," Thank you. Chairman Dodd, Senator Shelby, and Members of the Committee, I appreciate the opportunity to discuss monetary policy and the economic situation and to present the Federal Reserve's monetary policy report to the Congress. As you are aware, the U.S. economy is undergoing a severe contraction. Employment has fallen steeply since last autumn, and the unemployment rate has moved up to 7.6 percent. The deteriorating job market, considerable losses of equity and housing wealth, and tight lending conditions have weighed down on consumer sentiment and spending. In addition, businesses have cut back capital outlays in response to the softening outlook for sales, as well as the difficulty of obtaining credit. In contrast to the first half of last year, when robust foreign demand for U.S. goods and services provided some offset to weakness in domestic spending, exports slumped in the second half as our major trading partners fell into recession and some measures of global growth turned negative the first time in more than 25 years. In all, U.S. real gross domestic product declined slightly in the third quarter of 2008, and that decline steepened considerably in the fourth quarter. The sharp contraction in economic activity appears to have continued into the first quarter of 2009. The substantial declines in the prices of energy and other commodities last year and the growing margin of economic slack have contributed to a substantial lessening of inflation pressures. Indeed, overall consumer price inflation measured on a 12-month basis was close to zero last month. Core inflation, which excludes the direct effects of food and energy prices, also has declined significantly. The principal cause of the economic slowdown was the collapse of the global credit boom and the ensuing financial crisis, which has affected asset values, credit conditions, and consumer and business confidence around the world. The immediate trigger of the crisis was the end of the housing booms in the United States and other countries and the associated problems in mortgage markets, notably the collapse of the U.S. subprime mortgage market. Conditions in housing and mortgage markets have proved a serious drag on the broader economy, both directly through their impact on residential construction and related industries and on household wealth, and indirectly through the effects of rising mortgage delinquencies on the health of financial institutions. Recent data show that residential construction and sales continue to be very weak, house prices continue to fall, and foreclosure starts remain at very high levels. The financial crisis intensified significantly in September and October. In September, the Treasury and the Federal Housing Finance Agency placed the Government-sponsored enterprises Fannie Mae and Freddie Mac into conservatorship, and Lehman Brothers Holdings filed for bankruptcy. In the following weeks, several other large financial institutions failed, came to the brink of failure, or were acquired by competitors under distressed circumstances. Losses at a prominent money market mutual fund prompted investors, who had traditionally considered money market mutual funds to be virtually risk free, to withdraw large amounts from such funds. The resulting outflows threatened the stability of short-term funding markets, particularly the commercial paper market, upon which corporations rely heavily for their short-term borrowing needs. Concerns about potential losses also undermined confidence in wholesale bank funding markets, leading to further increases in bank borrowing costs and a tightening of credit availability from banks. Recognizing the critical importance of the provision of credit to businesses and households from financial institutions, the Congress passed the Emergency Economic Stabilization Act last fall. Under the authority granted by this act, the Treasury purchased preferred shares in a broad range of depository institutions to shore up their capital basis. During this period, the FDIC introduced its Temporary Liquidity Guarantee Program, which expanded its guarantees of bank liabilities to include selected senior unsecured obligations and all non-interest-bearing transactions deposits. The Treasury, in concert with the Federal Reserve and the FDIC, provided packages of loans and guarantees to ensure the continued stability of Citigroup and Bank of America, two of the world's largest banks. Over this period, governments in many foreign countries also announced plans to stabilize their financial institutions, including through large-scale capital injections, expansions of deposit insurance, and guarantees of some forms of bank debt. Faced with the significant deterioration of financial market conditions and the substantial worsening of the economic outlook, the Federal Open Market Committee continued to ease monetary policy aggressively in the final months of 2008, including a rate cut coordinated with five other major central banks. In December, the FOMC brought its target for the Federal funds rate to a historically low range of zero to one-quarter percent, where it remains today. The FOMC anticipates that economic conditions are likely to warrant exceptionally low levels of the Federal funds rate for some time. With the Federal funds rate near its floor, the Federal Reserve has taken additional steps to ease credit conditions. To support housing markets and economic activity more broadly and to improve mortgage market functioning, the Federal Reserve has begun to purchase large amounts of agency debt and agency mortgage-backed securities. Since the announcement of this program last November, the conforming fixed mortgage rate has fallen nearly 1 percentage point. The Federal Reserve also established new lending facilities and expanded existing facilities to enhance the flow of credit to businesses and households. In response to the heightened stress in bank funding markets, we increased the size of the Term Auction Facility to help ensure that banks could obtain the funds they need to provide credit to their customers, and we expanded our network of swap lines with foreign central banks to ease conditions in interconnected dollar funding markets at home and abroad. We also established new lending facilities to support the functioning of the commercial paper market and to ease pressures on money market mutual funds. In an effort to restart securitization markets to support the extension of credit to consumers and small businesses, we joined with the Treasury to announce the Term Asset-backed Securities Loan Facility, or TALF. The TALF is expected to begin extending loans soon. The measures taken by the Federal Reserve, other U.S. Government entities, and foreign governments since September have helped to restore a degree of stability to some financial markets. In particular, strains in short-term funding markets have eased notably since last fall, and London Interbank Offered Rates, or LIBOR, upon which borrowing costs for many households and businesses are based, have decreased sharply. Conditions in the commercial paper market also have improved, even for lower-rated borrowers, and the sharp outflows from money market mutual funds seen in September have been replaced by modest inflows. Corporate risk spreads have declined somewhat from extraordinarily high levels, although these spreads remain elevated by historical standards. Likely spurred by the improvements in pricing and liquidity, issuance of investment-grade corporate bonds has been strong, and speculative-grade issuance, which was near zero in the fourth quarter, has picked up somewhat. As I mentioned earlier, conforming fixed mortgage rates for households have declined. Nevertheless, despite these favorable developments, significant stresses persist in many markets. Notably, most securitization markets remain shut other than that for conforming mortgages, and some financial institutions remain under pressure. In light of ongoing concerns over the health of financial institutions, the Secretary of the Treasury recently announced a plan for further actions. This plan includes four principal elements. First, a new Capital Assistance Program will be established to ensure that banks have adequate buffers of high-quality capital based on results of comprehensive stress tests to be conducted by the financial regulators, including the Federal Reserve. Second is a Private-Public Investment Fund in which private capital will be leveraged with public funds to purchase legacy assets from financial institutions. Third, the Federal Reserve, using capital provided by the Treasury, plans to expand the size and scope of the TALF to include securities backed by commercial real estate loans and potentially other types of asset-based securities as well. And, fourth, the plan includes a range of measures to help prevent unnecessary foreclosures. Together, over time, these initiatives should further stabilize our financial institutions and markets, improving confidence and helping to restore the flow of credit needed to promote economic recovery. The Federal Reserve is committed to keeping the Congress and the public informed about its lending programs and balance sheet. For example, we continue to add to the information shown in the Fed's H41 statistical release, which provides weekly detail on the balance sheet and the amounts outstanding for each of the Federal Reserve's lending facilities. Extensive additional information about each of the Federal Reserve's lending programs is available online. The Fed also provides bimonthly reports to the Congress on each of its programs that rely on the Section 13(3) authorities. Generally, our disclosure policies reflect the current best practices of major central banks around the world. In addition, the Federal Reserve's internal controls and management practices are closely monitored by an independent Inspector General, outside private sector auditors, and internal management and operations divisions, and through periodic reviews by the Government Accountability Office. All that said, we recognize that recent developments have led to a substantial increase in the public's interest in the Fed's programs and balance sheet. For this reason, we at the Fed have begun a thorough review of our disclosure policies and the effectiveness of our communication. Today, I would like to highlight two initiatives. First, to improve public access to information concerning Fed policies and programs, we recently unveiled a new section of our Web site that brings together in a systematic and comprehensive way the full range of information that the Federal Reserve already makes available, supplemented by explanations, discussions, and analyses. We will use that Web site as one means of keeping the public and the Congress fully informed about Fed programs. Second, at my request, Board Vice Chairman Donald Kohn is leading a committee that will review our current publications and disclosure policies relating to the Fed's balance sheet and lending policies. The presumption of the committee will be that the public has the right to know and that the non-disclosure of information must be affirmatively justified by clearly articulated criteria for confidentiality based on factors such as reasonable claims to privacy, the confidentiality of supervisory information, and the need to ensure the effectiveness of policy. In their economic projections for the January FOMC meeting, monetary policymakers substantially marked down their forecasts for real GDP this year relative to the forecast they had prepared in October. The central tendency of their most recent projections for real GDP implies a decline of one-and-one-half percent to one-and-one-quarter percent over the four quarters of 2009. These projections reflect an expected significant contraction in the first half of this year, combined with an anticipated gradual resumption of growth in the second half. The central tendency for the unemployment rate in the fourth quarter of 2009 was marked up to a range of eight-and-a-half percent to eight-and-three-quarters percent. Federal Reserve policymakers continue to expect moderate expansion next year, with a central tendency of two-and-a-half percent to three-and-a-quarter percent growth in real GDP and a decline in the unemployment rate by the end of 2010 to a central tendency of 8 percent to eight-and-a-quarter percent. FOMC participants marked down their projections for overall inflation in 2009 to a central tendency of one-quarter percent to 1 percent, reflecting expected weakness in commodity prices and the disinflationary effects of significant economic slack. The projections for core inflation also were marked down to a central tendency bracketing 1 percent. Both overall and core inflation are expected to remain low over the next 2 years. This outlook for economic activity is subject to considerable uncertainty, and I believe that, overall, the downside risks probably outweigh those on the upside. One risk arises from the global nature of the slowdown, which could adversely affect U.S. exports and financial conditions to an even greater degree than currently expected. Another risk arises from the destructive power of the so-called adverse feedback loop in which weakening economic and financial conditions become mutually reinforcing. To break the adverse feedback loop, it is essential that we continue to complement fiscal stimulus with strong government action to stabilize financial institutions and financial markets. If actions taken by the administration, the Congress, and the Federal Reserve are successful in restoring some measure of financial stability, and only if that is the case, in my view, there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery. If financial conditions improve, the economy will be increasingly supported by fiscal and monetary stimulus, the salutary effects of the steep decline in energy prices since last summer, and the better alignment of business inventories and final sales, as well as the increased availability of credit. To further increase the information conveyed by the quarterly projections, FOMC participants agreed in January to begin publishing their estimates of the values to which they expect key economic variables to converge over the longer run, say at a horizon of 5 to 6 years, under the assumption of appropriate monetary policy and in the absence of new shocks to the economy. The central tendency for the participants' estimates of a longer run growth rate of real GDP is two-and-a-half percent to two-and-three-quarters percent. As to the longer rate of unemployment, it is four-and-three-quarter percent to 5 percent. And as to the longer rate of inflation, it is one-and-three-quarter percent to 2 percent, with the majority of participants looking for 2 percent inflation in the long run. These values are all notably different from the central tendencies of the projections for 2010 and 2011, reflecting the view of policymakers that a full recovery of the economy from the current recession is likely to take more than 2 or 3 years. The longer-run projections for output growth and unemployment may be interpreted as the Committee's estimates of the rate of growth of output and the unemployment rate that are sustainable in the long run in the United States, taking into account important influences such as the trend in growth rates of productivity in the labor force, improvements in worker education and skills, the efficiency of the labor market at matching workers and jobs, government policies affecting technological development, or the labor market and other factors. The longer-run projections of inflation may be interpreted, in turn, as the rate of inflation that FOMC participants see as most consistent with the dual mandate given to it by the Congress, that is the rate of inflation that promotes maximum sustainable employment while also delivering reasonable price stability. This further extension of the quarterly projection should provide the public a clearer picture of the FOMC's policy strategy for promoting maximum employment and price stability over time. Also, increased clarity about the FOMC's views regarding longer-run inflation should help to better stabilize the public's inflation expectations, thus contributing to keeping actual inflation from rising too high or falling too low. At the time of our last monetary policy report, the Federal Reserve was confronted with both high inflation and rising unemployment. Since that report, however, inflation pressures have receded dramatically while the rise in the unemployment rate has accelerated and financial conditions have deteriorated. In light of these developments, the Federal Reserve is committed to using all available tools to stimulate economic activity and to improve financial market functioning. Toward that end, we have reduced the target for the Federal Funds Rate close to zero and we have established a number of programs to increase the flow of credit to key sectors of the economy. We believe that these actions, combined with the broad range of other fiscal and financial measures being put into place, will contribute to a gradual resumption of economic growth and improvement in labor market conditions in a context of low inflation. We will continue to work closely with the Congress and the administration to explore means of fulfilling our mission of promoting maximum employment and price stability. Thank you, Mr. Chairman. " FOMC20051213meeting--78 76,MS. PIANALTO.," Thank you, Mr. Chairman. What a difference six weeks can make. At our last meeting, the Greenbook offered two alternative scenarios—stagflation and a consumer sentiment slump—which at least from the Fourth District’s perspective seemed plausible and worrisome. In early November, we had to consider the possibility that output growth might weaken even as inflation accelerated. Fortunately, the output and productivity data that we’ve received since that meeting have been on the upside, and the inflation news has been generally encouraging. Although there are still various scenarios to worry about today, stagflation and a consumer sentiment slump no long appear to be among them. My own information-gathering process during this intermeeting period leaves me very comfortable with the Greenbook baseline, which now expects more favorable paths for output, productivity, and inflation than it called for at our last meeting. I have a few observations about each of these. First, output. The national pace of economic December 13, 2005 46 of 100 on a slower improvement trend. Bankers report that the commercial loan pipelines are filling up, and competition among lenders is very strong. As I said, my District has been trailing the nation. The automobile industry has a large weight in my District, and recent developments there, though not unexpected, are pretty dreary, as President Moskow reported. The Big Three automobile companies and their suppliers are under intense pressure to downsize and reduce costs, especially labor costs. Many plant closings and layoffs have already been announced, and the dark clouds hanging over the industry are already having adverse effects on many communities. But most business leaders I speak with outside of the automobile industry are optimistic about their national markets as they look into next year. Next I’ll comment on productivity. The CEOs that I talked to are still working very hard to generate profits by increasing productivity. I’m amazed by how frequently and uniformly CEOs talk about efficiency efforts under way in their companies. A natural consequence of the productivity culture, of course, is that business people are watching their head counts very closely, even as their sales are expanding. Hospital executives are especially bullish about their ability to generate significant productivity gains, and they’ve been ramping up their capital spending on equipment and facilities. One of my directors works for a large commercial construction company and reports that this is a nationwide trend. Finally, inflation. Retailers tell me that they’ve trained their customers to shop for bargains only too well. Consumers are relentless in their hunt for bargains, and Internet shopping is growing rapidly in popularity and making that hunt for bargains easier. Retailers in the District tell me that they expect consumers to hang back and wait until the bitter end for steeper discounts, and those discounts are going to inevitably rise as Christmas looms close. Consequently, retailers expect to turn December 13, 2005 47 of 100 they seek at this time of the year. Discounting is extremely intense. Sales volume, then, should turn out well, but profits may be disappointing. Some manufacturers say that they are finally getting a little traction with price increases above and beyond the energy surcharges. But most manufacturers that I talked to report that competition remains very intense and they emphasize that they have little pricing power. Although businesses have had to absorb price increases for many of their commodity inputs, several business executives note that raw materials prices have stopped increasing for the most part and, in many instances, have started to decline. So as I look at the national economy, I’m very comfortable with the Greenbook baseline. I expect productivity growth to hold up rather well next year, along the lines of that faster productivity growth alternative scenario in the Greenbook. Although I indicated in my report at our last meeting that we could see stronger pass-through of energy prices, I was not hearing that from my business contacts in their reports this time around. In fact, many of them said that the energy and commodity price shocks that we’ve experienced in the past two years could move through our economy without elevating core inflation rates. The disappearance of the stagflation and consumer sentiment slump scenarios and the emergence of other risks serve as a reminder to me that the future, even the near-term future, is uncertain. The 70 percent confidence range surrounding the Greenbook baseline projection is wide enough to include all of the alternative simulations. I believe, as a couple of others have already said, that with another move today our policy accommodation will have been substantially removed, making the timing and extent of additional firming more uncertain for me. Thank you, Mr. Chairman. December 13, 2005 48 of 100" FOMC20050322meeting--125 123,MR. GRAMLICH.," Thank you, Mr. Chairman. I think I will be the fourteenth person to explain why the balance of risks is gradually changing. A few months ago, we were still worried about supposed soft spots but at this point the expansion looks pretty solid. Housing and consumption growth remain strong. The feared pothole in business investment never materialized, which strengthens the forecast in two ways. Not only is there no pothole, but now the strength of investment last year can be attributed to underlying forces, not tax incentives, and carried forward into this year. The international economy looks pretty vigorous, especially for emerging-market countries, and actual output expansion is now being forecast even for Japan. The Blue Chip forecasts, which I use as a reflection of conditions more than as forecasts, are now being revised upward. The whole picture looks quite strong, and, if anything, the risks are tilting to the upside. Conditions will be very strong if the personal saving rate doesn’t rise. A recent bank newsletter was entitled “A Whiff of Inflation in the Air.” I actually think it is still possible not to whiff inflation, but there is no denying that the risks are changing. Oil prices have jumped up again both for the spot price and the far futures price. In contrast March 22, 2005 59 of 116 present uptick seems more likely due to international demand conditions, making the higher prices less idiosyncratic and presumably more lasting. Other commodity prices have also jumped. The dollar has fallen already, and there will be continuing fears that it will fall further, with these fears presumably lasting until our international liability ratio stabilizes—a prospect that seems more remote by the day. So far, wages and unit labor costs have been a stabilizing force but wages may become less so as output gaps tighten, and productivity growth rates could at some point stabilize or decline. There is nothing surprising or disappointing in this. If a year ago we had known that output growth would be healthy here and around the world, that output gaps were closing, that oil prices were high, that commodity prices were high, and that the dollar was falling, we all would have been quite worried about inflationary threats. In a way, over this span the anti-inflation news has been reasonably good. Pass-throughs have proved modest, and wages have been rather well behaved. Productivity has hung in there. But there is still an enhanced risk of inflation. In recent meetings, I have held out one factor that could get me to be less hawkish—the prospect of real fiscal tightening. This has become less likely, too. There has been a dispute between those who want to cut spending and extend the tax cuts and those who want to maintain spending. When not dealing with steroids in baseball and feeding tubes in Florida, the Congress seems to be working toward one of their unique compromises: Let’s extend the tax cuts and maintain spending. [Laughter] There just doesn’t seem to be much voice for and hope for real fiscal tightening. Hence, whether one is looking at output growth, inflationary pressures, or fiscal policy, the March 22, 2005 60 of 116 for 25 basis points per meeting and for keeping the “measured pace” rhetoric for a little while longer, but I am also for tightening up our rhetoric in subtle or even occasionally non-subtle ways. There has been some dispute about the normative global impact of our low national saving rate, and I would like to say a word about that. When one aggregates the low personal saving and the large budget deficit, the U.S. national saving rate is at a post-war low. How bad is that? Given what appears to be a saving glut around the world, some argue that it’s actually a good thing our national saving is low. Otherwise, world long-term interest rates would fall to very low levels. It is definitely good for world savers that our own national saving is low. That maintains their return. But I am still more worried about stimulating world investment than about the returns realized by savers. We all know that in this country the number of workers per retiree will fall from 3.3 now to 2 in about 30 years—2 is actually high by world standards. With present trends and with present policy, the same ratio will be a little more than 1 for Canada, France, Germany, Korea, Russia, and the United Kingdom, and actually less than 1 for Italy and Japan. That’s right. Those two countries are on track to have more retirees than workers. Even in most emerging-market countries, the ratio will not be much above 2. Barring the unlikely case where national social security systems are totally fully funded, the younger generations in all of these countries are going to need more capital to pay the retirement and health costs of our generation. Hence, I remain much less worried about the upward pressure that our low national saving puts on world interest rates than the downward pressure it puts on world investment. Yes, in the short run our high budget deficit and low national saving are benefiting world savers. But, no, in the long run, I don’t think they are benefiting the world. Thank you. March 22, 2005 61 of 116" FOMC20080625meeting--3 1,MR. DUDLEY.," 1 Thank you, Mr. Chairman. I'm going to be referring to the handout that you should have in front of you. Financial markets have become more resilient to bad news in recent weeks. Although the news associated with several important groups of financial intermediaries--including investment banks, commercial banks, and the monoline insurers--has not been favorable, contagion has been limited compared with some of our earlier experiences during the past year. Moreover, the types of vicious feedback loops that were evident, for example, in early March have been largely absent more recently. Despite this, much of the news has not been good. Looking first at the U.S. equity and credit markets, a good portion of the improvement that occurred in the run-up to the April FOMC meeting has been unwound recently. The broad U.S. equity indexes are only marginally above their low points reached in mid-March and the price of the Standard & Poor's 500 financial sub-index has fallen to a new trough (exhibit 1). In contrast, corporate credit spreads have held on to much of the gains achieved after mid-March. As shown in exhibit 2, the spreads on both investmentgrade and high-yield corporate debt have been quite stable recently. However, as shown in exhibit 3, corporate credit default swap spreads have widened over the past few weeks. Most of the major investment banks have continued to struggle. As shown in exhibit 4, the share prices of the four remaining independent U.S. investment banks remain depressed. Further write-offs, capital-raising (which is increasing the number of common share equivalents outstanding), and investors' concerns about the consequences of deleveraging on long-term profitability have all been important factors weighing on share prices. In contrast to this poor equity-price performance, credit default swap (CDS) spreads remain much narrower than at the time of Bear Stearns's demise in mid-March (exhibit 5). The establishment of the Primary Dealer Credit Facility and the Federal Reserve's role in the acquisition of Bear Stearns by JPMorgan Chase are undoubtedly both important factors behind the divergence of equity prices and credit default swap spreads. Lehman Brothers, which reported a second-quarter loss that was considerably larger than expected, has been under the most stress. However, in contrast to Bear Stearns's experience in mid-March, Lehman's short-term financing counterparties have generally proved to be patient. The financing backstop provided by the Primary Dealer Credit Facility has been cited by many counterparties as a critical element that has encouraged them to keep their 1 The materials used by Mr. Dudley are appended to this transcript (appendix 1). financing lines to Lehman in place. The investment banks have begun to rapidly deleverage their balance sheets. As shown in exhibit 6, the gross leverage ratios for Lehman Brothers, Goldman Sachs, and Morgan Stanley all fell sharply in the second quarter. This stands in marked contrast to the rise in leverage ratios that persisted through the first quarter of this year. Regional banks have also come under considerable strain recently. Deterioration in their construction lending, commercial real estate, and residential mortgage books has caused many banks to raise their loan-loss provisions sharply. Potential acquirers of troubled regional banks have been discouraged by the accounting requirement that these banks must mark down the assets of the bank that they're acquiring to the current market value at the time of the acquisition. The financial guarantors have also been under stress. Both Standard & Poor's and Moody's recently downgraded Ambac and MBIA. The Moody's downgrade of MBIA was particularly sharp--five notches to A2 from AAA. These downgrades of the monoline guarantors have a number of important implications. First, the firms that have purchased protection from Ambac and MBIA will have to take significant write-downs. Citigroup, Merrill Lynch, and UBS appear to have the largest exposures to these two firms. Second, the ability of Ambac and MBIA to establish new AAA-rated subsidiaries that would enable them to write new municipal bond insurance is increasingly in doubt. Most likely, these firms will be forced to go into runoff mode in which they can no longer write new business. Third, the financial resources of these firms will be strained by the downgrades. For example, MBIA said that, as a result of the downgrades, it may have to pay out $2.9 billion to satisfy certain contracts and post up to $4.5 billion of additional collateral. Fourth, the risk of a default or a restructuring event by a major monoline guarantor could potentially unsettle the CDS market. As shown in exhibits 7 and 8, the share prices of the monolines have continued to slide, and their credit default swap spreads have risen further. As has been the case for some time, there remains--even after the credit rating downgrades--a big disconnect between the CDS spreads of these firms and their credit ratings. Despite these rating downgrades, the effect on the municipal securities market has been muted compared with the turmoil evident in the first quarter. Put simply, much of the adjustment in the short-term municipal market--for example, the demise of the muni auction rate securities market and the restructuring of many variable rate demand notes (VRDN) and tender option bond (TOB) securities, has already taken place. Although the yields on the VRDNs wrapped by Ambac and MBIA have increased sharply, up to now much of this paper has been remarketed rather than put back to the liquidity providers. The effect on the municipal bond market has been even more subdued. As shown in exhibit 9, the ratios of 10-year and 30-year municipal yields to comparable Treasury yields have risen only slightly recently and remain well below the peaks reached in mid-March. Investors have already been looking through the credit ratings of the monoline insurers to the quality of the underlying tax-exempt issuer. The performance of term funding markets also suggests a greater resilience to bad news. Subsequent to the May expansion of the TAF auction sizes and the increase in the foreign exchange swap lines with the European Central Bank and the Swiss National Bank, one-month and three-month LIBOR�OIS spreads have narrowed significantly (exhibits 10 and 11). The decline in term funding spreads is particularly noteworthy because it stands in contrast to the widening that occurred in the last month of the three preceding quarters--September, December, and March. The increase in the size of the TAF auctions has also been associated with a decline in bid-to-cover ratios. Also, as shown in exhibit 12, the spread between the stop-out rate and the minimum bid rate has been relatively low. In contrast to the U.S. auctions, the bid-to-cover ratios in the ECB and SNB auctions have risen sharply over the last three auctions (exhibit 13). This likely reflects several factors including (1) a reduction in the willingness of U.S. banks to lend at term to European banks--due mostly to balance sheet constraints and (2) strategic bidding behavior. As you recall, the ECB auction is a noncompetitive auction with the stop-out rate determined by the TAF auction. As a consequence, increasing the bid size in the ECB auction will not raise the price that the banks will have to pay, and that encourages more bidding in the ECB auctions. This strategic bidding explanation, however, is undercut by the fact that European banks have also been strong bidders in both the TAF and the SNB auctions. The introduction by ICAP of a competing measure of bank funding costs-- the New York Funding Rate (NYFR)--has mostly bolstered the credibility of LIBOR. The NYFR rates have consistently been within 1 or 2 basis points of LIBOR. However, it is unclear how much this conformity reflects the accuracy of LIBOR. It is possible that the NYFR respondents use LIBOR as a benchmark for their own responses, since LIBOR comes out earlier in the day than when they have to respond. Demand for the term securities lending facility (TSLF) auctions has also generally been subdued. Only one of the last nine auctions has been fully subscribed. This mainly reflects the convergence in Treasury and non-Treasury repo financing rates. Following the first TSLF auction, Treasury repo rates rose sharply. Given the minimum bid rates for the schedule 1 and schedule 2 auctions of 10 and 25 basis points respectively, the convergence in repo rates has eroded the economic appeal of the TSLF auctions as a funding vehicle. The $80 billion of the single-tranche repo program has been more attractive as a source of funding. Moreover, the PDCF backstop has made investors more willing to finance the non-Treasury collateral held by the investment banks and other primary dealers, and this has also reduced the demand for TSLF borrowing. The continued rise in commodity prices has been another important market development. As shown in exhibit 14, both energy and agricultural prices have been rising sharply. Although the weakness of the dollar has often been cited by analysts as a causal factor behind the surge in commodity prices, the recent rise in energy and food prices has been accompanied by a slightly stronger, rather than weaker, dollar (exhibit 15). Nevertheless, short-term movements in the dollar and oil prices do appear to have become more closely linked over the past few years. Exhibit 16 plots the six-month rolling correlation between the weekly change in the spot price of West Texas intermediate crude oil and the weekly change in the value of the tradeweighted dollar. As can be seen, these price changes have become increasingly negatively correlated in recent years. Of course, correlation does not imply causality. Even if there is causality, it is unclear in what direction the causality runs--from commodities to the dollar or from the dollar to commodities. Although many factors are undoubtedly at play, a couple of possible explanations that have made the rounds may be worth considering. First, higher oil prices swell the dollar reserves held by the oil-producing countries. Because these countries may respond to this dollar influx by selling dollars to diversify their foreign exchange reserve holdings, traders may sell dollars in anticipation. Second, trade data suggest that the composition of import demand from the oil-exporting nations is skewed away from the United States, and this may also weigh on the dollar. The rise in commodity prices has fanned anxieties about inflation. As shown in exhibit 17, the University of Michigan consumer sentiment survey measures of oneyear and five-to-ten-year inflation expectations have increased recently. In contrast, both Barclays' and the Board's five-year, five-year-forward measures of breakeven inflation have moderated a bit since the last meeting. These measures remain well inside the ranges evident over the past year (exhibit 18). The anxiety about higher commodity prices and inflation has been an important factor behind the sharp shift in monetary policy expectations. As shown in exhibits 19 and 20, the federal funds rate and Eurodollar futures curves have continued to shift upward since the April FOMC meeting. As shown in exhibits 21 and 22, our survey of primary dealer expectations also shows an upward shift in the expected path of the federal funds rate target. However, compared with the expectations embodied in futures prices, the rise has been more modest. As a result, the gap between the average of the dealers' forecasts and the market's forecast has continued to increase and is now unusually wide. The divergence between the dealers' forecasts and market expectations and the wide range of the dealers' forecasts one year ahead indicate that there is considerable uncertainty about the future path of short-term rates. This uncertainty is also evident in the fact that the implied volatility of short-term interest rates is unusually high currently. The tightening expected over the next year is not anticipated to begin soon. As shown in exhibits 23 and 24, options on federal funds rate futures contracts currently imply that market participants expect that the FOMC will stand pat at both this and the August FOMC meetings. Although considerable tightening is priced in over the next year, this is not unusual at this stage of the monetary policy cycle. Assuming that we are at the trough of the current rate cycle, the magnitude of tightening expected over the next year is not significantly greater than what has been priced in following other troughs in the federal funds rate target. Tomorrow we will be eight weeks beyond what may turn out to be the onset of the trough in the target rate. As shown in exhibit 25, the roughly 125 basis points of tightening that is currently priced in over the next year is comparable to what was anticipated at the same point after the federal funds rate trough in 1992. Finally, a few words about the Primary Dealer Credit Facility. (Art Angulo will talk about this in more detail tomorrow.) We have been actively managing our counterparty risk in this facility and have made it clear to market participants that this should be viewed as a backstop facility rather than as a core source of funding. By the end of next week, borrowing from this facility is likely to drop sharply because of two events. The first is this week's closing of the Bear Stearns�JPMorgan Chase transaction, which will result in the elimination of Bear Stearns's PDCF borrowing. The second is the anticipated closing next week of the Bank of America acquisition of Countrywide, which is expected to eliminate Countrywide's PDCF borrowing. In the absence of new financial shocks that could provoke renewed funding difficulties, we would anticipate little persistent PDCF borrowing after these mergers are completed. Last week I sent you a memo informing you of our plans to initiate a euro time deposit with the Netherlands Central Bank, subject to Regulation N approval by the Board. There were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the April FOMC meeting. As always, I am very happy to take any questions. " FOMC20081216meeting--216 214,MR. HOENIG.," Thank you, Mr. Chairman. The Tenth District's economy, like the others, has systematically worsened. Layoffs are increasing. Our retail sales are down. The housing market is certainly not improving, and manufacturing has weakened. In our two stronger areas, energy is showing a pretty good slowdown with these falloffs in prices, and rigs are being stacked; the agricultural sector is also feeling the pressure as commodity prices fall. So it is uniformly poor. As far as the national economy and outlook go, I have no major differences with the outlook that has been presented by others. I would tell you that we have done different projections ourselves. I think a lot depends on what will be developed on the fiscal side as we move from here, and I am kind of waiting to see about that. I do have one other comment and perhaps request as we think about this, and it follows on yesterday's conversation. It strikes me, as I look broadly and see what's happening in our own region, that the intermediation process is broken as it goes through the banking industry and then more broadly than that. The deleveraging process that is under way is actually accelerating--it is worsening and complicating our ability to fix the intermediation process. As a result, we as the central bank are going around that process as we try to get credit working, and I understand that. But it does have consequences--some good for those particular markets where we're bringing intermediation forward but also perhaps some not so good as other sectors are left behind in that. My point is that we really do have to focus, in working on the fiscal side with the Treasury or whomever, on fixing the broken intermediation process, and that is the banking industry. I know we are working with the TARP. It needs some additional work. But out of that comes my request. We spent a fair amount of time yesterday talking about the Japanese experience. I wonder if we wouldn't benefit if we looked at the Nordic experience of the early '90s--how you go in, take a look at that, and how you conduct policy around that--and have a discussion among ourselves because I think there are some lessons there that we might learn to our benefit as we move forward from here. That's a suggestion I have, not just my report on the District. Thank you. " FOMC20080430meeting--87 85,MR. EVANS.," Thank you, Mr. Chairman. I was pleasantly surprised that we have not had any major downside surprises since our March 18 meeting. So while I still recognize the economy's downside risks, I've become less comfortable about signing onto the Greenbook's judgment that a nonlinear step-down in activity currently is in train. On balance, our projection still looks for weakness in the near term and then has growth picking up as we move through 2008 and into 2009. We see a noticeable output gap opening this year but not one as large as in the Greenbook. Under this forecast, it is possible that some portion of 2008 might eventually be labeled a recession, but it is not yet conclusive that it will be. Indeed, given the highly unexpected development that events have proceeded as expected, I think the downside risks to growth have abated some. Some of the stress in financial markets has been mitigated by our new lending policies as well as actions by banks in recognizing losses and raising capital. Neither the incoming data nor the reports from my business contacts seem to be consistent with the bleak downside scenarios that I feared might transpire after we saw the December employment report early this year. In this regard, I will simply note a couple of observations from my contacts. A national shopping mall developer reported that his tenants experienced a small improvement in April retail sales compared with March. He was not expecting that. Similarly, Manpower indicated a small improvement in billable hours for temporary workers over the past month and a half, also unexpected. Now, I am not saying that I will be surprised if the outlook deteriorates further. I am saying that the likelihood of that event seems to be smaller today than I expected at our last two meetings. Accordingly, I think that current real interest rates are appropriately accommodative relative to the baseline forecast for economic growth and the risk to that outlook. As seen in chart 6 of the Bluebook, the real funds rate is essentially zero. Of course, this uses a core PCE measure of inflation and thus may overstate the true real rate since headline inflation has been consistently running above this core measure. There is the additional accommodation that is being provided by the range of new lending facilities we had put in place. The extra accommodation is appropriate to offset the large degree of restraint still being exerted from financial markets, and our expansion of the swap lines and the TAF adds to this accommodation. Furthermore, in the event of a nonlinear step-down in economic activity, as in the Greenbook forecast, our policy responses can be adjusted appropriately because we're well positioned now for that. On the price side, on balance, the recent news has been good. My forecast has core PCE inflation falling to just under 2 percent in 2010 largely because of the increasing resource slack in the economy. However, I think there are substantial upside risks to this outlook. All of my business contacts have noted how high and rising energy and commodity prices are creating cost pressures that many are passing on to their customers. As Dave Stockton mentioned, with his inflation catechism, without reviewing the past transcripts I will speculate that we have been projecting a leveling-out of energy prices since the price of oil was $70 a barrel. Weak domestic demand may limit the degree to which producers can pass through these higher costs, but it is unlikely to prevent noticeable increases in some downstream prices. The depreciation of the dollar also imposes risks even beyond the effects operating through the commodity price channel. Now, I do agree that labor costs have not been cited as a problem for inflationary pressures, and so that does add somewhat to trimming out the risks there. Inflation expectations were also an issue. No matter how often we say that core inflation is a more reliable measure of underlying inflationary tendencies, I find it difficult to believe that the public's inflationary expectations will not be affected by large and persistent increases in food and energy prices. The past five years have been unkind on this score. On average over this time, higher food and energy prices have pushed total inflation above core about � percentage point, and it is also sizable over the past ten years. Another challenge for inflationary expectations comes from our policy focus on the downside risks to growth during a time of rising headline inflation. Rightly or not, this could make the public question our attitudes toward inflation. We are accepting considerable inflationary risks when we hope that these concerns will disappear quickly with future adjustments to policy that have not yet been signaled. How we balance these conflicting risks should be an important component of our discussion tomorrow. Thank you, Mr. Chairman. " FOMC20070321meeting--73 71,MS. YELLEN.," Thank you, Mr. Chairman. Recent data on economic activity have been downbeat in many sectors, and I agree with the general tenor of the Greenbook that the near-term outlook is weaker than before. Indeed, we have cut expected growth this year almost ½ percentage point, to 2¼ percent. This pace of growth is substantially below potential, and we expect the unemployment rate to start to edge up fairly quickly. Even relative to this lower baseline, I think the downside risks to the prospects for output growth have sharpened in the intermeeting period. I’m especially concerned about two risks—broader retrenchment in financial markets along the lines that we’re seeing in the subprime mortgage market and a further hesitation and faltering of capital spending. As we discussed in detail two years ago, an asset price bubble inevitably leads to unsustainable imbalances in the economy and a misallocation of resources. The extraordinary run-up in house prices in recent years led to construction and sales booms that couldn’t last. So far the adjustments to more-sustainable levels of housing starts and sales have been relatively orderly. However, there is still an overhang of precarious financing from the past relaxed mortgage-lending standards that has to be eliminated. For example, in 2005 and 2006 something like 40 percent of first-time homebuyers put no money down with their purchase. The market is beginning to recognize the size of this overhang and, with the recent deterioration in the performance of subprime mortgages, is dramatically reassessing mortgage risk. Going forward, we will have to closely monitor increases in mortgage-risk compensation and tightening of credit standards. Such changes, especially if they go too fast or too far, could amplify the housing- sector decline as has been recognized, pushing housing prices and activity down, and with spillovers to consumer spending, they could prove to be a substantial drag on the overall economy. Despite the recent turmoil in equity and mortgage markets, a reassessment of overall risk has yet to occur. We are still in an environment of low long-term yields, ample liquidity, and what appears to be a generally low level of compensation for risk. For example, I recently talked with the principals of several major private-equity funds, who were not just amazed but also appalled about the amount of money their industry has attracted. [Laughter] One partner said that he would have no difficulty immediately raising $1 billion. Indeed, one of his biggest problems is would-be investors who get angry at him because he is unwilling to take their money. This unwillingness reflects his difficulty in identifying deals that are likely to yield adequate returns even though, for the buyout firms, debt also is available in what they depict as very attractive so-called covenant-lite terms—perhaps too attractive given the vulnerability of some of the highly leveraged yields. My contacts suggest that some private-equity firms with similar assessments of the shortage of profit opportunities are less restrained and do take additional money, partly because of the large upfront fees that are generated by these deals. So just as we have seen in mortgage markets, the bubble in private equity, as my sources characterize it, and the overabundance of liquidity more generally raise the risk of a sharp retrenchment in credit and higher risk spreads with associated risks to economic growth and, conceivably, even financial stability. A second, related risk concerns investment spending. It’s surprising that, despite the ample financing available, firms have still been reluctant to ramp up their capital spending. Certainly, any precipitous tightening of financing could curtail investment. However, as noted in one of the Greenbook alternative simulations, greater business pessimism about future returns to new capital is also a significant risk. The recent pullback in orders and shipments for capital goods has persisted and deepened more than any of us had anticipated. Even for high-tech spending, which continues to expand, my contacts on the manufacturing side are not very optimistic. Sales of PCs and related equipment were mildly disappointing in 2006, and our contacts don’t see the introduction of the Microsoft Vista operating system in January as having generated much enthusiasm among businesses. Turning to inflation, our outlook for core inflation, like that of the Greenbook, has changed little since January. I continue to anticipate gradually moderating inflation with core PCE price inflation edging down from 2¼ percent in 2006 to 2 percent this year. There are certainly clear upside risks to this forecast, especially given the resumption of increases in energy prices. These risks remain despite some weakening in the outlook for real activity. In principle, the anticipated subpar growth should help relieve inflationary pressures. However, we remain very uncertain about what par is. The continued low unemployment rate, coupled with recent sluggish output growth, suggests via Okun’s law that potential output could be growing in the vicinity of 2¼ percent. If, contrary to our assumption, that were the case, any labor market tightness now boosting inflation might not diminish this year. More-favorable news is found in recent survey evidence on inflation expectations. As many of you have commented in past meetings, inflation expectations are perhaps more influential to the inflation outlook than is the unemployment rate. Their relative stability over the past several years has probably been a key factor restraining the rise in inflation over the past two years. However, what has not generally been noted is the importance of near-term inflation expectations, those with a forecast horizon of a year or two. Both economic theory and empirical evidence suggest that these near-term inflation expectations are as important as long-run expectations for determining inflation dynamics. The latest Blue Chip and Professional Forecasters surveys both show expectations of core inflation edging down next year. For example, the SPF shows core PCE inflation dropping to 2 percent next year, exactly in line with our own forecast. I also see the general downward tilt in inflation expectations over the next couple of years as contributing to a favorable inflation prognosis." FOMC20060629meeting--87 85,MS. PIANALTO.," Thank you, Mr. Chairman. Much like the Greenbook, the reports that I hear from my directors and business contacts are consistent with an economy that is expanding, but at a slower pace than earlier this year. Activity related to residential real estate has softened, and I continue to hear from my business contacts that they are concerned that consumer spending will retrench in response to the softer housing market and higher energy prices. But I do not get much indication that this concern is having a substantial effect on their business plans. Capital spending plans in particular seem little changed from the beginning of this year. As for inflation, rising costs are widely reported by my business contacts, but most of these pressures are still related to energy and material prices. I continue to hear that productivity-adjusted wage pressures remain in check. Among producers of intermediate goods, the number of firms that report the ability to pass through costs seems to be increasing, but as of now, I am not hearing a lot in the way of substantial price increases at the retail level. Despite what I am hearing from my business contacts, the data tell a different story, and they have affected my thinking since our last meeting. The core inflation numbers have been drifting up, whether calculated by excluding food and energy or by the trimmed mean and median CPI measures that we monitor in Cleveland. Since December the majority of items in the CPI weighted by their expenditure shares have risen at annual rates in excess of 3 percent. It is still possible, of course, that the pattern of these price increases that have been showing up lately is just an outsized but transitory pass-through of energy and commodity prices or the realignment of rents to the exceptional residential housing market that we have seen in the past few years. But this explanation is becoming increasingly difficult for me to defend. At our May meeting I expressed concerns that risks were weighted against both our objectives, and the Greenbook baseline now reflects those concerns: weaker economic growth and higher inflation. At this time, I do not see any signs that the real economy is going to be weaker than projected in the Greenbook baseline, but unfortunately I do not expect an inflation outlook that is much better than the Greenbook baseline either. That is my report, Mr. Chairman. Thank you." FOMC20081007confcall--51 49,MR. EVANS.," Thank you, Mr. Chairman. I'd like to say that your own commentary touched on almost all the issues that I had in front of me. I can support this action. I'm not sure it's the ideal time, but I can certainly support this. I agree with you that I think inflationary pressures will be coming down. I think that we're looking at significant resource slack. Commodity prices are coming down, and the prospects for growth are not good at all. I think the only thing keeping us from calling this a recession is the official people who are in charge of doing that. I don't want you to misinterpret my question about our balance sheet and the size of what we're extending to the markets when I asked about $3 trillion when I added in the Treasury proposal. Clearly there is a lot of financial stress out there, and I think that we're facing a very substantial credit crunch of unusual proportions. I agree that these facilities are attempting to unlock the lending capacity, as Vice Chairman Geithner mentioned. I think that's extremely helpful. I just have concerns--these are very, very large, unprecedented actions--and I'm sure that everybody else shares them as well. I'm reasonably confident that there's adequate risk management in terms of the collateral, but this is certainly something that we all should be concerned about. You also mentioned the transmission mechanism. I normally don't think that timing issues are that important. But when we cut the funds rate tomorrow morning and when the headwinds are still the predominant factor, I just wonder whether or not the economy will notice. I think that ultimately the liquidity will continue to flow out, and it will have some effect, but I don't know how large it will be, and that is a risk. Nevertheless, the opportunity to take a coordinated action with the foreign central banks that you mentioned is very important, and as President Plosser and you already mentioned, I'm not sure what this means for future actions, but we're not very good at being able to say how the economy is going to go from here. So I can support this action. Thank you, Mr. Chairman. " FOMC20050630meeting--10 8,MR. PEACH.," Hardly a day goes by without another anecdote-laden article in the press claiming that the U.S. is experiencing a housing bubble that will soon burst, with disastrous consequences for the economy. Indeed, housing market activity has been quite robust for some time now, with starts and sales of single- family homes reaching all time highs in recent months and home prices rising rapidly, particularly along the east and west coasts of the country. But such activity could be the result of solid fundamentals underlying the housing market. After all, both nominal and real long-term interest rates have declined substantially over the last decade. Productivity growth has been surprisingly strong since the mid-1990s, producing rapid real income growth primarily for those in the upper half of the income distribution. And the large baby-boom generation has entered its peak earning years and appears to have strong preferences for large homes loaded with amenities. One of the conditions of an asset bubble is that the price of the asset has risen well above what is consistent with underlying fundamentals. In the current debate, two measures of relative value have been applied to single-family home prices— price relative to income and rent relative to price. In the comments that follow I will concentrate on the price-to-income measure, but my conclusions apply equally to the rent-to-price measure. June 29-30, 2005 12 of 234 average price of homes purchased (or mortgages refinanced) with loans purchased by Fannie Mae and Freddie Mac, or conforming conventional loans. Therefore, it excludes cash sales as well as purchases or refinancings financed with FHA [Federal Housing Administration], VA [Veterans Affairs], and jumbo conventional mortgages. It is called a repeat-sales index because it is derived by observing the sales prices—or appraised values, in the case of refinancings—of properties at specific addresses at two or more points in time. Finally, it is a transactions-based index in that it reflects the prices of homes that are sold (or refinanced) rather than the entire universe of single-family homes. A lesser known home price index is the constant-quality new home price index published by the Bureau of the Census (exhibit 2). This index is based on a sample of new homes sold, regardless of how the sale was financed. Hedonic methods are employed to hold the physical and locational characteristics constant over time. This index is part of the Census Bureau statistical program through which the single- family residential investment deflator of the national income and product accounts is derived. As shown in exhibit 3, the increase in prices indicated by these two indexes is quite different. For example, over the four years from 2000 to 2004, the OFHEO index increased at a compound annual rate of 8.2 percent, while the constant-quality index increased at a 5.4 percent annual rate. As shown in exhibit 4, the current ratio of price over median family income derived from these two indexes is vastly different. If the OFHEO index is giving an accurate picture of what is happening to home prices, I think one could say with some confidence that prices have been bid up to unsustainable levels. However, if the constant-quality index is a better reflection of reality, home prices actually look somewhat low relative to median family income, particularly compared to the late 1970s. I believe the constant- quality index provides a more accurate indication of what is happening to the price of a typical single-family home. In contrast, the OFHEO index is subject to upward biases that accumulate over time and distort ratios such as price-to-income and income-to-rents. To help us understand the biases in the OFHEO index, exhibit 5 presents the distribution by value of all single-family homes in the U.S. in 2003, with the specific values at the 25th, 50th, 75th, and 80th percentiles. 4 The median value in 2003 was $150,000 with the distribution skewed toward the right. The value at the 25th percentile was $90,000 while the value at the 75th percentile was $250,000. We do not know with certainty where the OFHEO index falls on this distribution, as it is an index rather than a series of values. But we can be reasonably certain that it lies somewhere between the average price of all existing single-family homes sold and the average price of homes purchased with conventional loans. That means the OFHEO index is a closer reflection of what is happening at the 75th percentile rather than the 50th percentile. Moreover, it is very likely that over time the point on that distribution represented by the OFHEO index has been drifting to the right. One June 29-30, 2005 13 of 234 cause of this rightward drift is what I call transaction bias. As shown in exhibit 6, the American Housing Survey (AHS) data suggest that both appreciation rates and turnover rates increase as one moves out the home value distribution. For example, from 1997 to 2003 the compound annual rate of appreciation at the 25th percentile was 4.5 percent, increasing to 8.7 percent at the 80th percentile. Corresponding average turnover rates for the period from 1997 to 2003 were 5.9 percent and 7.4 percent. That means, of course, that the average rate of appreciation of the units that turn over is higher than the average rate of appreciation of the entire distribution. While the amount of bias in any one year is likely to be small, it does cumulate over time and becomes quite important when one is comparing levels versus income or rents. Another potential upward bias in the OFHEO index is that while it is a repeat- sales index, there is evidence to suggest that it is not a constant-quality index. In addition to the strong pace of new housing starts, another aspect of the housing boom of the past decade has been a significant increase additions and alterations to the existing housing stock. Exhibit 7 presents in the top panel the ratio of the OFHEO index over the constant-quality index plotted over the period from 1977 to the present. In the lower panel are plotted real improvements per unit of housing stock per year over the same period. Over the past decade real improvements per unit have increased about 25 percent, which appears to be associated with a further increase in the ratio of the OFHEO index over the constant-quality home price index. Research suggests that higher-income households have a higher income elasticity of demand for improvements to their primary residences, suggesting that this source of upward bias is likely to be more pronounced in the right half of the distribution of all single-family homes. 5 Another way of looking at the issue of home prices over income is to go back to the AHS data and see what is happening at various points on the distribution of all single-family homes. This information is presented in exhibit 8. At the 25th percentile the ratio of home price to income has been relatively stable, while it has increased sharply at the 75th and 80th percentiles, reminiscent of the price-to­ income ratio computed with the OFHEO index. Let me pause just a moment and emphasize that I am comparing home prices at a percentile with the incomes of the people who live in those homes at the same percentile. This chart is likely the equivalent of the finding that the increase of home prices has been most pronounced in areas of the country where home prices were already relatively high due in part to relatively inelastic supply. It is likely that in these areas of the country, where land values are high, the inclination to make substantial improvements to existing properties is the greatest. Clearly, not everyone agrees that the constant-quality new home price index provides an accurate indication of what is happening to the price of a typical single- family home. For example, it has been argued that most new construction takes June 29-30, 2005 14 of 234 place at the fringe of metropolitan areas where land prices may not be rising as fast as is intra-marginal land. There are several counter arguments. First, the theory leading to the conclusion that intra-marginal land values increase at a faster rate than land at the fringe is based on a theory of the development of a metropolitan area with fairly restrictive assumptions. Modern metropolitan areas have multiple commercial/employment centers. Many households have preferences for rural or suburban residences over urban residences. Restrictions on development to counter suburban sprawl have reportedly resulted in sharp increases in prices of parcels of land suitable for home building. Finally, I would like to note that the increases in land prices implicit in the constant-quality home price index, shown in exhibit 9, are substantial, particularly in the Northeast and the West. These estimates were derived assuming that land represents 50 percent of the value of the total property and that the prices of the other inputs increase at the same rate in all regions of the country. In closing, I would like to comment on one other aspect of the housing bubble issue that has received substantial attention. Earlier this year a major real estate related trade association released the results of a survey indicating that a significant percentage of single-family home sales were of investment properties and second homes. This was widely interpreted as evidence of speculative buying of rental properties, another feature of a housing bubble. Again, I believe that such reports should be viewed skeptically. According to the AHS, in 2003 single-family investment properties, defined as homes renter-occupied or for rent, represented 14.2 percent of all single-family homes while second homes represented another 4.7 percent. Therefore, we should not be surprised that such properties represent about 20 percent of the sales that take place at any point in time. Moreover, the American Housing Survey data indicate that single-family investment properties have been declining as a share of all single-family homes for some time and declined in absolute numbers from 2001 to 2003. A principal reason the rental vacancy rate for single-family homes has risen in recent years is that the number of renter-occupied single-family homes has declined as people switch from renting to owning. So if a lot of people are buying rental properties, it must also be the case that a lot are selling as well. That concludes my report. Thank you." FinancialCrisisReport--18 In 2002, the Treasury Department, along with other federal bank regulatory agencies, altered the way capital reserves were calculated for banks, and encouraged the retention of securitized mortgages with investment grade credit ratings by allowing banks to hold less capital in reserve for them than if the individual mortgages were held directly on the banks’ books. 11 In 2004, the SEC relaxed the capital requirements for large broker-dealers, allowing them to grow even larger, often with borrowed funds. 12 In 2005, when the SEC attempted to assert more control over the growing hedge fund industry, by requiring certain hedge funds to register with the agency, a federal Court of Appeals issued a 2006 opinion that invalidated the SEC regulation. 13 These and other steps paved the way, over the course of little more than the last decade, for a relatively small number of U.S. banks and broker-dealers to become giant financial conglomerates involved in collecting deposits; financing loans; trading equities, swaps and commodities; and issuing, underwriting, and marketing billions of dollars in stock, debt instruments, insurance policies, and derivatives. As these financial institutions grew in size and complexity, and began playing an increasingly important role in the U.S. economy, policymakers began to ask whether the failure of one of these financial institutions could damage not only the U.S. financial system, but the U.S. economy as a whole. In a little over ten years, the creation of too-big-to-fail financial institutions had become a reality in the United States. 14 9 Gramm-Leach-Bliley Act of 1999, also known as the Financial Services Modernization Act, P.L. 106-102. See also prepared statement of SEC Chairman Christopher Cox, “Role of Federal Regulators: Lessons from the Credit Crisis for the Future of Regulation,” October 23, 2008 House Committee on Oversight and Government Reform Hearing, (“It was a fateful mistake in the Gramm-Leach-Bliley Act that neither the SEC nor any regulator was given the statutory authority to regulate investment bank holding companies other than on a voluntary basis.”). 10 The 2000 Commodity Futures Modernization Act (CFMA) was enacted as a title of the Consolidated Appropriations Act of 2001, P.L. 106-554. 11 See 66 Fed. Reg. 59614 (Nov. 29, 2011), http://www.federalregister.gov/articles/2001/11/29/01-29179/risk-based- capital-guidelines-capital-adequacy-guidelines-capital-maintenance-capital-treatment-of. 12 See “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities,” RIN 3235-AI96, 17 CFR Parts 200 and 240 (8/20/2004) (“amended the net capital rule under the Securities Exchange Act of 1934 to establish a voluntary alternative method of computing net capital for certain broker-dealers”). The Consolidated Supervised Entities (CSE) program, which provided SEC oversight of investment bank holding companies that joined the CSE program on a voluntarily basis, was established by the SEC in 2004, and terminated by the SEC in 2008, after the financial crisis. The alternative net capital rules for broker- dealers were terminated at the same time. 13 Goldstein v. SEC , 451 F.3d 873 (D.C. Cir. 2006). 14 The financial crisis has not reversed this trend; it has accelerated it. By the end of 2008, Bank of America had purchased Countrywide and Merrill Lynch; Wells Fargo had acquired Wachovia Bank; and JPMorgan Chase had purchased Washington Mutual and Bear Stearns, creating the largest banks in U.S. history. By early 2009, each controlled more than 10% of all U.S. deposits. See, e.g., “Banks ‘Too Big To Fail’ Have Grown Even Bigger: Behemoths Born of the Bailout Reduce Consumer Choice, Tempt Corporate Moral Hazard,” Washington Post FOMC20070628meeting--128 126,MR. PLOSSER.," Thank you, Mr. Chairman. Since our last meeting, the news in the Third District economy has been mixed but, on balance, slightly more positive than the previous report. The District continues to grow at a moderate pace, and we expect that pace to continue. The bright spot since our last meeting is a rebound in regional manufacturing activity, which had been flat for the past six months. In June, the Philadelphia Business Outlook Survey index of current activity rose sharply—18 percentage points—from a level of 4.2. This is the highest level it has obtained since April 2005. The index of new orders also showed a sizable jump, and capital spending plans firmed in the survey. Respondents also expected further improvement in manufacturing activity over the coming months. Job growth in the region, however, was somewhat slower over the past two months compared with earlier in the year, but we really didn’t expect much since payrolls seemed to rise much more rapidly than expected during the first quarter. Year-to-date payroll growth is running about 0.6 percent at an annual rate. That rate is slower than the national average but is fairly typical of our region, where population growth is rather flat. Labor force participation is rather flat as well. Unemployment rates, however, remain low in our three states, and firms still report having difficulty finding both skilled and unskilled workers. It is no surprise, as everyone has said, that residential construction in our region continues to decline and remains weak. The value of contracts for residential buildings has fallen more than 30 percent in the region during the first five months of this year compared with last year at this time—but that, we have to remember, was near the peak. Real estate agents and homebuilders generally report slowing of sales in May. While the number of existing homes for sale on the market has increased, average selling prices have not changed much. I would characterize the nonresidential real estate market in the region as fairly firm, although construction is not as strong as last year. Office vacancy rates continue to fall, and in Center City Philadelphia, they dropped to 10 percent. They were about 17 percent just around eighteen months ago. Real estate firms report that overall demand for industrial space continues to be robust and that vacancy rates for this type of space are near record lows in some markets. Rental rates continue to rise, particularly for warehouse space, and rents are at a record high in those areas. I take these reports as indications of continued expansion in economic activity going forward. Interestingly enough regarding building, I had two observations from CEOs. One is CEO of a building supply company that manufactures throughout the United States and has sales of almost $10 billion. He said that, remarkably, even with what is going on with homebuilding, his sales are holding up very, very strongly and they are doing very, very well this year. Another CEO, whose company produces products mostly for residential cabinetry and other types of things, one of the largest in the country, says that, while new home sales for his work are way down, they have largely been offset by remodeling activity—people have substituted remodeling for buying a new home. As long as I’m reporting anecdotes here, I will pass on one other anecdote, for what it is worth, about trucking. I listened to President Fisher and President Poole talk about volumes in trucking. Just as an observation, an executive who runs a trucking company throughout the country told me that one thing that has happened in trucking is that, rather than shipping boom boxes, they are shipping iPods. [Laughter] That is true of a lot of consumer goods. Instead of shipping large CRT screens, they now ship flat panel displays. So even while the volume of goods is being reduced, gasoline prices are high, and they are laying off truckers and downsizing the volume, the value of what they are shipping has been maintained pretty well. So he was noting a dynamic of value versus volume here, which I thought was very interesting. On the inflation front in the District, prices for industrial goods continue to increase, but retail price increases have not been widespread. However, many of our business contacts continue to express concern over rising energy costs and food prices and the effect on their businesses and the consumers. I interpret this to mean that they continue to be puzzled by our focus on core inflation when they see that overall inflation is what affects the consumer and their businesses, and they seem to doubt core inflation’s value as a policy objective or a measure of underlying inflation. They may be wrong in that, but it tells me that, if they continue to be confused by how we view core inflation and what we use it for, we might need to improve our communication to the public about how we think about it and why we focus on it. On the national level, I have become more comfortable with the economic situation as the year has progressed. At our meeting in May, we were beginning to see some positive signs regarding both real economic activity and inflation. Durable good orders were up, allaying some concerns about the first quarter’s weakness in business investment. Improved ISM numbers were signaling that the slowdown in manufacturing might be ending; and although housing markets remained weak, there were limited signs of any significant spillovers to other sectors. Labor markets remained firm. At that time there were signs that core inflation might be moderating. As a consequence, I expressed hope that in the coming months those data would be reinforced. Fortunately, from my perspective, those hopes have been largely realized. Coming into this meeting, we have received more positive news on the economy, and I have become somewhat more confident that the economy is on track to return to near-trend growth later this year as the effect of the housing correction moderates, albeit very slowly. Indeed, data received to date suggest that we will see a substantial rebound in real GDP growth this quarter, as the Greenbook has noted. After several months of stagnation, manufacturing activity seems to have picked up, and business fixed investment is moderately strengthened. Labor markets remain firm, and yet in recent quarters we have noted a seeming disconnect between strong labor markets and weaker GDP growth. However, we now may be getting some hints that this puzzle is more apparent than real, and I want to reinforce the point that President Yellen made earlier in that I think two factors suggest this. First, from December to May the household survey showed almost no employment growth whatsoever, whereas the establishment survey showed 1.2 percent annual growth during that period. Second— and again as President Yellen noted—the Business Employment Dynamics report came out. It was only for the third quarter of last year, but it showed about 155,000 fewer jobs created in the third quarter than we thought. What is important about that report is that it arguably does a better job of tracking the birth and death of firms in the data, and so there is some reason to believe that, while this is suggestive, the payroll employment that we have been seeing may not be as strong as perhaps we thought, and that may make some of this puzzle less of a concern. Moreover, as President Yellen pointed out, it is also relevant for the longer term because, if employment wasn’t as strong as we thought, productivity is going to end up being higher than we thought, and it will help resolve some of that slowdown in productivity. So I think there are various hints that that may be the direction that we are headed. In my own forecast, I see slightly more underlying strength and so a somewhat faster return to trend growth than the Greenbook does. The current stance of monetary policy is maintained. I see strength in personal income, a strong balance sheet (as we saw earlier today), strong equity markets, and a resiliency already shown by consumers despite the lower home equity values and higher gasoline prices, suggesting that there is probably slightly more momentum in consumer spending than suggested in the Greenbook. I am modestly more optimistic about the labor market than the Greenbook—modestly, as I anticipate less of a downturn in labor force participation rates than is built into that forecast. The rise in long-term interest rates reflects the market’s upgrading of its assessment of the economy’s strength going forward. Indeed, as has been noted a couple of times, that uptick in long-term interest rates has been, I won’t say a worldwide phenomenon, but certainly widely spread in many countries around the world, which may be saying that global growth is more stable, predictable, and positive than perhaps we thought. Now, this is not to say that I do not see risks around this growth forecast. Of course, as everyone else does, I see housing as the biggest downside risk that we face. There is still considerable uncertainty out there, and I do not want to underestimate the risk. Housing inventories remain high, and I do not see any strong evidence of pickup in demand. Despite the problems in subprime lending markets, however, I think the financial sector remains healthy—healthier now than it was perhaps in the early ’90s with the previous housing boom. I am more comfortable with the notion that there will be no spillovers into other parts of the economy, and thus I have become more comfortable with forecasts of return-to- trend growth in the second half of this year and into ’08. On the inflation front, higher energy prices have led to an acceleration of headline inflation, but there has been some improvement in core inflation measures in recent months. The three-month growth rates in the core CPI and the core PCE have been decelerating since February. Although these developments in inflation are encouraging, I remain cautious about extrapolating too much from recent data. During this cycle we have seen periods of deceleration reversed a couple of months later. Indeed, the Greenbook expects that much of the favorable readings on core PCE inflation will prove transitory. So I remain concerned that our core inflation rates may not continue their recent drift down. I would also caution that headline inflation, as I noted earlier, has remained stubbornly high. Thus, in approaching my forecast, I have assumed that the appropriate policy path was one that would return the economy to steady-state growth and to my inflation target by the end of the forecast period. Given my outlook on the underlying strength of the economy and an inflation goal of 1.5 percent for the PCE, it should not be surprising that my forecast incorporates a slightly tighter policy path than the Greenbook does. In particular, in my forecast the federal funds rate rises 50 basis points, to 5.75 percent, by early ’08. As progress is made on bringing down inflation starting in the second half of ’08, the fed funds rate moves down, ending at about 5 percent by the end of 2009. This policy path reflects my view that, unless we take further action by additional firming or an announcement or both that commits us to an inflation goal that is lower than the market currently expects, which seems to be about 2.5 percent, I believe it will be difficult to sustain an inflation rate that is in keeping with my view of price stability. I believe this can be accomplished with relatively little effect on real growth in 2008. My assumption in the model with which I’m working is that, once we begin to raise rates, the markets will quickly recognize our commitment to lower inflation and expectations will move down accordingly, mitigating the real output effects of this modest tightening. The movement down in expectations could be expedited by the Committee’s explicitly announcing the target. This view of expectations formation is more heavily weighted to forward-looking elements than to distributed-lag elements of past inflation. By the way, I want to applaud the staff for their work on inflation dynamics. I thought it was an excellent piece of work. I found the discussion very helpful and a step in the right direction, both conceptually and empirically. In any event, the bottom line for my forecast is that I anticipate that the economy will grow just below trend of 3 percent in 2008 and at trend of 3 percent in 2009, and we achieve an inflation goal of 1.5 percent by the end of the period. Of course, this forecast is based on my desired inflation objective, which may not be representative of other members of the Committee. If there were a common objective that differed from my own view, then my presumed appropriate policy path might be different. Given this observation and the lack of an agreed-upon goal, I think we need to be concerned about how the public will interpret these forecasts, but I will save my thoughts on that for the next go-round." FOMC20080430meeting--204 202,VICE CHAIRMAN GEITHNER.," I don't think the canary is wheezing. Look, I think there are lots of good arguments on both sides of this. I think all the good ones have been made. The markets have been giving us a pretty good test against the concern, which I think we all share, that if we move today we risk some significant erosion of our inflation credibility or inflation expectations feeding through the dollar into a commodity price spiral. We have had a pretty good test of it. Over the past several weeks, there has been a very substantial shift in expectations for the path of the fed funds rate, which embody substantial expectations around a near-term cut and very little beyond that and some modest retracing as we go forward. Expectations have come down despite what has happened to oil prices. Inflation has come down. The dollar is stronger on net over that period. This is pretty good validation that the path that is represented in alternative B does not come with excessive risk that we will be eroding our credibility. We can't know for sure. It's good to be worried about that risk, but the protection against that risk is fairly good. What strikes me about this discussion is the extent of the gap in this Committee in how we think about the way to measure the stance of monetary policy. What we could do is use a seminar and a bit of history on this. It would be nice to run monetary policy back over the past four decades to see, if it had been set with a basic policy regime in which we looked only at the real fed funds rate deflated by headline inflation today, what the outcomes would have been for the economy at that time. That's essentially what you guys are saying. It seems to me that you are basically saying that equilibrium doesn't vary and that deflating the nominal fed funds rate with some mix of headline and core today is the best way to judge the stance of policy. But I think it's worth having a little exercise in it. It is hard to look back. " CHRG-111hhrg74855--20 Mr. Doyle," Mr. Chairman, thank you for holding this hearing and inviting all of the important stakeholders to provide their testimony today. In particular, I am happy to see Vincent Duane from PJM here today. As you know, PJM is the regional transmission organization that keeps the lights on in my district and I think it is important to get their input on how this bill will affect them. I am glad we are holding this hearing today to bring attention to some potential unintended consequences of reforming our financial regulatory system. It was only a year ago that our financial system was on the edge of grinding to a halt. Though there were many contributing factors, lack of regulations in our commodities market undoubtedly added to the problem. I applaud my colleagues, the chairman of the House Financial Services and Agriculture Committee, for their work on this legislation to remedy the poor regulation of over-the-counter derivatives and force irresponsible speculators out of the market. However, in their attempt to be thorough, I am concerned that my colleagues have overlooked a duplicative effect that this bill could have on energy markets at the end of the day, rate payers, also. Since the creation of regional transmission organizations, FERC has had a responsibility to monitor energy markets in each RTO and review and report on any hint of manipulation or abuse. In fact, with the passage of EPACT 2005, we gave FERC even greater authority to protect against fraud and abuse in electricity and natural gas markets. Let me be clear, we need to clean up our financial derivatives markets and I think this bill does a good job of getting us there. The CFTC needs to increase oversight and control of these financial products and bring more transparency to the swaps market. We just need to be sure that it doesn't inadvertently require our RTOs to endure another layer of regulation that would keep them from providing electricity to consumers at competitive rates. I look forward to the testimony from all our distinguished witnesses and hope that we can produce an excellent bill to bring to the floor. With that, Mr. Chairman, I will yield back my time. " CHRG-111hhrg51698--465 Mr. Cooper," Chairman Peterson, Ranking Member Lucas, and Members of the Committee, I am Karl Cooper. I am the Chief Regulatory Officer of NYSE Liffe. NYSE Liffe is the new futures exchange launched by NYSE Euronext just this past September. All in all now, NYSE Euronext operates seven cash equity exchanges and seven derivatives exchanges in five different countries around the world. It is a pleasure to appear before you today to share NYSE Euronext's views and thoughts on the ``Derivatives Markets Transparency and Accountability Act.'' We strongly support the two major purposes of the proposed legislation: to support the integrity of U.S. contract markets and to promote the transparency of the over-the-counter derivatives market. We do have to share with you, though, our reservations that many provisions of the bill may not be the most effective means to achieve your ends. That is because the bill tends to run counter to the international cooperative approach that the CFTC has championed over the past many years, and has led to some great successes. Namely, it has allowed U.S. market participants to have access to foreign markets, and it has also allowed U.S. exchanges to compete globally. I would like to focus my remarks, though, on three specific provisions of the bill: first, section 3, which deals with the direct regulation of foreign exchanges; section 13 of the bill, which mandates centralized clearing; and finally, section 16. With regard to foreign exchanges, we are concerned that, without evidence that the CFTC has been unable to obtain through cooperative means critical trade information, that the mere mandate of that by the Congress could have regulatory retaliatory consequences by foreign regulators. That would not serve Congress's purpose. It would not serve U.S.-based exchanges that are trying to compete, such as ourselves, globally. And it would hinder our ability to bring new exchange-traded and centrally cleared solutions that are desperately needed now in light of the current market turmoil. With regard to section 13, we have a similar concern around the international impact, potentially, of the legislation. But let me first say that, obviously, we support the centralized clearing of OTC derivatives. We have established and launched the first CDS clearing solution this past December 22nd in our London exchange, Liffe, with our partner, LCH.Clearnet. But the legislation, as drafted, would not allow foreign MCOs that are regulated by an acceptable foreign regulator to play that clearing function, at least for commodities outside of excluded commodities. Second, we would suggest that the exemptive provision in section 13 should be broader to give the CFTC the ability to work through the complex issues of bringing the OTC derivative products into a centralized clearing format, with the flexibility around the types of products that should go into the clearinghouse. With regard to section 16, which limits allowable CDS to only those transactions where the participant has the underlying risk, we think that this restrictions goes too far. Of course the CDS marketplace needs additional enhanced regulation. There must be controls for systemic risk. There must be monitoring for fraud, abusive and manipulative activity. But simply banning all but the limited types of transactions that the bill currently would allow would eliminate market making, would eliminate index trading, and would basically eliminate speculation. The Commodity Exchange Act has always allowed for speculation, but it has not allowed excessive speculation. So, that is where the balance could best be struck. And, again, without coordinating our efforts with our international regulatory colleagues, we would have the effect of pushing the business offshore, which would not serve U.S. citizens and the U.S. economy in the long run. Thank you very much for inviting me to appear before you today. And I would be happy to answer any questions you might have. [The prepared statement of Mr. Cooper follows:] Prepared Statement of Karl D. Cooper, Chief Regulatory Officer, NYSE Liffe, LLC, New York, NY; on Behalf of NYSE Euronext Chairman Peterson, Ranking Member Lucas, Members of the Committee. My name is Karl Cooper, and I am the Chief Regulatory Officer of NYSE Liffe, LLC (``NYSE Liffe''), a subsidiary of NYSE Euronext. NYSE Liffe is a relatively new exchange, having been designated by the Commodity Futures Trading Commission (``Commission'') as a contract market in August 2008. I am pleased to appear this morning on behalf of NYSE Euronext and its affiliated exchanges as the Committee considers the Derivatives Markets Transparency and Accountability Act of 2009. NYSE Euronext operates the world's largest and most liquid exchange group. NYSE Euronext brings together seven cash equities exchanges in five countries and seven derivatives exchanges. In the United States, we operate the New York Stock Exchange, NYSE Arca, NYSE Alternext (formerly the American Stock Exchange), and NYSE Liffe. In Europe, we operate five European-based exchanges that comprise Euronext--the Paris, Amsterdam, Brussels and Lisbon stock exchanges, as well as the Liffe derivatives markets in London, Paris, Amsterdam, Brussels and Lisbon. We also provide technology to more than a dozen cash and derivatives exchanges throughout the world. NYSE Euronext's geographic and product diversity has helped to inform our analysis of the bill you are considering today. NYSE Euronext supports the essential purposes of the Committee draft legislation: (i) enhancing the integrity of U.S. contract markets; and (ii) bringing transparency and risk reduction to the over the counter (``OTC'') derivatives markets. Nonetheless, we are concerned that the breadth of the bill may have unintended consequences. Our comments today focus on those provisions of the bill that we believe could inhibit the ability of U.S. exchanges to compete globally and deny U.S. market participants access to critical risk management products. The Commission, with the encouragement and active support of Congress and market participants, has long played an active role in developing standards of regulatory best practices and strengthening customer and market protection through international cooperation including, in particular, information sharing among regulatory authorities. The Commission has been an active participant in the meeting of the International Organization of Securities Commissions (``IOSCO'') and, more recently, has joined with the Committee of European Securities Regulators (``CESR'') to consider ways to facilitate the conduct and supervision of international business. In addition, the Commission is party to a number of bilateral and multilateral memoranda of understanding, each of which is designed to assure timely access to critical market information. Similarly, the regulatory relief that the Commission has provided to foreign exchanges that seek to do business with U.S. market participants is predicated on a Commission finding that the exchange is subject to a comprehensive regulatory program that is comparable, though not identical, to the Commission's own regulatory program. As important, such relief is subject to extensive terms and conditions. In particular: (i) satisfactory information sharing arrangements must be in place among the Commission, the foreign exchange, and the foreign exchange's regulatory authority; and (ii) the foreign exchange and each member of the exchange that conducts business under the relief must consent to the Commission's jurisdiction. In all cases, the Commission retains authority to modify, suspend, terminate or otherwise restrict the terms of any relief that it may provide. By any measure, we believe the Commission's approach to international regulation has been a success, assuring the protection of customers and the integrity of the exchange-traded markets, while facilitating the development of global derivatives markets. A critical key to this success has been the Commission's willingness to cooperate with those regulatory authorities in foreign jurisdictions that share a common regulatory philosophy. A different regulatory approach, one that imposed our regulatory structure on any foreign exchange or intermediary that sought to do business with U.S. market participants, might well have led to regulatory retaliation, causing the global competitiveness of U.S. exchanges to suffer. As the Committee continues its consideration of the Derivatives Markets Transparency and Accountability Act of 2009, we ask the Committee to ensure that this legislation will in no way weaken the spirit of international cooperation that has played such an important role in the growth of the regulated derivatives markets, and which the Commission has so successfully fostered. Section 3. Transparency of Off-Shore Trading. It is the fear of regulatory retaliation that underlies our concern with the provisions of section 3 of the Committee draft legislation. We appreciate the Committee's desire that the Commission have access to critical trade information relating to contracts listed for trading on foreign exchanges that settle to a contract listed for trading on a U.S. contract market. We also recognize that this section is narrowly written to target a specific perceived problem. Nonetheless, as written, section 3 appears to subject the foreign exchange to the direct supervision of the Commission. As discussed above, the Commission has full authority through its information sharing arrangements with a foreign exchange authorized to permit direct access and its home country regulator to obtain the type of information described. Further, the Commission can rescind this authorization at any time, if the requested information is not provided. In the absence of evidence that the Commission has been unable to obtain required trade information through cooperative means, we believe section 3 sets an unnecessarily confrontational tone and risks setting off a chain reaction of retaliatory measures. Section 13. Clearing of OTC Derivatives. For many of the same reasons, we are troubled by the provisions of section 13, which would require that, except for OTC derivatives instruments on ``excluded commodities,'' all OTC derivatives must be cleared through a derivatives clearing organization registered with the Commission. To be clear, NYSE Euronext strongly supports legislative action that would encourage and facilitate the clearing of OTC derivatives instruments. In this regard, we note that, on December 22, our London derivatives exchange, Liffe, acting in cooperation with LCH.Clearnet Ltd., launched the first clearing solution for the processing and clearing of credit default swaps (``CDSs'') based on certain credit default indexes. Shortly thereafter, we received necessary exemptions from the Securities and Exchange Commission to offer CDS clearing to qualified U.S. customers. (Both Liffe and LCH.Clearnet are supervised by the U.K. Financial Services Authority.) Nonetheless, we believe section 13 goes too far in seeking to force a clearing solution for OTC derivatives instruments limited to DCOs. We are especially concerned that this section apparently would no longer permit a multilateral clearing organization supervised by a foreign financial regulator that the Commission determines ``satisfies appropriate standards'' to clear OTC derivatives instruments, as is currently provided under section 409 of the FDIC Improvements Act of 1991. Liffe expects to receive authorization shortly from the Financial Services Authority to act as a self-clearing recognized investment exchange. Among other services, Liffe anticipates acting as a central clearing counterparty for OTC derivatives instruments. Under the provisions of section 13, however, Liffe could not offer these services to U.S. persons (except with respect to excluded commodities), unless it first applied for registration with the Commission as a DCO. Such registration would subject Liffe to duplicative and, in some instances, potentially conflicting regulatory requirements. The OTC derivatives market is a global market, which demands a global response. An American solution to clearing OTC derivatives instruments is no less palatable than a European solution. Yet, this legislation would lend support to those in Europe who are urging such action. Separately, we believe the standards pursuant to which the Commission would be able to grant an exemption from clearing are too narrow. Fully implementing a clearing solution for OTC derivatives will be very difficult. The Commission should have broader authority to grant exemptions where appropriate. Section 16. Credit Default Swaps. With all of the negative publicity that credit default swaps have received over the past several months, we appreciate the Committee's concern and its desire to restrict in some way the volume of trading in these instruments. But the fact remains that credit default swaps are a vitally important tool in managing risk. In difficult economic times, the diversification of risk, if used properly, will continue to add value to the marketplace. We believe section 16 goes too far in seeking to reduce any perceived financial risk in the trading of CDS. Its provisions would effectively close the market in the U.S., driving the business overseas. This is because it is impossible to conceive of a situation in which both parties to a CDS would experience a financial loss if an event to a credit default swap occurs. By definition, one party must benefit from such a trade. The market for CDS, no less so than the market for exchange-traded futures, needs speculators if it is to maintain sufficient depth. Without the liquidity that speculators bring to the market, price spreads would widen, severely reducing, if not eliminating, its value. Moreover, we are concerned that the provisions of section 16 would prohibit swaps on credit default indexes. We believe it is unlikely that institutional participants that use these indexes to hedge their securities portfolios hold all of the securities that comprise the index. Nonetheless, these swaps are more liquid and are easier to trade than CDSs on a single name security. Although not perfect, they provide a sufficient hedge at a lower cost than a series of CDSs on single names. Conclusion. Thank you, again, for the opportunity to appear before the Committee today. I would be happy to respond to any questions you may have. " FOMC20060510meeting--126 124,MR. WARSH.," Thank you, Mr. Chairman. I hesitate to joke here at my second FOMC. I made a joke at my first that the inaugural meeting requires the new Governors to sing, and my colleague took me up on that. [Laughter] So I will not offer a joke about dancing this time. [Laughter] In the interest of time. [Laughter] Going to the central tendency in terms of where the economy is, I suppose I consider myself much more optimistic than the Greenbook forecast about the state of the economy. I think some of the shocks to the economy, energy prices being the latest, speak in some ways to the durability, the flexibility, and the resilience of this economy which, on the one hand, I shake my head about but, on the other hand, I think we have to believe to some degree. I will not go into too many of the facts, which have already been described, but consumption was up 5½ percent in the first quarter. Business capital expenditures were up about 16½ percent on an annualized basis, with strong durable goods orders. And the increase in tax receipts that Governor Olson spoke about is a very good leading indicator, even though some of the details behind that increase are hard to know. President Poole referenced the growth in corporate profits. Let me add a couple of notes on that. What we are really seeing in the equity capital markets is, by and large, profitability-driven growth in the S&P and in the Dow as opposed to some sort of P/E multiple expansion. It does give some of us more confidence in the strength that we are seeing in the equity capital markets as well as another source of optimism as to what some of the income-statement benefits might be to consumers. As we think about what might be the elephants in the markets, certainly the housing market is one from FOMC meetings that preceded my time here. The new elephants in the market in terms of tone and tenor are inflation and inflation expectations. I would like to talk about them more in just a moment. When we look at the data since our last meeting, though there is a lot of noise, on balance I share the view that they tend to be more positive than expectations. Average nonfarm payroll growth in the past six months was almost 200,000, including the April figure, and the idea of less-robust labor markets appears belied by the solid gains that we have seen in hours worked, the acceleration in wages, and the low unemployment rate, which is still at 4.7 percent. So our thinking about a possible slowdown in the second half of the year has to at least be balanced or perhaps partly counterbalanced by what could be the first meaningful gains in take-home pay for nonsupervisory workers. Understanding those income-statement benefits to real consumers is probably a more certain exercise at this point than trying to figure out the effect on the consumer of the housing markets, which Governor Bies spoke about. On the business front, I am at least as optimistic as I was six weeks ago about the state of business investment. CEOs, when they have seen the appreciation of share prices in the last quarter, even as they have seen prices appreciate for many of their competitors, remain more robust, more excited, and, I think, more eager to spend money. We have seen an increase in the backlog in debt underwriting by most of the big bulge-bracket firms, and so though some of that money is, no doubt, being spent on stock repurchases, some debt is being raised in expectation of merger and acquisition activity. At least part of it is based on a view that, as there is more uncertainty priced in the markets for the second half, companies are getting their ducks in a row to obtain some extra liquidity. Let me make one final point before briefly talking about inflation. I am encouraged, like the rest of you, about the synchronized global growth that we are talking about. My biggest concern, particularly in May of an election year, is about what is likely to be a bipartisan foray into creeping protectionism in the dialogue of politicians here in Washington between now and the November elections. The position discussions about free trade that we have heard on both sides of the aisle over the past several years are, I think, going to diminish very significantly. There could also be many more discussions in highly contested congressional election districts about the need to isolate the U.S. markets, to cut ourselves off from a lot of foreign opportunities. To be candid, the business community probably isn’t that eager to enter this debate with a message oriented toward free trade. So I do think that creeping protectionism may become stronger between now and November and will have consequences for our economy to integrate with foreign markets and to continue to expand. We may have more difficulty fighting back in some of the export markets, even with some depreciation of the dollar. The Federal Reserve has a possible role in trying to moderate some of that discussion. Finally, just a moment on inflation: I guess the way I would characterize it from a market perspective, and I think this is consistent with Dino’s and the Vice Chairman’s comments, is that market expectations of inflation are more fragile than they were some months ago. I would not describe myself as an alarmist about that. However, the traders at many of the securities firms and the folks who are hitting the trading buttons are contemporaries of mine. They are from a generation that has not experienced inflation at first hand the way that some folks around this table have. The psychological point of that statement is that, though we may have seen some laxity in their concern about inflation over the preceding six months and even today, that laxity could turn into some irrationality if inflation expectations get above our reasonable expectations and our comfort level. On balance, I think that the markets, particularly those marginal traders, are looking for some leadership from the Federal Reserve. Perhaps we have seen somewhat less market discipline in the TIPS markets and in some of the other markets, such as commodities. Other folks have spoken more eloquently than I about what is happening in the TIPS markets and some of the dangerous signs in the surveys, so I will only offer two final notes. First, on the energy market side and on the commodity side, it is harder and harder to describe the run-up in prices as solely or even predominantly demand driven. When I think about the new retail products that are now finding their way to typical broker–dealer relationships at retail-oriented chains, I see a massive surge of inflows into new silver-oriented mutual funds and copper-oriented exchange-traded funds. A lot of that speculative money is coming very late into these markets, and that situation should suggest to us that some folks, rightly or wrongly, are assigning some sort of inflation hedge to that product, with retail investors, as usual, being the last to get in on it. Finally, on the energy front, I have been thinking about the difference between where we are now and where we might be several months from now. I was encouraged by the same-store sales numbers that we saw in April, even in March and April together. Those numbers are very encouraging, but as we get into the summer driving season, the energy prices may be seen as persistent. The market may take a view that the higher prices are more permanent than most consumers believe now, and I think that’s probably an extra reason for our caution on the inflation front. So on balance, Mr. Chairman, I am quite optimistic about the strength of the economy but at least as leery about the expectations for inflation going forward." FOMC20060510meeting--122 120,MR. KOHN.," Thank you, Mr. Chairman. I agree with many of the rest of you that inflation risks rose over the intermeeting period, though I think I see a more limited rise than I sensed from some of the comments I have heard. Several factors do suggest higher inflation risk. Stronger growth than expected has left resource utilization a little higher than we thought—only a touch, I think, but still higher. The core CPI and PCE data were disappointing—were higher than anticipated. That, however, did follow several months in which those data came in lower than we had expected. And if you look at the Greenbook’s 2006 projection, it reverses a downward revision from last time. That is not to say it is not worrisome, but we were revising down for a while, and now we have had an upward revision. I think the commodity price increases are hard to understand, especially outside the energy area, where you can think about supply disruptions. Both the energy prices and the commodity prices could feed through to a limited extent into headline inflation. I think they do indicate, at the very least, that global demand has continued to be quite strong. In that regard, they would add to global inflation risks. The decline in the dollar is a bit worrisome. The pass-through to import prices has been very, very small over recent decades. But to the extent that the lower dollar is not passed through to import prices, it would be squeezing the profits of those people who are exporting to the United States, and I think, through either channel, this suggests at least a slight reduction in the competitive pressures on domestic producers— not big, but a slight reduction. We did have a small uptick in inflation expectations looked at through the markets or the Michigan survey. However, those expectations are still in the range of recent years, and I can recall a number of occasions post-Katrina and in the last few springs in which they have ticked up in similar situations and then come back down again, particularly after energy prices leveled out. None of these signs of higher inflation are very significant in and of themselves or if they were taken one by one; but taken together, they cannot be dismissed. They do suggest at least a small rise in inflation expectations and a small rise in inflation risk that could start pushing up underlying inflation further. That said, the data we have received over the intermeeting period should give us a little more confidence that conditions are being put in place or are in train to limit these risks and to keep the upside risk limited. The trajectory of information over the intermeeting period, especially on consumption and housing, points to quite a bit of moderation of growth in the second quarter. We are looking at 3-point- something, and the issue is what the point-something is; it is not 4-point-something or 5-point-something. Housing market information, I think, confirms that there is a slowdown in process that will restrain aggregate demand going forward. Sales have bounced around a lot, but inventories have risen substantially by any measure. That is going to be weighing on prices. The price data are ambiguous and hard to read. If you take a heroic leap and start seasonally adjusting the existing house prices on a month-by-month basis instead of a twelve-month basis, it looks as though they have been flattening out. But we will get better data later. If, indeed, prices are flattening out, we have not yet really seen that effect on consumption. So in that sense, the tightening of policy and the flattening-out of housing prices are still in the pipeline. Higher long-term interest rates: Some of that increase is an endogenous response to global growth and would require a higher path of short-term rates to keep inflation under control, but some of it is in the risk premium. The extent to which the risk premium has risen will damp demand for any given course of monetary policy. The energy-price increase will contribute to moderating growth of domestic demand, provided that we do not allow that energy-price increase to reduce real interest rates. Like some others here, I am kind of encouraged by the data on labor compensation. They are mixed, but I have interpreted them on balance to suggest that pressures on businesses from labor cost developments are muted. The ECI is certainly consistent with that, and so are four-quarter changes in compensation per hour and unit labor costs. The markup of price over unit labor cost actually increased from a very high level to an even higher level. I agree with President Poole that businesses will not voluntarily give up that markup, but we do have a recent experience if you look in the late ’90s. That markup peaked at the end of ’97, I believe, and dropped very, very sharply in ’98 and ’99, despite the fact that the economy was growing with some vigor. You can see that on page 39 of the Greenbook. So perhaps we need to think about that episode and how it happened. Certainly we have a precedent for vigorous growth and declining markup absorbing rising compensation costs. So where does that leave me overall? I agree with the staff. The most likely outcome—given the structure of interest rates, financial conditions, markets, and a flattening of energy prices—is for stable underlying inflation, core PCE to stay in the neighborhood of 2 percent, where it has been since early 2004. But I am a little more nervous about the stability than I was at the last meeting. Thank you, Mr. Chairman." FOMC20060510meeting--81 79,MS. JOHNSON.," Well, it is certainly true that resource utilization in certain industrial countries— Japan, for example—is moving in that direction. Even Europe to some degree is moving in that direction. For the major emerging-market economies of India, China, and so forth, where we have seen the big increase in the global labor force that has been thought to lie behind some of the downward pressure on wages everywhere and some of the flatness in finished goods prices, I am not so sure I did get a sense that we are reaching some kind of capacity constraint. If anything, China surprised everybody in Q1. The numbers that they released are on a sort of Q4- to-Q4 basis. We translate those internally and, therefore imperfectly, into quarter-on-quarter changes, and so we have Chinese Q1 growth that is a 12, 13 percent rate. I do not see any sign that China is slowing. The whole debate about a hard landing in China is just gone. So in that sense, I do not really see that we are hitting global constraints where it most matters. We probably do have a permanent terms-of-trade change—or at least an extended, persistent terms-of-trade change—in terms of raw materials as a result of a change in the composition of global growth, and I do not think the composition of global growth has to go back to being almost all industrial countries with most emerging market countries barely growing. I do not see that happening. The countries that have enjoyed terms-of-trade gains because they have commodity resources are probably going to continue to enjoy them; and what they do with those resources, how they choose to consume them, or what they do with domestic investment will become, I think, an important factor in this notion of global capacity. I do not have any real new news on port capacity, bottlenecks, or shipping rates; but since nobody has been talking about these subjects for quite some time, I take no news to be good news, and I do not think bottlenecks in that area have contributed much to what we have been seeing lately." FinancialCrisisReport--41 The securities firms central to the financial crisis were subject to a variety of SEC regulations in their roles as broker-dealers, investment advisors, market makers, underwriters, and placement agents. Most were also subject to oversight by state securities regulators. 79 The securities firms were required to submit a variety of public filings with the SEC about their operations and in connection with the issuance of new securities. The SEC’s Office of Compliance Inspections and Examinations (OCIE) conducted inspections of broker-dealers, among others, to understand industry practices, encourage compliance, evaluate risk management, and detect violations of the securities laws. In addition, under the voluntary Consolidated Supervised Entities program, the SEC’s Division of Trading and Markets monitored the investment activities of the largest broker-dealers, including Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, Citigroup, and JPMorgan Chase, evaluating their capital levels, use of leverage, and risk management. 80 Like bank regulators, if the SEC became concerned about a particular securities firm, it could choose from a range of informal and formal enforcement actions. Informal actions could include issuing a “deficiency letter” identifying problems and requiring the securities firm to take corrective action by a certain date. Formal enforcement actions, undertaken by the SEC’s Division of Enforcement, could include civil proceedings before an administrative law judge; a civil complaint filed in federal district court; civil fines; an order to suspend or remove personnel from a firm or bar them from the brokerage industry; or a referral for criminal prosecution. Common securities violations included selling unregistered securities, misrepresenting information about a security, unfair dealing, price manipulation, and insider trading. 81 Statutory and Regulatory Barriers. Federal and state financial regulators responsible for oversight of banks, securities firms, and other financial institutions in the years leading to the financial crisis operated under a number of statutory and regulatory constraints. One key constraint was the sweeping statutory prohibition on the federal regulation of any type of swap, including credit default swaps. This prohibition took effect in 2000, with enactment of the Commodity Futures Modernization Act (CFMA). 82 The key statutory section explicitly prohibited federal regulators from requiring the registration of swaps as securities; issuing or enforcing any regulations or orders related to swaps; or imposing any recordkeeping 77 See SEC website, “About the SEC: What We Do,” www.sec.gov. 78 Id. 79 Some firms active in the U.S. securities and mortgage markets, such as hedge funds, operated without meaningful federal oversight by taking advantage of exemptions in the Investment Company Act of 1940. 80 See 9/2008 “SEC’s Oversight of Bear Stearns and Related Entities: The Consolidated Entity Program,” report prepared by Office of the SEC Inspector General, Report No. 446-A. Report No. 446-A, (9/2008). 81 See SEC website, “About the SEC: What We Do,” www.sec.gov. 82 CFMA was included as a title of H.R. 4577, the Consolidated Appropriations Act of 2001, P.L.106-554. requirements for swaps. 83 In addition, the law explicitly prohibited regulation of any “‘interest rate swap,’ including a rate floor, rate cap, rate collar, cross-currency rate swap, basis swap, currency swap, equity index swap, equity swap, debt index swap, debt swap, credit spread, credit default swap, credit swap, weather swap, or commodity swap.” 84 These prohibitions meant that federal regulators could not even ask U.S. financial institutions to report on their swaps trades or holdings, much less regulate swap dealers or examine how swaps were affecting the mortgage market or other U.S. financial markets. FOMC20060328meeting--38 36,MS. JOHNSON.," We now have complete fourth-quarter data for U.S. trade and the balance of payments. Several elements of those data seem to me to be worth mentioning at this meeting as they correspond to issues with which we have wrestled in putting together the international portion of your Greenbook forecast. The U.S. current account deficit came in at an annual rate of $900 billion in the fourth quarter—7 percent of nominal GDP. The jump from the previous quarter was sizable, and the number gives me, at least, a bit of sticker shock. With $900 billion already recorded, it is not surprising that our forecast for the current account deficit crosses $1 trillion and reaches about 8 percent of GDP by the end of the forecast period. With the U.S. economy projected to perform well through the end of next year, we have no reason to expect that the financing of such a large deficit will cause problems in foreign exchange and asset markets. But the risk of such problems is again a factor in the forecast. The deficit on goods and services, at $790 billion, accounts for most of the fourth- quarter current account deficit. Of that figure, the non-oil merchandise balance is about 70 percent. The balance on trade in services is actually a small positive. We look for the bill for imported oil and the balance on services trade to change little through the end of 2007. However, we expect that the non-oil merchandise balance will widen significantly over the forecast period, contributing a little more than one- half of the increase in the current account deficit, and that deterioration of net investment income will largely explain the remainder. Net investment income had remained stubbornly positive even as the United States became a large net international debtor. The initial release of fourth-quarter balance of payments data shows a small negative for net investment income. Even if that negative is subsequently revised away, we expect a negative change in the income balance through the end of next year that is almost as large as the widening in the non-oil merchandise trade balance. The decline we anticipate in net investment income reflects both the growing U.S. net debt position and the projected rise over time in the interest rates applied to our net position in fixed-income assets. The information available to us about the financing of the external deficit for last year as a whole supports our view that there is no basis for expecting an imminent, disruptive consequence for asset markets of the growing U.S. external imbalance. In 2005, private foreign investors made net purchases of U.S. securities that totaled almost as much as the entire current account deficit. This category of financial flows increased greatly from the previous year, consistent with upward pressure on the dollar in exchange markets over much of that time. The appetite of private foreign investors for corporate and municipal bonds was particularly strong. Foreign direct investment into the United States also rose during 2005 to a figure that is quite robust, even if not at the scale of the extremely large inflows in the late 1990s and 2000. The offsetting flows of direct investment abroad by U.S. entities were small, reflecting the temporary, favorable tax break on repatriated foreign earnings. Reported foreign official holdings of dollars in the United States did increase last year, but at a rate significantly below that in 2004. Of the $217 billion increase in foreign official holdings reported in the Greenbook for 2005, a very large portion is due to increased official holdings by China. Although official Japanese holdings of dollar assets had significantly risen in 2004, the ending of exchange market intervention by Japanese authorities in March of that year resulted in no further official acquisition of dollar assets last year by them. Oil exporters, particularly Russia, accounted in 2005 for a moderate share of the change in foreign official dollar holdings. All told, foreign official acquisition of dollar assets does not appear to have been a dominant feature in the picture of financial flows painted by the balance of payments statistics for last year. Beyond the current quarter, our baseline forecast calls for real exports of goods and services to expand at an annual rate of 5 percent. This export growth mainly reflects our outlook for real GDP growth abroad. We project that, over the final three quarters of this year, average real output growth abroad will be comparable to that of the U.S. economy; for next year, we expect foreign growth to exceed U.S. growth by about ¼ percentage point. We see the global expansion as broadly based across regions, with real GDP growth in the emerging market economies significantly faster than that in the industrial countries, but with both groups doing well. We expect that, among the foreign industrial countries, Canada and the United Kingdom will continue to be relatively strong and Japan’s recovery will become well established, although its rate of output growth will abate somewhat going forward. Among the Asian emerging market economies, we look for a slowing in the rate of growth from recent rates, importantly in China, but expect that on average those economies will maintain a pace of expansion of nearly 6 percent. In Latin America, we project that our major trading partners will all see solid growth that averages almost 4 percent this year and a bit less next year. Although the dollar moved up slightly over the intermeeting period, we again forecast some dollar depreciation in real terms, as we remain mindful of the financing requirements posed by our external deficits. Over time, that depreciation should work to boost our real exports, although for the forecast period the lagged effects of dollar appreciation during 2005 are more dominant and the contribution from the dollar diminishes rather than strengthens through the end of 2007. Dollar depreciation should add somewhat to import price inflation this year and next. However, changes in global commodity prices have been sizable and have largely determined the path of nonfuel core import prices. Prices of global nonfuel commodities have ratcheted up further in recent months. Futures prices for these commodities indicate some future flattening, but lagged responses to these increases should boost core import price inflation to 3 percent this year before some deceleration occurs next year. Our projections for the U.S. economy, for relative prices of nonfuel imports, and for global energy prices combine to imply a rate of growth for real imports of goods and services over the remaining seven quarters of the forecast period that is slightly greater than that for exports. With nominal imports currently more than 150 percent of nominal exports, the resulting implication for the nominal trade deficit is inevitably a further widening. In our baseline for this Greenbook, the contribution of exports to U.S. real GDP growth for the rest of this year and next is, at an annual rate, just a bit more than 0.5 percentage point. The arithmetic contribution from imports varies by quarter, in part because of the way real imports are seasonally adjusted. On average, imports subtract more than exports add, resulting in a net negative contribution to GDP growth from the external sector that is 0.3 to 0.4 percentage point at an annual rate." FOMC20080916meeting--124 122,MR. PLOSSER.," Thank you, Mr. Chairman. New data and survey and anecdotal information in the Third District suggest that the economy in our District continues to be weak. There have been further declines in some industries and deceleration of growth in others, but generally data are coming in as expected. Employment growth was flat over the three-month period ending in July, and I expect that unemployment rates in our three states will tick up in August, when the regional data come out, much as it did in the national data. Overall, the activity in our region, as I said, has remained weak since the last meeting. Housing construction continues to be weak. Sales of existing homes remain sluggish, and inventories remain high. One builder said, ""Things don't feel very good. I feel as though I am in a tar pit. My feet are maybe now on the bottom; my nose is still above the level of the tar; and while I may feel the bottom, it still doesn't feel very good."" On the commercial real estate side, we saw a slight uptick in the value of July contracts, but they are not very high. In fact, they really remained at the average level of the last seven years. Retailers remain pessimistic in the latest Beige Book. District banks saw loans rise slowly but steadily in August. The Beige Book reports from them see slight gains in consumer and real estate lending and C&I loans essentially flat. The good news is from our business outlook survey for September, which will be released to the public on Thursday at 10:00 a.m., but the results are in. The survey is from the first two weeks of September. The general activity index has been negative, if you recall, for the last nine months--since December 2007. The last value was minus 12.7. The September number, not to be released until Thursday, is a positive 3.4, so that's a swing of 15 points to the good. This is clearly somewhat encouraging, although we don't want to get too excited about one month--but it is good news. Furthermore, both the new orders and shipment indexes in the survey improved in September. Price pressures have abated somewhat with the fall in commodities and oil, but they remain. The six-month-ahead outlook indexes also improved substantially in the new survey. This is the best picture that the survey has painted in certainly quite a while--about the last six or eight months. In summary, the economic conditions of the Third District remain weak and sluggish but are not materially different from what we and our business contacts had been expecting over the near term. While a lot of attention in the short run is being paid to financial markets' turmoil, our decision today must look beyond today's financial markets to the real economy and its prospects in the future. In this regard, things have not changed very much, at least not yet. Indeed, the Greenbook forecast has changed only modestly since the last Greenbook. The economy remains weak but not appreciably different from what I anticipated or even what the Greenbook anticipated at the last meeting. I agree that the recent financial turmoil may ultimately affect the outlook in a significant way, but that is far from obvious at this point. We also need to acknowledge the long lag times associated with the effect of monetary policy actions on the real economy. Actions today will not help us very much in the very, very near term where the real economy is concerned. On the inflation front, there has been some good news. The decline in the retail price of gas has contributed to a decline in headline inflation in August. In my view, the price declines in commodities and oil have mitigated somewhat the upward pressure on expectations and have reduced the likelihood that inflation expectations will become unanchored, at least in the near term. Nevertheless, I remain concerned about the inflation outlook going forward. In part, my concern stems from the fact that I do not see that the ongoing expected slowdown in economic activity is entirely demand driven. As I noted before, the impact of financial shocks and high commodity prices can plausibly lead to a decline in the growth rate of potential output. If so, there will be less offset to inflation going forward than incorporated in the baseline Greenbook forecast, which relies heavily on slack variables to control inflation. The Greenbook simulation entitled ""costly reallocation"" provides some welcome effort from the staff in this regard, and I appreciate that. Yet the details of that experiment were a bit sketchy for me, and at some point I would be interested in a little more detail as to how that actually plays out. In my view, the main driver for the outlook of future inflation over the next two years is not, nor has it been, oil prices per se, but the path of monetary policy that the Committee will adopt over the next several months and quarters. I appreciate the memo that the staff produced regarding the stance of monetary policy. According to the memo, the current stance of policy is not unusually accommodative. However, I would like to note that that conclusion depends critically on the specific forecast and the nature of the FRB/US model. A different model, one that says that inflation expectations are more forward looking, may well lead to a very different conclusion. But I take the message of the memo to be that the assessment of the stance of monetary policy is dependent, at a point in time, on a model, and I very much agree with that assessment. Given that my model is somewhat different from the staff's model, I continue to believe that monetary policy at its current level is accommodative and that, if this current stance is sustained, the economy will experience faster inflation in the medium term. Clearly, we must pay attention to the adverse effects of the financial disruptions. But we also must recognize that our policy actions today and over the next several months will affect the outcomes of inflation over the medium term. As I said, it is my view that the current stance of policy is inconsistent with price stability in the intermediate term and so rates ultimately will have to rise. Now, I acknowledge that there are risks to economic growth going forward. The slowdown and the financial market turmoil could turn out to be worse than I expect. I also recognize that, given the events over the weekend, now is probably not the time to shock markets by raising rates. But neither is it a time to panic and lower rates. A cut today may be reassuring to some in the financial markets, but it also may serve to scare markets by sending a signal that we are much more worried than perhaps they are. There is just way too much volatility and dust blowing around to make such snap judgments on monetary policy. We have been aggressive with our liquidity provisions, and we will continue to be so, and I support that. Stability coming from monetary policy is an important attribute, and I think we have an opportunity to provide some stability here. However, I am uncomfortable with the current Greenbook baseline path that has the funds rate remaining unchanged well into the second half of next year. In my view, that will not deliver an acceptable path of inflation outcome over the medium term. At the same time, I do not perceive an immediate threat to the unanchoring of expectations, so I can accept keeping the funds rate at an unchanged level at this meeting. But at some point, before the unemployment rate begins to improve substantially, I believe this Committee will need to raise rates in order to deliver on our inflation objectives. Regarding language, I can live with the language in alternative B. Thank you, Mr. Chairman. " FOMC20060808meeting--122 120,MR. WARSH.," Thank you, Mr. Chairman. From a capital markets perspective, as I think about this decision, what matters more than the pricing of this issuance—that is, the decision on 25 basis points—is really what the after-market effects are. How is this security going to trade over the next weeks and months? When I think about the decision in that context, it puts the burden on the communications, which are only in small part in the message of our statement today. At the end of the day, I am willing to agree to a pause. But, again, I think that puts the burden on laying the predicate that we are in fact poised and prepared to act as necessary. That begins with our statement, but it doesn’t end there. Given the data that are likely to come in between this meeting and the next (a couple of CPIs, a couple of PPIs, maybe a revised PCE) and what’s likely to happen to some of the forward-looking market indicators (TIPS spreads, some of the commodity prices), I think it is very important that the markets understand, before the trading in the security gets very significant, the depth of our thinking on the subject and of the discussion around this meeting. The minutes can be part of that communication. Such communication is important so that they don’t perceive us when we meet next to be reacting to one or two pieces of data, the way they seem to have overreacted to one or two pieces of data last week, but really recognize the depth of our thinking on this subject. To be consistent with that view, I think Governor Kohn’s suggestion of indicating a pause as powerfully as we can is critical. The markets, in the first days, are going to take our pause to be a stop, as reflected currently in the Eurodollar futures contracts and the fed fund futures contracts. But we need to disabuse them of that view as quickly, as frequently, and as consistently as we can so that the pause does not become read as a stop. We will then have set out the conditions for the ways in which we might react if different data arise. Again, I think that the decision today is not an easy one. It’s important that the markets recognize that it is unlikely that our work here is done. With all that said, I’m prepared to support Governor Kohn’s suggestion." FOMC20050202meeting--149 147,MR. BERNANKE.," Thank you, Mr. Chairman. The economic recovery seems well entrenched, and domestic final demand continued strong, foreshadowing healthy growth in 2005. I don’t see inflation risks as having changed materially in recent months. In particular, labor costs have been remarkably subdued. However, with the recovery no longer fragile, continued withdrawal of monetary accommodation at a measured pace remains the appropriate policy, in my view. Some have cited a possible slowdown in labor productivity growth as an upside risk for inflation on the grounds that slower productivity growth implies a more rapid rise in unit labor costs. While lower productivity does, of course, lead to higher unit labor costs, all else equal, the links between productivity growth and inflation, as well as the implications for policy, are actually quite February 1-2, 2005 102 of 177 First, it’s important to note that an assumption of slower productivity growth is already incorporated into the Greenbook forecast. The staff projects output per hour in the nonfarm business sector to rise at about a 1.7 percent annual rate in 2005, less than recent experience and about a percentage point below the profession’s consensus estimate of the long-run trend. The projected slowdown reflects both cyclical factors and the assumption that there will be some giveback of the extraordinary recent gains. As productivity growth has surprised repeatedly on the upside for almost a decade now, I think the risks for the Greenbook productivity projections should be viewed as well balanced, at worst. The staff projects that the deceleration in the cyclical component of output per hour should have little effect on inflation but will instead lower profit margins. And even though the expected slowdown in structural productivity growth will put upward pressure on prices, the staff expects the impact on inflation of that productivity slowdown to be offset by other factors like declining energy prices and a stabilization of the dollar. To summarize, the Greenbook’s baseline forecast shows that some slowing of productivity growth, at least, is not inconsistent with continued stable inflation. The interesting question is: What will happen if productivity growth in 2005 comes in even lower than the 1.7 percent projected by the staff? If firms view the resulting increase in the rate of growth of unit labor costs as more or less permanent, then historical experience suggests that these costs will be passed on to consumers fairly quickly, thereby boosting inflation in the short run. However, it does not follow that policy should therefore be tightened more aggressively. The appropriate response depends also on the reaction of aggregate demand to this change in productivity growth. If a slowing in productivity growth occurs that is both perceived as permanent and is also largely unexpected by households and firms, then stock prices should fall and households should mark down their estimates of permanent income. The resulting decline in aggregate demand will tend to offset the inflationary impacts of the productivity slowdown. Also, because firms will expect February 1-2, 2005 103 of 177 illustrated in chart 6 of the Bluebook, the optimal policy response to a permanent slowdown in productivity growth may well involve a slower pace of tightening rather than a faster one, despite a possible short-run bump in inflation. This scenario is just a mirror image of the post-1995 experience in which a perceived increase in secular productivity growth sparked a stock market boom and rapid growth in spending, and hence was not disinflationary, despite the fact that unit labor costs declined. What if productivity growth slows substantially but aggregate demand does not respond? In that instance, unfortunately, we might be called upon to make a judgment about whether the slowdown is likely to prove temporary or permanent. If it is temporary, then neither inflation nor policy should respond very much. If the slowdown is judged to be permanent, however, the failure of aggregate demand to adjust would suggest that households and firms anticipated the slowdown, while the staff was too optimistic. In this case, the slowdown in productivity should indeed be met with a tightening of policy in the short run. However, the funds rate should be lower in the long run, reflecting the fact that the neutral fed funds rate will also be lower. This scenario is the mirror image of the 2002-2003 period in which productivity gains created disinflationary pressures that did require aggressive easing in the short run. To summarize, slower productivity growth does not necessarily require a tighter policy. First, some slowing is already anticipated and incorporated into the Greenbook forecast. Second, if a significant slowing occurs, the key issue is the extent to which aggregate demand responds to the slowdown. A sufficiently large decline in aggregate demand might well reverse the presumption that tighter policy is needed when unit labor costs rise. Thank you." FOMC20050322meeting--130 128,MS. BIES.," Thank you, Mr. Chairman. Economic growth this quarter, as several of you have noted, has been stronger than we earlier had anticipated. Retail sales excluding autos have grown at over a 9 percent annual rate in the first two months of the quarter. Business investment has been strong and does not show a significant decline as a result of companies having moved March 22, 2005 69 of 116 purposes. Manufacturing output has also been growing soundly, and capacity usage is now close to its average of the last decade at 78.5 percent. And employment has been growing at a good pace. Over the last few months, we have seen core inflation move modestly higher. And we are seeing data that indicate price pressures coming from both the sales and the cost sides of companies. The strong growth of recent months is making it easier to raise prices, and rising costs from both commodities and labor are also adding to cost pressures. This economic expansion is reaching its fourth anniversary, and sales levels now are giving businesses the confidence to be able to raise prices. The Beige Book and comments by several of the Presidents today indicate that businesses are finding it easier to do so. The NFIB survey shows more pricing power for small businesses, and other business surveys are indicating the same. As Dave Stockton noted earlier, rising import prices are also giving domestic companies more pricing power. On the cost side, the extraordinary pace of productivity growth has slowed in the past year. Productivity grew at a 5.6 percent pace in the year ending in the first quarter 2004, but fell to about one-fourth that pace in the second half of last year. While productivity is still very strong from an historical perspective, it has slowed enough that the direction of unit labor costs has changed. Unit labor costs began rising in the second quarter of 2004, after falling for two years, and grew at 2.3 percent in the last quarter. Thus, with the outlook for continued strong economic growth, I believe that we cannot be as sanguine about the trend in prices in coming months. We need to be signaling that we are more dependent on incoming data, and I think that requires a change from the “measured pace” language to give us more flexibility in the months ahead. Thank you." FOMC20081216meeting--377 375,MR. MADIGAN.," ""The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to � percent. Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further. Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters. The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasuries securities. Early next year, the Federal Reserve will also implement the term assetbacked securities loan facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity."" " CHRG-111shrg51290--63 PREPARED STATEMENT OF PATRICIA A. McCOY George J. and Helen M. England Professor of Law University of Connecticut School of Law March 3, 2009 Chairman Dodd and Members of the Committee: Thank you for inviting me here today to discuss the problem of restructuring the financial regulatory system. I applaud the Committee for exploring bold new approaches to financial regulation on the scale needed to address our nation's economic challenges. In my remarks today, I propose transferring consumer protection responsibilities in the area of consumer credit from Federal banking regulators to a single, dedicated agency whose sole mission is consumer protection. This step is essential for three reasons. First, during the housing bubble, our current system of fragmented regulation drove lenders to shop for the easiest legal regime. Second, the ability of lenders to switch charters put pressure on banking regulators--both State and Federal--to relax credit standards. Finally, banking regulators have routinely sacrificed consumer protection for short-term profitability of banks. Creating one, dedicated consumer credit regulator charged with consumer protection would establish uniform standards and enforcement for all lenders and help eliminate another death spiral in lending. Although I examine this issue through the lens of mortgage regulation, my discussion is equally relevant to other forms of consumer credit, such as credit cards and payday lending. The reasons for the breakdown of the home mortgage market and the private-label market for mortgage-backed securities are well known by now. Today, I wish to focus on lax lending standards for residential mortgages, which were a leading cause of today's credit crisis and recession. Our broken system of mortgage finance and the private actors in that system--ranging from mortgage brokers, lenders, and appraisers to the rating agencies and securitizers--bear direct responsibility for this breakdown in standards. There is more to the story, however. In 2006, depository institutions and their affiliates, which were regulated by Federal banking regulators, originated about 54 percent of all higher-priced home loans. In 2007, that percentage rose to 79.6 percent.\1\ In some states, mortgages originated by State banks and thrifts and independent nonbank lenders were regulated under State anti-predatory lending laws. In other states, however, mortgages were not subject to meaningful regulation at all. Consequently, the credit crisis resulted from regulatory failure as well as broken private risk management. That regulatory failure was not confined to states, moreover, but pervaded Federal banking regulation as well.--------------------------------------------------------------------------- \1\ Robert B. Avery, Kenneth P. Brevoort & Glenn B. Canner, The 2007 HMDA Data, Fed. Res. Bull. A107, A124 (Dec. 2008), available at http://www.federalreserve.gov/pubs/bulletin/2008/pdf/hmda07final.pdf.--------------------------------------------------------------------------- Neither of these phenomena--the collapse in lending criteria and the regulatory failure that accompanied it--was an accident. Rather, they occurred because mortgage originators and regulators became locked in a competitive race to the bottom to relax loan underwriting and risk management. The fragmented U.S. system of financial services regulation exacerbated this race to the bottom by allowing lenders to shop for the easiest regulators and laws. During the housing bubble, consumers could not police originators because too many loan products had hidden risks. As we now know, these risks were ticking time bombs. Lenders did not take reasonable precautions against default because they able to shift that to investors through securitization. Similarly, regulators failed to clamp down on hazardous loans in a myopic attempt to boost the short-term profitability of banks and thrifts. I open by examining why reckless lenders were able to take market share away from good lenders and good products. Next, I describe our fragmented financial regulatory system and how it encouraged lenders to shop for lenient regulators. In part three of my remarks, I document regulatory failure by Federal banking regulators. Finally, I end with a proposal for a separate consumer credit regulator.I. Why Reckless Lenders Were Able To Crowd Out the Good During the housing boom, the residential mortgage market was relatively unconcentrated, with thousands of mortgage originators. Normally, we would expect an unconcentrated market to provide vibrant competition benefiting consumers. To the contrary, however, however, highly risky loan products containing hidden risks--such as hybrid adjustable-rate mortgages (ARMs), interest-only ARMs, and option payment ARMs--gained market share at the expense of safer products such as standard fixed-rate mortgages and FHA-guaranteed loans.\2\--------------------------------------------------------------------------- \2\ A hybrid ARM offers a 2- or 3-year fixed introductory rate followed by a floating rate at the end of the introductory period with substantial increases in the rate and payment (so-called ``2-28'' and ``3-27'' mortgages). Federal Reserve System, Truth in Lending, Part II: Proposed rule; request for public comment, 73 Fed. Reg. 1672, 1674 (January 9, 2008). An interest-only mortgage allows borrowers to defer principal payments for an initial period. An option payment ARM combines a floating rate feature with a variety of payment options, including the option to pay no principal and less than the interest due every month, for an initial period. Choosing that option results in negative amortization. Department of the Treasury et al., Interagency Guidance on Nontraditional Mortgage Product Risks: Final guidance, 71 Fed. Reg. 58609, 58613 (Oct. 4, 2006).--------------------------------------------------------------------------- These nontraditional mortgages and subprime loans inflicted incalculable harm on borrowers, their neighbors, and ultimately the global economy. As of September 30, 2008, almost 10 percent of U.S. residential mortgages were 1 month past due or more.\3\ By year-end 2008, every sixth borrower owed more than his or her home was worth.\4\ The proliferation of toxic loans was the direct result of the ability to confuse borrowers and to shop for the laxest regulatory regime.\5\--------------------------------------------------------------------------- \3\ See Mortgage Bankers Association, Delinquencies Increase, Foreclosure Starts Flat in Latest MBA National Delinquency Survey (Dec. 5, 2008), available at www.mbaa.org/NewsandMedia/PressCenter/66626.htm. \4\ Michael Corkery, Mortgage `Cram-Downs' Loom as Foreclosures Mount, Wall St. J., Dec. 31, 2008. \5\ The discussion in this section was drawn, in part, from Patricia A. McCoy, Andrey D. Pavlov, & Susan M. Wachter, Systemic Risk through Securitization: The Result of Deregulation and Regulatory Failure,__Conn. L. Rev. __(forthcoming 2009) and Oren Bar-Gill & Elizabeth Warren, Making Credit Safer,__ U. Penn. L. Rev. __ (forthcoming 2009).---------------------------------------------------------------------------A. The Growth in Dangerous Mortgage Products During the housing boom, hybrid subprime ARMs, interest-only mortgages, and option payment ARMs captured a growing part of the market. We can see this from the growth in nonprime mortgages.\6\ Between 2003 and 2005, nonprime loans tripled from 11 percent of all home loans to 33 percent.\7\--------------------------------------------------------------------------- \6\ I use the term ``nonprime'' to refer to subprime loans plus other nontraditional mortgages. Subprime mortgages carry higher interest rates and fees and are designed for borrowers with impaired credit. Nontraditional mortgages encompass a variety of risky mortgage products, including option payment ARMs, interest-only mortgages, and reduced documentation loans. Originally, these nontraditional products were offered primarily in the ``Alt-A'' market to people with near-prime credit scores but intermittent or undocumented income sources. Eventually, interest-only ARMs and reduced documentation loans penetrated the subprime market as well. \7\ FDIC Outlook, Breaking New Ground in U.S. Mortgage Lending (Summer 2006), available at www.fdic.gov/bank/analytical/regional/ro20062q/na/2006_summer04.html. --------------------------------------------------------------------------- If we unpack these numbers, it turns out that hybrid ARMs, interest-only mortgages, and option payment ARMs accounted for a growing share of nonprime loans over this period. Option payment ARMs and interest-only mortgages went from 3 percent of all nonprime originations in 2002 to well over 50 percent by 2005. (See Figure 1). Low- and no-documentation loans increased from 25 percent to slightly over 40 percent of subprime loans over the same period. By 2004 and continuing through 2006, about three-fourths of the loans in subprime securitizations consisted of hybrid ARMs.\8\--------------------------------------------------------------------------- \8\ See generally McCoy, Pavlov & Wachter, supra note 5; FDIC Outlook, Breaking New Ground in U.S. Mortgage Lending (Summer 2006), available at www.fdic.gov/bank/analytical/regional/ro20062q/na/2006_summer04.html. --------------------------------------------------------------------------- Figure 1. Growth in Nontraditional Mortgages, 2002-2005\9\--------------------------------------------------------------------------- \9\ FDIC Outlook, Breaking New Ground in U.S. Mortgage Lending (Summer 2006), available at www.fdic.gov/bank/analytical/regional/ro20062q/na/2006_summer04.html. As the product mix of nonprime loans became riskier and riskier, two default indicators for nonprime loans also increased substantially. Loan-to-value ratios went up and so did the percentage of loans with combined loan-to-value ratios of over 80 percent. This occurred even though the credit scores of borrowers with those loans remained relatively unchanged between 2002 and 2006. At the same time, the spreads of rates over the bank cost of capital tightened. To make matters worse, originators layered risk upon risk, with borrowers who were the most at risk obtaining low equity, no-amortization, reduced documentation loans. (See Figure 2). Figure 2. Underwriting Criteria for Adjustable-Rate Mortgages, 2002- 2006 FOMC20060920meeting--181 179,MS. YELLEN.," Thank you, Mr. Chairman. It is still too early to know whether our current policy stance will succeed in lowering inflation to an acceptable level over time, but the data since our last meeting reassured me that our decision to step off the escalator was wise, and I think we should remain on the sidelines today. Recent inflation readings have contained no adverse surprises. Inflation expectations remain contained. I think the inflation outlook is slightly improved because of the reduction in energy and commodity prices, and growth during the second half of the year now appears quite likely to fall short of trend. I view the risks to the attainment of our objectives as more balanced than they were in August, and I certainly judge the downside risks to growth to have increased. Your discussion of nonlinearities, Mr. Chairman, was interesting, and it is important to be sensitive to that possibility. That said, I think that the upside risks to inflation still outweigh the downside risks to growth. With inflation projected to remain uncomfortably high over a sustained period and with the economy still likely operating beyond potential, I favor alternative B and think it’s important that we do at least hint at an upward bias for fed funds rate changes. With respect to the language, I prefer alternative B to alternative B+ because the latter points to a greater possibility of a near-term tightening. I am concerned, however, that markets appear to think that the fed funds rate has peaked and that cuts seem very likely by next spring. I do not think alternative B would shake that view in the market. In contrast, I find myself more in agreement with the Greenbook baseline for the fed funds rate, suggesting that we’re likely to want to hold it near its present level for some time to bring inflation down. Now, markets obviously may turn out to be right. But if, as the months go by, developments raise our confidence in the Greenbook baseline view, then I think it would be useful for us to think about ways to signal to markets— possibly through some forward-looking language—an extended policy path in somewhat clearer terms than any of the options in table 1 currently allow." CHRG-110shrg38109--171 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM BEN S. BERNANKEQ.1. I have been concerned for some time about the implementation of the Basel II Capital Accord and the impact Basel II may have on the safety and soundness of the U.S. banking system. In particular, I am worried that Basel II may lead to a sharp reduction in the amount of capital banks are required to hold, which would put U.S. taxpayers at risk of having to pay for expensive bank failures. Accordingly, I believe that it is critical that Basel II be implemented with the utmost care and diligence. Would you please update the Committee on the status of the Basel II Capital Accords and the current timeframe for implementing Basel II? I would like you to comment on whether there is enough time for banking regulators to finalize the rules implementing Basel II, so that banks adopting Basel II can start the test run for Basel II presently scheduled to begin next year. What, if any, is the likelihood that the timeframe currently envisioned may need to be adjusted?A.1. First, let me reiterate that the primary goal of the agencies in implementing Basel II in the United States is to enhance the safety and soundness of the U.S. banking system. Accordingly, we will not permit capital levels to decline under the Basel II framework so as to potentially jeopardize safety and soundness. We remain committed to ensuring that regulatory capital levels at all U.S. banking organizations remain robust. It is important to keep in mind that under Pillar II, banking supervisors will be reviewing total capital plans relative to risk at each Basel II bank, not just the minimum capital requirements calculated under Pillar I. We also continue to believe, subject to the receipt of comments on the outstanding Basel II notice of proposed rulemaking (NPR), that it is critical to move forward with Basel II implementation so that our largest and internationally active banking organizations have the most risk reflective regulatory capital framework and can remain competitive with other banking organizations that apply similar risk sensitive frameworks. The Basel II NPR issued in September 2006 remains open for comment through March 26, 2007. As outlined in the NPR, the first opportunity for a bank to be able to begin a parallel run (that is, apply the Basel II framework and report results to the appropriate supervisor, but continue to use Basel I ratios for regulatory purposes) would be January 2008. The first opportunity for a bank to begin applying the Basel II framework subject to the proposed transition floors would be January 2009. We remain committed to this schedule; however, it will be challenging to meet the previously announced June 2007 date for a final rule. We are very interested in public comments submitted on the proposal. We will need to take sufficient time to fully consider comments and to make corresponding modifications to the proposed framework as the agencies deem to be appropriate. Because the comment period is still open, it is difficult to estimate how comprehensive the comments will be. While we already are aware of a number of issues raised by the industry, in complex rulemakings such as this one there are always unanticipated issues as well. The extent and complexity of the comments overall will have an impact on the ultimate timing for issuing a final rule. We continue to believe that it is important to meet the previously stated first live start date of January 2009 and at this time do not anticipate that that start date will need to be adjusted.Q.2. Your testimony noted that the U.S. current account deficit remains large, averaging about 6\1/2\ percent of nominal GDP. You also note that economic growth abroad should support further steady growth in U.S. exports this year. Do you anticipate much improvement in the current account deficit over the next year as a result of export improvement? Do you see any other economic factors changing over the next year that might lead to an improved trade deficit?A.2. In the past year, U.S. exports have grown strongly, reflecting a number of factors, including solid foreign economic growth, increases in investment spending abroad that have boosted sales of capital goods produced in the United States, and the booming market for agricultural goods and other commodities. These developments have played out against the backdrop of continued innovation and productivity growth in the U.S. economy that, along with the decline in the foreign exchange value of the dollar since earlier in this decade, have buoyed the attractiveness of American-made products. As a result of strong export growth, in combination with sharp declines in the price of imported oil, the trade deficit has narrowed from 6 percent of U.S. GDP in the third quarter of last year to about 5\1/4\ percent of GDP in the fourth, and the current account deficit has improved by a broadly similar extent. These movements, coming as they did toward the end of 2006, may well cause the trade and current account deficits for 2007 as a whole, measured as a share of GDP, to be smaller than those for 2006. Focusing on their evolution from the current quarter onwards, however, it is uncertain whether our Nation's external deficits will narrow further over the next few years. On the export side, the extraordinary growth in overseas sales of some U.S. products during 2006 may be difficult to sustain; for example, exports of aircraft grew more than 20 percent last year. On the import side, the price of imported oil has bounced back from recent lows, and futures markets suggest that further increases may be in the offing. Another important determinant of U.S. trade flows, the foreign exchange value of the dollar, is volatile and extremely difficult to predict. Finally, even if the trade balance were to continue to improve, it is not clear that the current account balance--which is equal to the trade balance plus the balance on international income flows and transfers--would follow suit. The need to finance continued trade deficits, even if these deficits are smaller than in the past, puts upward pressure on the Nation's external debt and thus investment income payments to foreigners, thereby tending to expand the current account deficit.Q.3. This Committee continues to have a great degree of interest in the Chinese economy, particularly currency practices. China's foreign exchange reserves now stand at over $1 trillion, creating excess liquidity in their banking system. Some financial experts have stated that the United States should not view China's large stock of foreign currency reserves as a problem. What is your view of this level of reserves? Do you believe China's ratio of reserves to money supply is reasonable? To what extent do you believe that China's reserves are the result of speculation? Could this, in fact, result in an even lower value for the RMB should that currency become more flexible in the future?A.3. For some time now, the monetary authorities in China have been resisting upward pressure on the value of the renminbi in foreign exchange markets by purchasing dollars and perhaps other foreign currencies. Even though these accumulated purchases have reached a value of more than $1 trillion, it is not certain that the accumulation has created excess liquidity in China's banking system. Reserves and liquidity do not move in lockstep in China, because Chinese authorities have policy tools available to drain liquidity, including issuance of official securities (so-called ``sterilization bonds'') and increasing banks' reserve requirements. At present, it does not appear that China has had any substantial difficulty using either of these tools to drain liquidity, although that may change in the future. Because the linkage between reserves and money need not be tight, it would be hard to determine a reasonable range for the ratio of reserves to the money stock appropriate for China's economy. I do not believe China's substantial accumulation of reserves in itself represents a problem for the United States or for United States monetary policy. Official demand in China and other countries for United States assets reflects the dollar's role as preeminent reserve currency, which results in great part from the strength of our economy and the safety and liquidity of the United States financial system. Because foreign holdings of U.S. Treasury securities represent only a small part of total U.S. credit market debt outstanding, U.S. credit markets should be able to absorb without great difficulty any shift in foreign allocations. And even if such a shift were to put undesired upward pressure on U.S. interest rates, the Federal Reserve has the capacity to operate in domestic money markets to maintain interest rates at a level consistent with our domestic economic goals. It is not easy to identify the portion of the upward pressure on the renminbi, and hence on the accumulation of reserves, that might be the result of speculation. It is also difficult to predict where the renminbi would settle were the currency to float freely. However, speculation in the renminbi would not occur if investors did not expect the Chinese currency to appreciate at some point. It seems reasonable to conclude that, at the present exchange rate with the dollar, the renminbi is undervalued. CHRG-111shrg50814--205 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System February 24, 2009 Chairman Dodd, Senator Shelby, and members of the Committee, I appreciate the opportunity to discuss monetary policy and the economic situation and to present the Federal Reserve's Monetary Policy Report to the Congress.Recent Economic and Financial Developments and the Policy Responses As you are aware, the U.S. economy is undergoing a severe contraction. Employment has fallen steeply since last autumn, and the unemployment rate has moved up to 7.6 percent. The deteriorating job market, considerable losses of equity and housing wealth, and tight lending conditions have weighed down consumer sentiment and spending. In addition, businesses have cut back capital outlays in response to the softening outlook for sales as well as the difficulty of obtaining credit. In contrast to the first half of last year, when robust foreign demand for U.S. goods and services provided some offset to weakness in domestic spending, exports slumped in the second half as our major trading partners fell into recession and some measures of global growth turned negative for the first time in more than 25 years. In all, U.S. real gross domestic product (GDP) declined slightly in the third quarter of 2008, and that decline steepened considerably in the fourth quarter. The sharp contraction in economic activity appears to have continued into the first quarter of 2009. The substantial declines in the prices of energy and other commodities last year and the growing margin of economic slack have contributed to a substantial lessening of inflation pressures. Indeed, overall consumer price inflation measured on a 12-month basis was close to zero last month. Core inflation, which excludes the direct effects of food and energy prices, also has declined significantly. The principal cause of the economic slowdown was the collapse of the global credit boom and the ensuing financial crisis, which has affected asset values, credit conditions, and consumer and business confidence around the world. The immediate trigger of the crisis was the end of housing booms in the United States and other countries and the associated problems in mortgage markets, notably the collapse of the U.S. subprime mortgage market. Conditions in housing and mortgage markets have proved a serious drag on the broader economy both directly, through their impact on residential construction and related industries and on household wealth, and indirectly, through the effects of rising mortgage delinquencies on the health of financial institutions. Recent data show that residential construction and sales continue to be very weak, house prices continue to fall, and foreclosure starts remain at very high levels. The financial crisis intensified significantly in September and October. In September, the Treasury and the Federal Housing Finance Agency placed the government-sponsored enterprises, Fannie Mae and Freddie Mac, into conservatorship, and Lehman Brothers Holdings filed for bankruptcy. In the following weeks, several other large financial institutions failed, came to the brink of failure, or were acquired by competitors under distressed circumstances. Losses at a prominent money market mutual fund prompted investors, who had traditionally considered money market mutual funds to be virtually risk-free, to withdraw large amounts from such funds. The resulting outflows threatened the stability of short-term funding markets, particularly the commercial paper market, upon which corporations rely heavily for their short-term borrowing needs. Concerns about potential losses also undermined confidence in wholesale bank funding markets, leading to further increases in bank borrowing costs and a tightening of credit availability from banks. Recognizing the critical importance of the provision of credit to businesses and households from financial institutions, the Congress passed the Emergency Economic Stabilization Act last fall. Under the authority granted by this act, the Treasury purchased preferred shares in a broad range of depository institutions to shore up their capital bases. During this period, the Federal Deposit Insurance Corporation (FDIC) introduced its Temporary Liquidity Guarantee Program, which expanded its guarantees of bank liabilities to include selected senior unsecured obligations and all non-interest-bearing transactions deposits. The Treasury--in concert with the Federal Reserve and the FDIC--provided packages of loans and guarantees to ensure the continued stability of Citigroup and Bank of America, two of the world's largest banks. Over this period, governments in many foreign countries also announced plans to stabilize their financial institutions, including through large-scale capital injections, expansions of deposit insurance, and guarantees of some forms of bank debt. Faced with the significant deterioration in financial market conditions and a substantial worsening of the economic outlook, the Federal Open Market Committee (FOMC) continued to ease monetary policy aggressively in the final months of 2008, including a rate cut coordinated with five other major central banks. In December the FOMC brought its target for the federal funds rate to a historically low range of 0 to \1/4\ percent, where it remains today. The FOMC anticipates that economic conditions are likely to warrant exceptionally low levels of the Federal funds rate for some time. With the Federal funds rate near its floor, the Federal Reserve has taken additional steps to ease credit conditions. To support housing markets and economic activity more broadly, and to improve mortgage market functioning, the Federal Reserve has begun to purchase large amounts of agency debt and agency mortgage-backed securities. Since the announcement of this program last November, the conforming fixed mortgage rate has fallen nearly 1 percentage point. The Federal Reserve also established new lending facilities and expanded existing facilities to enhance the flow of credit to businesses and households. In response to heightened stress in bank funding markets, we increased the size of the Term Auction Facility to help ensure that banks could obtain the funds they need to provide credit to their customers, and we expanded our network of swap lines with foreign central banks to ease conditions in interconnected dollar funding markets at home and abroad. We also established new lending facilities to support the functioning of the commercial paper market and to ease pressures on money market mutual funds. In an effort to restart securitization markets to support the extension of credit to consumers and small businesses, we joined with the Treasury to announce the Term Asset-Backed Securities Loan Facility (TALF). The TALF is expected to begin extending loans soon. The measures taken by the Federal Reserve, other U.S. Government entities, and foreign governments since September have helped to restore a degree of stability to some financial markets. In particular, strains in short-term funding markets have eased notably since the fall, and London interbank offered rates (Libor)--upon which borrowing costs for many households and businesses are based--have decreased sharply. Conditions in the commercial paper market also have improved, even for lower-rated borrowers, and the sharp outflows from money market mutual funds seen in September have been replaced by modest inflows. Corporate risk spreads have declined somewhat from extraordinarily high levels, although these spreads remain elevated by historical standards. Likely spurred by the improvements in pricing and liquidity, issuance of investment-grade corporate bonds has been strong, and speculative-grade issuance, which was near zero in the fourth quarter, has picked up somewhat. As I mentioned earlier, conforming fixed mortgage rates for households have declined. Nevertheless, despite these favorable developments, significant stresses persist in many markets. Notably, most securitization markets remain shut, other than that for conforming mortgages, and some financial institutions remain under pressure. In light of ongoing concerns over the health of financial institutions, the Secretary of the Treasury recently announced a plan for further actions. This plan includes four principal elements: First, a new capital assistance program will be established to ensure that banks have adequate buffers of high-quality capital, based on the results of comprehensive stress tests to be conducted by the financial regulators, including the Federal Reserve. Second is a public-private investment fund in which private capital will be leveraged with public funds to purchase legacy assets from financial institutions. Third, the Federal Reserve, using capital provided by the Treasury, plans to expand the size and scope of the TALF to include securities backed by commercial real estate loans and potentially other types of asset-backed securities as well. Fourth, the plan includes a range of measures to help prevent unnecessary foreclosures. Together, over time these initiatives should further stabilize our financial institutions and markets, improving confidence and helping to restore the flow of credit needed to promote economic recovery.Federal Reserve Transparency The Federal Reserve is committed to keeping the Congress and the public informed about its lending programs and balance sheet. For example, we continue to add to the information shown in the Fed's H.4.1 statistical release, which provides weekly detail on the balance sheet and the amounts outstanding for each of the Federal Reserve's lending facilities. Extensive additional information about each of the Federal Reserve's lending programs is available online. \1\The Fed also provides bimonthly reports to the Congress on each of its programs that rely on the section 13(3) authorities. Generally, our disclosure policies reflect the current best practices of major central banks around the world. In addition, the Federal Reserve's internal controls and management practices are closely monitored by an independent inspector general, outside private-sector auditors, and internal management and operations divisions, and through periodic reviews by the Government Accountability Office.--------------------------------------------------------------------------- \1\ For links and references, see Ben S. Bernanke (2009), ``Federal Reserve Programs to Strengthen Credit Markets and the Economy,'' testimony before the Committee on Financial Services, U.S. House of Representatives, February 10, http://www.federalreserve.gov/newsevents/testimony/bernanke20090210a.htm--------------------------------------------------------------------------- All that said, we recognize that recent developments have led to a substantial increase in the public's interest in the Fed's programs and balance sheet. For this reason, we at the Fed have begun a thorough review of our disclosure policies and the effectiveness of our communication. Today I would like to highlight two initiatives. First, to improve public access to information concerning Fed policies and programs, we recently unveiled a new section of our Web site that brings together in a systematic and comprehensive way the full range of information that the Federal Reserve already makes available, supplemented by explanations, discussions, and analyses. \2\ We will use that Web site as one means of keeping the public and the Congress fully informed about Fed programs.--------------------------------------------------------------------------- \2\ The Web site is located at http://www.federalreserve.gov/monetarypolicy/bst.htm--------------------------------------------------------------------------- Second, at my request, Board Vice Chairman Donald Kohn is leading a committee that will review our current publications and disclosure policies relating to the Fed's balance sheet and lending policies. The presumption of the committee will be that the public has a right to know, and that the nondisclosure of information must be affirmatively justified by clearly articulated criteria for confidentiality, based on factors such as reasonable claims to privacy, the confidentiality of supervisory information, and the need to ensure the effectiveness of policy.The Economic Outlook and the FOMC's Quarterly Projections In their economic projections for the January FOMC meeting, monetary policy makers substantially marked down their forecasts for real GDP this year relative to the forecasts they had prepared in October. The central tendency of their most recent projections for real GDP implies a decline of \1/2\ percent to 1\1/4\ percent over the four quarters of 2009. These projections reflect an expected significant contraction in the first half of this year combined with an anticipated gradual resumption of growth in the second half. The central tendency for the unemployment rate in the fourth quarter of 2009 was marked up to a range of 8\1/2\ percent to 8\3/4\ percent. Federal Reserve policymakers continued to expect moderate expansion next year, with a central tendency of 2\1/2\ percent to 3\1/4\ percent growth in real GDP and a decline in the unemployment rate by the end of 2010 to a central tendency of 8 percent to 8\1/4\ percent. FOMC participants marked down their projections for overall inflation in 2009 to a central tendency of \1/4\ percent to 1 percent, reflecting expected weakness in commodity prices and the disinflationary effects of significant economic slack. The projections for core inflation also were marked down, to a central tendency bracketing 1 percent. Both overall and core inflation are expected to remain low over the next 2 years. This outlook for economic activity is subject to considerable uncertainty, and I believe that, overall, the downside risks probably outweigh those on the upside. One risk arises from the global nature of the slowdown, which could adversely affect U.S. exports and financial conditions to an even greater degree than currently expected. Another risk derives from the destructive power of the so-called adverse feedback loop, in which weakening economic and financial conditions become mutually reinforcing. To break the adverse feedback loop, it is essential that we continue to complement fiscal stimulus with strong government action to stabilize financial institutions and financial markets. If actions taken by the Administration, the Congress, and the Federal Reserve are successful in restoring some measure of financial stability--and only if that is the case, in my view--there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery. If financial conditions improve, the economy will be increasingly supported by fiscal and monetary stimulus, the salutary effects of the steep decline in energy prices since last summer, and the better alignment of business inventories and final sales, as well as the increased availability of credit. To further increase the information conveyed by the quarterly projections, FOMC participants agreed in January to begin publishing their estimates of the values to which they expect key economic variables to converge over the longer run (say, at a horizon of 5 or 6 years), under the assumption of appropriate monetary policy and in the absence of new shocks to the economy. The central tendency for the participants' estimates of the longer-run growth rate of real GDP is 2\1/2\ percent to 2\3/4\ percent; the central tendency for the longer-run rate of unemployment is 4\3/4\ percent to 5 percent; and the central tendency for the longer-run rate of inflation is 1\3/4\ percent to 2 percent, with the majority of participants looking for 2 percent inflation in the long run. These values are all notably different from the central tendencies of the projections for 2010 and 2011, reflecting the view of policymakers that a full recovery of the economy from the current recession is likely to take more than 2 or 3 years. The longer-run projections for output growth and unemployment may be interpreted as the Committee's estimates of the rate of growth of output and the unemployment rate that are sustainable in the long run in the United States, taking into account important influences such as the trend growth rates of productivity and the labor force, improvements in worker education and skills, the efficiency of the labor market at matching workers and jobs, government policies affecting technological development or the labor market, and other factors. The longer-run projections of inflation may be interpreted, in turn, as the rate of inflation that FOMC participants see as most consistent with the dual mandate given to it by the Congress--that is, the rate of inflation that promotes maximum sustainable employment while also delivering reasonable price stability. This further extension of the quarterly projections should provide the public a clearer picture of the FOMC's policy strategy for promoting maximum employment and price stability over time. Also, increased clarity about the FOMC's views regarding longer-run inflation should help to better stabilize the public's inflation expectations, thus contributing to keeping actual inflation from rising too high or falling too low. At the time of our last Monetary Policy Report, the Federal Reserve was confronted with both high inflation and rising unemployment. Since that report, however, inflation pressures have receded dramatically while the rise in the unemployment rate has accelerated and financial conditions have deteriorated. In light of these developments, the Federal Reserve is committed to using all available tools to stimulate economic activity and to improve financial market functioning. Toward that end, we have reduced the target for the Federal funds rate close to zero and we have established a number of programs to increase the flow of credit to key sectors of the economy. We believe that these actions, combined with the broad range of other fiscal and financial measures being put in place, will contribute to a gradual resumption of economic growth and improvement in labor market conditions in a context of low inflation. We will continue to work closely with the Congress and the Administration to explore means of fulfilling our mission of promoting maximum employment and price stability. FOMC20071031meeting--45 43,MR. FISHER.," By that I mean, by the way, that the subprime market is a focus of angst, which it should be, but the ridiculous practice of the suspension of reason in valuing all asset classes, if not over, is in remission. We have a long way to go before full recovery and must acknowledge that shocks regarding access might occur. I am confident, as I have said in previous meetings, that—just to be polite—some cow patties might show up in the punchbowls of some portfolios, perhaps especially in Europe and Asia. But I would submit, Mr. Chairman, that we are on our way back to markets priced by reason rather than by fantasy. So, while we must remain ready to act as needed, I think it is appropriate to focus our discussion today and tomorrow foursquare on the economy, and I want to turn to that now. The wealth effect of the severe markdown in housing is as yet incalculable and worrisome. As the Greenbook states and my sounding with CEOs confirms, there are as yet no appreciable, let alone debilitating, signs of spillover into the rest of the economy. The economy has been weakened. You see it in the rails and trucking and retail. It has not shown signs of succumbing as much as one might have expected to the full-blown virus that is afflicting housing. As Dave mentioned, going back to July, banks in our District and everywhere else have reported tightening terms and standards on loans to businesses and households. The overall sentiment or mood of the country, as reported by the press and the surveys, is sour. Yet we haven’t seen sharp increases in initial claims, low PMI (purchasing managers index) readings, or sharply falling durable goods orders. Households are still reasonably optimistic about their job prospects. Consumer spending continues to grow, albeit at a slower pace. The CEO of Disney started his discussion with me this time by saying, “I hate to be the bearer of good news,” and went on to cite an internal survey they recently completed that shows that families plan to spend liberally on vacations, despite setbacks in presumed housing prices, as well as strong ad statistics for their broadcasting network. There remain widespread reports of labor shortages, not just in our District but also elsewhere. The bottom line, Mr. Chairman, is that, there is clearly a fat left tail on growth—the economy is growing slower. But the economy is growing at a positive pace. Some might say that it has slowed to a sustainable pace. In part, this is due to infrastructure investment, spending on nondefense capital goods that is better than expected, decent if not robust E&S demand, fiscal stimulus, and strong export performance that we talked about earlier, assisted by superior demand growth abroad, facilitated by a progressively weaker dollar. I note that we meet the day after the trade-weighted dollar celebrated a post–Bretton Woods low—not an easy thing for a strong dollar man to note. Certainly, there is a risk that downward economic momentum will emerge. I worry about the plight of the big, populous states like Florida and California under the crush of the housing implosion. I take note of the reports from UPS, the rails, and the truckers as to the deceleration in year-over-year trends in pre-holiday shipments. I realize that Wal-Mart same-store growth has slowed, that mall traffic is down, and so on. But not a single one of my thirty-five CEO interlocutors, except for the homebuilders, felt that the economy was at risk of falling off the table. Fluor and the other big builders—or logistics organizers, as I like to call them—report a booming domestic infrastructure business, especially in the petrochemical sector. The technology folks, as manifested by the earnings reports of Microsoft, Apple, and others, continue to find that demand is brisk. Cisco’s CEO confirms that business with all but the financial institutions “has begun to flow again” after being laid low by the uncertainty of August. The airlines report volume conditions as “less bad” than they were in the third quarter. UPS’s CFO, about to become CEO, who serves on President Lockhart’s board, is concerned, like the rails, about consumer holiday demand, and notes that trans-Pacific shipments into the United States have slowed. Yet when he digs deep into the data, he will tell you that the tech side looks good. So the net effect is that, while nowhere near robust, “domestically, conditions have not materially worsened.” Except for housing and Bill’s two law firms, we are not hearing of significant lagging of receivables or collectibles. Many of my interlocutors, however, worry about prices, as do our staff members in Dallas. We differ significantly, Mr. Chairman, from the central assumption of the Greenbook in our views on headline inflation looking forward. I noticed you cocking an eye in my direction, Brian, when you were talking about the outliers. The Greenbook has a 3 percent number for PCE inflation for this year, followed by a deceleration, to a pace of 1.8 percent in 2008 and 1.7 in 2009. We in Dallas are not as confident that we will continue to experience a disinflation of the momentum of the PCE. Partly this stems from concerns expressed anecdotally by big importers like Wal-Mart, who report stiffening Chinese prices, by the CEO of JCPenney, who is planning for cost increases of goods imported from China on the order of 3 to 4 percent next year, and by the users of pulp and recycled waste paper that are set to announce a 5 percent increase in essential paper products effective in February, having just announced a double-digit increase not too long ago. Our concern at the Dallas Fed stems from two more-pervasive sources than that anecdotal evidence I just cited, and those are food and energy, for which we anticipate a more pernicious pass-through effect from recent rapid price increases of underlying commodities. The concern we have for food is encapsulated in the eye-popping chart on page II-30 of Part 2 of the Greenbook. You have to have a hawk’s eye to see this chart from that end of the table, but it shows an incredible divergence between food prices and the core PCE. Now this pattern has a historical precedent. A spread of this magnitude between food prices and core indexes occurred on several occasions between 1951 and 1980. In 1973, the gap was 20 percent. In 1974, the gap was closed when the CPI rose up accordingly. But we have not seen a gap of this nature in over a quarter-century. Wholesale food prices are up 6.3 percent for the year to date. Through September, the CPI for food is up 5.7 percent. As mentioned by one of the previous interlocutors, milk and green grocery prices are rising at double-digit paces. This goes beyond ethanol, Mr. Chairman, as a driver of shifts in crop rotation and production. It is occurring against a ramping up of the caloric intake of a few billion new eaters in China, India, and elsewhere. This is hardly encouraging, and it injects a modicum of doubt in predicting a significant decline in PCE inflation. We spoke about energy price dynamics earlier. They further cloud the picture. If you talk to Exxon or Independence, they will tell you that there is no problem in finding oil, in refining it, or in delivering the final product. They will, however, note that there are two key impulses at work. First, there is no evident slowdown in demand growth according to them— that is, domestically—and the appetite in the BRICs (Brazil, Russia, India, and China) and in the developing countries was described as voracious. An enormous amount of infrastructure in chemical plant capacity is being constructed everywhere, from the Gulf Coast of the United States to the Middle East to China and Singapore, in order to be nearer to either feedstock or growing final demand. Any analysis of the income elasticity of demand for oil in low but rising income nations like China and India points to demand for oil that will grow even faster than their slightly slower but still rapidly growing income levels. Second, price pressures on crude at the margin are compounded by noncommercial activity, which we did not talk about earlier. Noncommercial contracts, the busywork of what are called “city refiners” in the industry—that is, the city of London and the financial exchanges—have of late been running at triple their traditional volume according to Exxon’s CEO, driving oil through $90. Thus far, gasoline and distillates, which is where the pass-through rubber hits the consumer price road, have been tame in response. Bill discussed the low crack spread, for example. Yet our models at the Dallas Fed for retail gasoline prices envision increases above $3 a gallon next year if crude stays above $85, which we consider a reasonable probability. Similarly, price pressures for distillates are increasingly probable. Finally, while currently high inventories continue, it is noteworthy that natural gas prices have reversed their summer slide downward to $5.50 per million Btu and are now quoted at $7 at the Henry Hub. All this gives me, Mr. Chairman, a sense of discomfort, like that expressed by President Hoenig and President Plosser, on the headline inflation front and is a reminder that the balance of risk is not necessarily skewed only toward slower growth. Thank you, Mr. Chairman." FOMC20060328meeting--163 161,MR. KROSZNER.," Obviously, from the remarks that we heard earlier today and yesterday, there is an enormous amount of strength and resiliency in the economy. Clearly, the economy has rebounded from a temporary slowdown in the fourth quarter. The specifics that I have heard from each of the Districts confirm the broad Greenbook view that this is going to be a pretty strong quarter. I particularly like the quotation from President Fisher that it will be “blowing and going” during this quarter. A forecast of 3¾ percent real GDP growth for 2006 with perhaps a bit of slowing in 2007 seems quite reasonable given the data that we have in hand. Consumption remains solid, and despite some less-sanguine reports at the end of last week about some orders, business investment still appears to be reasonably strong. Since there seems to be much agreement with the central tendency of the forecast, rather than review my reasons for supporting it—and I support most of the reasons that people put forward—what I want to do is focus on a few potential risk factors going forward. Not that I necessarily think that these things are likely to happen, but as Dave Stockton mentioned yesterday, there are a number of uncertainties in the forecast, which we need to focus on: First, with respect to housing; second, with respect to energy and commodity prices; and, third, with respect to expectations in the yield curve and the term premium issues that the Chairman asked us about yesterday. We have been receiving some mixed signals with respect to the housing market, although the components that tend to have the most information for assessing the future direction of the market, permits and sales of new single-family homes, suggest some considerable cooling from the very hot period in 2005. The evidence that I have from talking to property developers in the Chicago area and a bit in D.C. seems to be consistent with this evaluation, particularly in things like the condo market. We see a lot of slowing there, particularly in the Chicago area—at least from what I have heard anecdotally. Not only are we faced with the forecaster’s typical dilemma of trying to predict a trend break or a turning point, but we also have relatively few experiences in the United States over the last few decades of a downturn in the housing market. So the key concern is going to be the effect on wealth and on consumption and obviously also on the construction market. In the Greenbook, I believe the direct contribution of wealth to real PCE growth was approximately 1 percent in 2005, and the forecast is about ¾ percent in 2006, with at least half of each of these increments due to housing wealth. So, obviously, we have to be very sensitive to the concerns there. In some countries, such as the United Kingdom and Australia, even some relatively moderate downturns or slowdowns in the housing market seem to have been associated with some fairly important GDP effects. President Stern yesterday made an important point of what’s driving what. Many of the discussions about the housing market suggest that there will be some sort of exogenous shock that somehow may send the housing market down, as opposed to the housing market’s being part of the broader economy in which there are consumption demands for investment and in which houses are an asset as part of a portfolio. It is important to put housing in that context. In the other countries where we have seen downturns and GDP effects, it is hard to pull out what part was due to housing’s lead as opposed to housing’s just being one of the factors affected by a general economic downturn. So with those caveats in mind, and obviously we have to be careful about extrapolating from other countries’ experiences, I do think we should be mindful of the potential risks that are there. Second, energy and commodity prices: So far we have been very fortunate in seeing little, if any, of the run-up in energy and commodity prices feeding through to core measures of inflation, and from what I can tell in the discussions relating to the Greenbook, this has been a bit of a surprise to the staff and a bit of a surprise to the Committee. Now, this may well be due to a confluence of very fortunate factors that perhaps could be reversed in the near term, or it may be due to some longer-run changes, which President Fisher discussed. We had some discussion of this yesterday. So, as you know, productivity growth and international competition could be important factors, but at this point I do not feel that I understand enough whether this situation is just temporary and we are lucky or whether it is part of an ongoing process. And so I think we just have to be mindful of the potential risk there. And obviously with the uptick in forecasts for growth outside the United States, which could be associated with an increase in demand for energy and raw materials, further upward pressure could be put on those prices. Finally, inflation expectations in the yield curve and term premiums: Fortunately, generally the market-based and survey-based measures of inflation seem to be fairly steady, reasonably well contained. I share Kevin’s concern that some of these expectations being above 2, 2½, even in some cases closer to 3 may be a bit of a challenge, but broadly the numbers that we have been seeing around 2 seem to suggest that inflation expectations are well anchored. And it seems that one of the great achievements of this body that I have now been very fortunate and very honored to become part of is the reduction of inflation uncertainty and the reduction of inflation expectations. And these reductions, I think, help us at least in part to understand the very low term premiums that we have been seeing in the United States. But we must also recognize that we have been seeing lower real and nominal rates and generally lower term premiums around the world. In talking to market participants, I hear much less of a fear of an inflation spike in many countries around the world—not that there was a fear of an inflation spike in the United States—but I think a greater certainty about the direction and focus of the FOMC and a greater trust is extremely important. This gets back to a point that President Lacker made yesterday about the incredibly important role of expectations. What we do has to be seen not just in terms of the traditional backward-looking role of thinking about how the higher cost of capital could affect choices that people make, but also about our credibility in going forward. Choices that we make may have opposite effects on interest rates than what we have seen in the past. Raising interest rates in the short-term may have a damping effect rather than an increasing effect on longer rates. If you look to forecasts of economists outside this room and the System, you also see a fair amount of optimism, suggesting growth in the future. So the lower real and nominal rates in the longer-term markets do not seem to be due to concerns about significant slowing of the economy but to differences in views about inflation uncertainty and the level of inflation going forward. So, particularly since some of our measures—of core PCE, core CPI—are at or toward the upper end of the range of where I would feel comfortable (and, I believe, from what I have heard, a number of others around the table would feel comfortable), we have to be vigilant about that. Maintaining our credibility and the good work that this Committee has done is something that I want not to become dreaming the impossible dream but something that is the reality and that we can continue. Thank you, Mr. Chairman." CHRG-111hhrg51698--15 Mr. Greenberger," Thank you, Mr. Chairman. Mr. Chairman, Ranking Member Lucas, first of all, I want to congratulate this Committee. It has been at the forefront of elucidating these issues by the many hearings it has held; and if you want to understand the problems either with speculation in the energy or agriculture markets or credit default, the problems with credit default swaps and its cause of the present meltdown, you only have to read the work of this Committee. Second, Mr. Chairman, I want to congratulate you and then Ranking Member Goodlatte for the good work you did in the last Congress. I know that bipartisanship is the mark of good legislation, especially with the advent of President Obama's emphasis on that. I congratulate you for having gotten the Transparency Act through by an over \2/3\ vote, if I calculate correctly. I think you had 283 votes. But, also, I want to congratulate you on something you yourself did not mention and you deserve a lot of credit for, and so does Ranking Member Goodlatte. On June 26th, on 1 day's notice, when gasoline prices were going over $4 and crude oil was approaching a world record high of $147, you on 1 day's notice with Ranking Member Goodlatte crafted legislation that passed on June 26th by a 402-19 vote that ordered the CFTC to immerse itself in those markets and use all its powers to drain any speculation, if it were there, in causing these problems. Unfortunately, neither your June 26th bill, nor your September 18th bill was able to make its way through the Senate, but it was a model of aggressive leadership and bipartisanship, your doing that. If this Committee wants the CFTC to stay as the principal regulator in this, it must work aggressively and it must demonstrate to the American people--and when I say ``the American people,'' the industrial consumers of commodities are at this table, the farmers, the heating oil dealers, the gas station owners, the airlines are all very supportive of what you are doing and would ask for a little bit more in order to control these markets. And by that I talk about aggregated spec limits. I am not going to take time talking about it now, but that is something you should seriously consider. With regard to your legislation, Mr. Damgard has worried about what Gerald Corrigan of Goldman Sachs testified to you are the, ``bespoke,'' swaps transactions. Those are individually negotiated swaps transactions. Your bill has a broad exemption in there. Yes, the CFTC, after a public hearing, has to grant those exemptions, but this bill takes care of the nonstandardized but beneficial swaps transactions that need to be performed. I would also say, when the airline industry is mentioned as suffering from this, I expect you will hear from the airline industry that it suffered substantially from the deregulation that it experienced over the last summer. So, yes, you have called for mandatory clearing, but you have an exemption in there. I would point out Senator Harkin, whose bill is tougher on the Senate side, does not allow for exemptions. Your bill does. By the way, in 1993 the CFTC passed the so-called swaps exemption that allowed for tailored swaps to be marketed. Your exemption is broader than that, and I am of the opinion that the breadth you have articulated is needed. Naked credit default swaps have tripled--at least tripled the exposure to debt in these markets. It is one thing for there not to be enough money to pay, for example, for the subprime mortgages, but the naked credit default swaps allowed people to bet that those mortgages wouldn't be paid. As Eric Dinallo pointed out, New York's Insurance Superintendent who has responsibility for AIG and for MBIA, it tripled--the bets tripled the amount of money the American taxpayer must infuse into the financial system. I feel strongly that the ban on naked credit default swaps is important. I identify myself completely with prior testimony of the Chairman of the Chicago Mercantile Group. I agree that the futures market is a beautiful market if it is properly policed. The swaps market was taken out of the jurisdiction of the CFTC. The Enron and London loopholes took agriculture and energy out of the CFTC. If they are put back into the CFTC, yes, the futures market is a wonderful market if you have good institutions like CME policing it and you have a strong CFTC overseeing those markets. And that is what your draft bill accomplishes. I would urge some minor tweaking, but it is a very good bill, and you are to be congratulated. Thank you. [The prepared statement of Mr. Greenberger follows:]Prepared Statement of Michael Greenberger, J.D., Professor, University of Maryland School of Law, Baltimore, MD I want to thank this Committee for inviting me to testify on the important issue that is before it today. I also want to congratulate and thank Chairman Peterson, Ranking Member Lucas, the whole Committee, and the Committee staff for the Committee's continuing hard work, thoughtful analysis, and leadership that it has brought to bear on the widespread concerns that the deregulated over-the-counter derivatives market has caused the most serious financial distress in the Nation's economy since the Great Depression. Since the summer of 2008, this Committee has repeatedly taken the leadership on regulatory issues of greatest concern to the American people. When gas prices were reaching over $4.00 a gallon by the end of June 2008, this Committee drafted on a day's notice and supervised the June 26, 2008 passage by a vote of 402-19 emergency legislation that would have required the CFTC to implement emergency procedures in the crude oil futures markets to bring down the then sky rocketing price of gasoline, heating oil, and crude oil.\1\ The Committee then drafted and supervised the passage by a 283-133 September 18, 2008 vote of the Commodity Markets Transparency Act of 2008, which was designed to bring transparency and accountability to the OTC energy markets, thereby stifling excessive speculation and unnecessarily high prices for America's energy needs.\2\ Evidence adduced since the passage of this September 2008 legislation on the House floor has made it even clearer that excessive speculation in the unregulated energy and swaps markets has caused and continues to cause unnecessary and substantial volatility in the agriculture and energy markets.\3\ On January 14, 2009, for example, it was reported that, ``[b]etween Christmas [2008] and a week ago oil prices soared 40 percent, only to reverse almost as sharply in recent days.'' \4\ `` `The oil markets are suffering acute whiplash,' said Daniel Yergin, an energy consultant and author of `The Prize,' a history of world oil markets. `Price volatility is adding to the sense of shock and confusion and uncertainty.' '' \5\--------------------------------------------------------------------------- \1\ David Cho, ``House Passes Bill Bolstering Oil Trade Regulator'', Wash. Post, June 27, 2008, at D8 available at http://www.washingtonpost.com/wp-dyn/content/article/2008/06/26/AR2008062604005.html. \2\ Commodity Markets Transparency and Accountability Act, 110th Cong. (2008) available at http://thomas.loc.gov/cgi-bin/bdquery/z?d110:HR06604:@@@R. \3\ Michael Masters, Adam White, The Accidental Hunt Brothers (July 31, 2008) available at http://accidentalhuntbrothers.com/ (stating ``[t]he total open interest of the 25 largest and most important commodities, upon which the indices are based, was $183 billion in 2004. From the beginning of 2004 to today, Index Speculators have poured $173 billion into these 25 commodities.''); Maher Chymaytelli, Opec Calls for Curbing Oil Speculation, Blames Funds, January 28, 2009, available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aw4VozXUOVwU (stating ``Oil surged 46 percent in the first half of 2008 to a record $147.27 only to plunge by the end of the year. So-called net-long positions in New York crude futures by hedge funds and other large speculators betting on higher prices peaked at 115,145 contracts in March, according to data from the CFTC. They switched direction in July to a net-short position, or wager against prices, which reached 52,984 contracts by mid-November, the CFTC data show. Oil futures traded 6 cents down at $41.52 a barrel on the New York Mercantile . . . down 72 percent from last year's record.''); The Price of Oil. (January 11, 2009). CBS: 60 Minutes. \4\ Clifford Kraus, Where Is Oil going Next, New York Times (January 14, 2009) B1 at http://www.nytimes.com/2009/01/15/business/worldbusiness/15oil.html. \5\ Id.--------------------------------------------------------------------------- From October through December 2008, this Committee has held a highly productive, informative and widely publicized series of hearings on the role unregulated over-the-counter (``OTC'') financial derivatives have played in causing the present economic meltdown. Now, under the leadership of Chairman Peterson, a new and comprehensive discussion draft of the Derivatives Markets Transparency and Accountability Act of 2009, has been circulated for comment and is the subject of today's hearings. Again, that draft legislation is designed to apply time-tested tools of market regulation to the OTC agriculture, energy and financial derivatives markets. There can be little doubt that the overwhelming message of the testimony presented to this Committee in its hearings on OTC derivatives has largely established a consensus that the previously unregulated OTC markets have caused severe systemic economic shocks to the economy, because of a lack of transparency to the nation's financial regulators of these private bilateral agreements, and because of inadequate capital reserves set aside by OTC derivative counterparties to underpin the trillions of dollars of financial commitments they made (and are now owed) through the OTC transactions in question. In almost all the credit markets examined, the derivative transactions have increased exponentially the risk and resulting indebtedness within the underlying markets. For example, New York Insurance Superintendent, Eric Dinallo, who has been responsible for overseeing two major troubled financial institutions that come within his regulatory ambit (AIG and MBIA), has demonstrated that outstanding credit default swaps (``CDS'') ``could total three times as much as the actual debt outstanding'' in the markets for which the CDS provide guarantees.\6\ In other words, because of ``naked'' credit default swaps that provide payouts to counterparties who have no interest insurable risk emanating from debts within these markets (i.e., they are simply wagering, for example, in exchange for a relatively small insurance-like premium, that subprime mortgages will not be paid off), the actual billions of dollars of losses in these markets have been magnified three fold by rampant and uncontrolled ``betting'' on these markets.\7\--------------------------------------------------------------------------- \6\ The Role of Financial Derivatives in the Current Financial Crisis: Hearing before the Senate Agricultural Comm., 110th Cong. at 3 (October 14, 2008) (written testimony of Eric Dinallo, Superintendent, New York State Insurance Dept.) available at http://www.ins.state.ny.us/speeches/pdf/sp0810141.pdf. \7\ The Role of Financial Derivatives in the Current Financial Crisis: Hearing before the Senate Agricultural Comm., 110th Cong. (October 14, 2008) (stating ``by 2000 we engaged in the Commodities Futures Modernization Act, which specifically did a few things. It made credit default swaps not a security, so it couldn't be regulated as a security; as you said, put it out of reach of the CFTC; and it said this act shall supersede and preempt the application of any state or local law that prohibits or regulates gaming or the operation of bucket shops.'')--------------------------------------------------------------------------- By virtue of bailouts, guarantees, and loans (e.g., the FED exchanging Treasuries at its discount window for banks' troubled subprime assets) made by the United States Treasury and/or the Federal Reserve, the American taxpayer has been required to make good on unfulfilled or potentially unfulfilled commitments of our largest financial institutions in the OTC derivatives market of up to $6 trillion.\8\ With the advent of the stimulus legislation and President Obama's soon to be announced overarching financial package, the American public's outlay will doubtless soon grow by further trillions of dollars through further possible guarantees, purchases of troubled assets (i.e., a ``bad bank''), mortgage and other loans, and further capital infusions into the financial system.--------------------------------------------------------------------------- \8\ David Leonhardt, The Big Fix, N.Y. Times (February 1, 2009), (stating that ``the debt that the Federal Government has already accumulated [. . .] is equal to about $6 trillion, or 40 percent of G.D.P. [. . .] The bailout, the stimulus and the rest of the deficits over the next 2 years will probably add about 15 percent of G.D.P. to the debt. That will take debt to almost 60 percent, which is above its long-term average but well below the levels of the 1950s. But the unfinanced parts of Medicare, the spending that the government has promised over and above the taxes it will collect in the coming decades requires another decimal place. They are equal to more than 200 percent of current G.D.P.'')--------------------------------------------------------------------------- Of course, the subject of today's hearing does not, and cannot, address the present multi-trillion dollar ``hole'' in our economy, which, in turn, has brought the world markets to their knees. This hearing and the legislation to which it is addressed is forward looking. The underlying thesis here is: if we are fortunate enough to dig ourselves out of the huge financial mire in which we find ourselves, a regulatory structure must be put in place that will prevent the risk creating and risk bearing folly that led to the present fiasco. I have appended hereto a paper I prepared that outlines the severe damage unregulated OTC derivatives have caused to the market and that proposes a generic regulatory program designed to apply traditional and time tested tools of regulatory oversight now governing our equity, debt and regulated futures markets to our OTC derivatives markets. Suffice it to say, that I am in agreement with many who have already come before this Committee and the Senate Agriculture Committee on these issues, including Terrence A. Duffy, Executive Chairman of the CME Group, Inc.; \9\ Eric Dinallo (the New York Insurance Superintendant); \10\ Professor Henry Hu, Professor of Law at the University of Texas Law School; \11\ Professor William K. Black of the University of Missouri-Kansas City; \12\ and Erik Sirri, Director of SEC's Division of Trading and Markets \13\ as to the regulation of financial OTC derivatives; and Adam K. White, CFA,\14\ and PMAA's witnesses as to agriculture and energy OTC derivatives. Former Chair of the Federal Reserve, Paul Volker, has elsewhere made recommendations and observations consistent with the above referenced testimony,\15\ as has the January 29, 2009 Special Report on Regulatory Reform of the Congressional Oversight Panel mandated by the Emergency Economic Stabilization Act of 2008 (``the bailout legislation'').\16\ Finally, former SEC Chair Arthur Levitt has recommended reversal of the deregulatory effects of 2000 Commodity Futures Modernization Act on the OTC markets,\17\ and even former Fed Chair Alan Greenspan has admitted that it was an error to deregulate the credit default swaps market.\18\--------------------------------------------------------------------------- \9\ The Role of Credit Derivatives in the U.S. Economy: Hearing Before the House Comm. on Agriculture, 110th Cong. (December 8, 2008). \10\ The Role of Credit Derivatives in the U.S. Economy: Hearing Before the House Comm. on Agriculture, 110th Cong. (November 20, 2008). \11\ The Role of Credit Derivatives in the U.S. Economy: Hearing Before the House Comm. on Agriculture, 110th Cong. (October 15, 2008). \12\ Role of Financial Derivatives in Current Financial Crisis: Hearing Before Senate Agricultural Comm., 110th Cong. (October 14, 2008). \13\ The Role of Credit Derivatives in the U.S. Economy: Hearing Before the House Comm. on Agriculture, 110th Cong. (November 20, 2008). \14\ To Review Legislation Amending the Commodity Exchange Act: Hearing Before the House Comm. on Agriculture, 110th Cong. (July 10, 2008). \15\ Paul A. Volcker, Address to the Economic Club of New York, at 1-2 (April 8, 2008) available at econclubny.org/files/Transcript_Volcker_April_2008.pdf). \16\ Congressional Oversight Panel, 111th Cong., Special Report on Regulatory Reform: Modernizing the American Financial Regulatory System: Recommendations for Improving Oversight, Protecting Consumers, and Ensuring Stability (2009). \17\ Goodman, The Reckoning: Taking Hard New Look at a Greenspan Legacy, N.Y. Times (October 9, 2008) available at http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?pagewanted=1&_r=1; Michael Hirsh, The Great Clash of '09: A looming battle over re-regulation, Newsweek, (December 24, 2008) available at http://www.newsweek.com/id/176830. \18\ Congressional Oversight Panel, 111th Cong., Special Report on Regulatory Reform: Modernizing the American Financial Regulatory System: Recommendations for Improving Oversight, Protecting Consumers, and Ensuring Stability. (2009) at 7 (quoting former Federal Reserve Chairman Alan Greenspan ``Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief.''--------------------------------------------------------------------------- I am pleased that the draft legislation that we discuss today adopts most of the points made in my appended paper and the recommendations of the witnesses I have cited above. In this regard, I support Discussion Draft's: 1. Requirement of mandatory clearing of OTC derivatives both through the CFTC or other appropriate Federal financial regulators and by the CFTC exclusively in the energy and agriculture markets. 2. Reporting requirements and regulatory oversight obligations placed on designated clearing organizations (``DCOs''). 3. Tailored, precise, and limited exemptions that may be granted by the CFTC to the mandatory clearing requirements for individually negotiated or, in the words of Goldman Sachs' E. Gerald Corrigan, ``bespoke'' derivatives, i.e., derivatives that by the instrument's limited reach and their unsuitability for trading cannot cause systemic risk to the nation's economy. 4. Imposition of speculative limits for noncommercial trading on designated contract markets (``DCMs''), designated transaction execution facilities (``DTEFs'') and on other electronic trading facilities, as well as foreign boards of trade, especially insofar as those speculation limits are recommended by Position Limit Advisory Groups composed in significant part by commercial hedgers within the relevant markets, i.e., those who have intimate knowledge of the degree of speculation needed in each market to provide liquidity. 5. Establishment of a clear and concise definition of a ``bona fide hedging transaction'' limiting that exclusion from speculation limits to those actually engaged as a primary business activity in the ``physical marketing channel'' of the commodity. 6. Imposition of three additional core principles to the criteria for establishing of a designated clearing organization (``DCO''): (1) disclosure of general information; (2) publication of trading information; and (3) fitness standards. 7. ``Transition rule'' requiring existing uncleared swaps or uncleared swaps executed for the period after enactment to establish the regulatory scheme to be required by the statute to be reported to the CFTC. 8. The banning of ``naked'' credit default swaps, i.e., those swaps that are merely a wager on the viability of an institution or financial instrument without requiring the corresponding underlying risk from the failure of those institutions or instruments. 9. The creation of an independent CFTC Inspector General confirmed by the Senate. 10. The appointment of at least 200 new full time CFTC employees.With regard to my comments in support of the draft legislation, I want to particularly call attention to two commendable aspects of the legislation. 1. The ban on ``naked'' credit default swaps. Former SEC Chairman Christopher Cox has since September 2008 repeatedly criticized these instruments as ``naked'' shorts on public corporations that evade the requirements for shorting stocks in the regulated equity markets.\19\ He and the New York Insurance Superintendent, Eric Dinallo, have warned that these instruments encourage the ``moral hazard'' of providing perverse incentives to take actions that cause companies covered by the CDS to fail or, in the case of naked short of subprime mortgage paper, borrowers to default on their mortgage loans.\20\ As to incentives of undercut the mortgage backed paper, i.e., mortgage backed securities or collateralized debt obligations, that has led many holders of CDS guarantees to oppose, for example, mortgage workouts so that mortgage defaults trigger ``naked'' CDS payments. Chairman Peterson had it exactly right when he recently said: `` `It is hard for me to understand what useful purpose these things are serving, . . . I'm not out to get Wall Street, but what's gone on there is jeopardizing the world economy.' '' \21\ Those who support ``naked'' CDS argue that it is needed for ``price discovery.'' However, the reported ``short interest'' on public companies in the regulated equities market already is an adequate ``price discovery mechanism'' for the worth of those companies. For price discovery on CDS guarantees of collateralized debt obligations, those CDS that insure actual risk on CDO investments should serve any needed price discovery function; to the extent that ``real'' CDS are inadequate for that purpose, the undisputed harm done to the economy by ``naked'' CDS far outweighs any price discovery benefits from allowing the continued trading of ``naked'' CDS. Had ``naked'' CDS been banned in the passage of the CFMA in 2000, it is my firm belief that there would have been no need for this hearing today in that the outlawing of that product, in and of itself, would have substantially mitigated the worldwide financial meltdown we are now experiencing.--------------------------------------------------------------------------- \19\ O'Harrow and Denis, Downgrades and Downfall, Washington Post (December 31, 2008) A1 (stating `` `The regulatory blackhole for credit-default swaps is one of the most significant issues we are confronting on the current credit crisis,' Cox said, `it is requires immediate legislative action.' ''). \20\ The Role of Financial Derivatives in the Current Financial Crisis: Hearing before the Senate Agricultural Comm., 110th Cong. 3 (October 14, 2008) (opening statement of Eric Dinallo, Superintendent, New York State Insurance Dept.) (stating ``We engaged in the ultimate moral hazard . . . no one owned the downside of their underwriting decisions, because the banks passed it to the Wall Street, that securitized it; then investors bought it in the form of CDOs; and then they took out CDSs. And nowhere in that chain did anyone say, you must own that risk.''). \21\ Matthew Leising, Bloomberg.com, ``Peterson Plans Bill to Force Credit Default Swaps Clearing'' (December 15, 2008). 2. Mandatory Clearing. While the financial services industry has supported the ``availability'' of clearing OTC derivatives as a ``firewall'' against systemic risk, they have, for the most part, opposed mandatory clearing. As has been explained in testimony by the CME Group, for example, a clearing facility, which is guaranteeing the performance of both counterparties to an OTC derivative contract, can only assume that substantial risk for performance for those contracts about which it has complete understanding. The requirement to understand contractual risk, inter alia, requires that the OTC cleared contracts be standardized, i.e., so that the clearing facility has substantial comprehension of the guarantor role it is playing. Those who oppose mandatory clearing worry about the inability to clear non-standardized OTC derivatives. As far back as 1993, however, the CFTC has promulgated a ``swaps'' exemption for individual negotiated swaps agreements that are not executed on an electronic trading facility.\22\ Moreover, the draft legislation provides an arguably broader ``individualized'' exemption with the corresponding precise standards that assure that the exemption will only be granted when systemic risks will not be posed. In short, the draft legislation is a reasonable compromise that accommodates individually negotiated contracts that cannot be cleared. It should also be born in mind that the Senator Harkin's legislation flatly bans exceptions from his requirement that all OTC contracts be exchange traded--not merely cleared.\23\ In this regard, the New York Stock Exchange has just advocated that ``U.S. policy makers should extend existing [exchange] rules so that they apply to unregulated derivatives instead of drafting new legislation that may take years to implement, . . .'' \24\--------------------------------------------------------------------------- \22\ 17 C.R.F. Part 35 (1993). \23\ The Derivatives Trading Integrity Act, 111th Cong. (January 15, 2009); Senate Agriculture Comm., Statement of Chairman Tom Harkin: Role of Financial Derivatives in the Current Financial Crisis (Oct. 14, 2008); Posting of James Hamilton to Jim Hamilton's World of Securities Regulation, http://jimhamiltonblog.blogspot.com/2009/01/senate-bill-would-regulate-otc.html (Jan. 17, 2009, 14:58) (stating ``[t]he broad goal of the [Senator Harkin's] legislation is to establish the standard that all futures contracts trade on regulated exchanges.''). \24\ Lisa Brennan, ``Exchange Rules Should Apply to Derivatives, NYSE Says'' (Bloomberg, February 2, 2009).--------------------------------------------------------------------------- My only questions and/or comments on the draft legislation are: 1. Express Pre-approval Findings of Suitability of Designated Clearing Organizations. The CFMA sets out 14 core principles for the establishment of a DCO. As mentioned above, the discussion draft adds three new core principles borrowed from the core principles applicable to designated transaction execution facilities DTEFs (i.e., non-retail exchange trading for high net work institutions and individuals). However, as made clear by the CFTC's Director of Clearing and Intermediary Organizations, Ananda Radhakrishnan, under the Commodity Exchange Act, ``DCOs do not need pre-approval from the CFTC to clear derivatives, [but] any such initiative would be required to comply with the relevant core principles set forth in the [statute] and the CFTC would review it for compliance with those principles. . . .'' \25\ In other words, the statute allows facilities to self certify as DCOs and the CFTC would only then examine compliance with core principles after the fact. As is now well known, the CFTC ``announced'' on December 23, 2008 that ``the CFTC staff would not object to the [DCO] certification.'' \26\ The CME submitted its plans to the CFTC staff prior to the operation of its DCO. The ``CFTC staff reviewed CME's plans to clear credit default swaps, including CME's planning risk management procedures, . . .'' \27\ My search of the CME docket number on the CFTC website shows no accompanying order by the Commission or the CFTC staff indicating or explaining such approval. I hasten to add that I have little doubt about the qualifications (or indeed the great benefit) of the CME, the world's largest derivatives exchanges, engaging in this clearing. However, others are eligible to apply for DCO status and in an age when the American public is clamoring for transparency in governmental actions, especially actions surrounding the present financial crisis, and given the great importance of approving an institution to clear these highly volatile and potentially toxic products, it would seem that pre-approval of a clearing facility should be required and that the Commission--not just the staff--should issue affirmative and detailed findings about its confidence in the applicant serving as a DCO. Indeed, prior to the passage of the CFMA in December 2000, the CFTC and its staff issued 18 single space pages of detailed findings endorsing the safety and soundness of the first applicant to clear swaps.\28\ Since the CFTC staff checks the safety and soundness of a DCO one way or another, the Committee should add a provision to the legislation requiring pre-approval of DCOs trading OTC derivatives and that that pre-approval be accompanied by findings demonstrating that the DCO applicant meets all applicable statutory requirements. Given the importance of the clearing facility in serving as a firewall against breakdown of the economy, it seems a small burden to require a transparent Commission document reflecting its careful attention this important decision.--------------------------------------------------------------------------- \25\ The Role of Financial Derivatives in the Current Financial Crisis: Hearing before the Senate Agricultural Comm., 110th Cong. 3 (October 14, 2008). \26\ Press Release, Commodity Futures Trading Commission, CFTC Announces That CME Has Certified a Proposal to Clear Credit Default Swaps (Dec. 23, 2008) available at http://www.cftc.gov/newsroom/generalpressreleases/2008/pr5592-08.html. \27\ Id. \28\ Order Granting the London Clearing House's Petition for an Exemption Pursuant to Section 4(c) of the Commodity Exchange Act, 64 Fed. Reg. 53346-64 (October 1, 1999). 2. Fraud and Manipulation. As the CFMA is presently drafted, the swaps exemption in section 2(g) of the Act excludes swaps from the anti-fraud and anti-manipulation provisions within the statute.\29\ (This exclusion distinguishes itself from ``exempt'' commodities, e.g., energy futures, which are subject to the Act's fraud and manipulation prohibitions.) Senator Harkin's legislation, S. 272, by requiring the exchange trading of swaps and the elimination of ``exemptions'' and ``exclusions'' brings the swaps market within the umbrella of the Act's central fraud and manipulation prohibitions. As Patrick Parkinson (Deputy Director, Division of Research and Statistics of the Federal Reserve System) made clear in his November 20, 2008 testimony before this Committee, the President's Working Group on Financial Markets is advising that OTC clearing facilities qualifications be measured against the ``Recommendations for Central Counterparties'' of the Committee on Payment and Settlement Systems of which Mr. Parkinson was the Co-Chair and on which the CFTC and SEC served.\30\ Those recommendations are replete with concerns about combating fraud in the clearing process. In the present climate of American public's distrust of financial markets, OTC swaps, as is true of ``exempt'' futures, should be subject to fraud and manipulation prohibitions. Moreover, it would seem to be a difficult argument to make that, whereas swaps should be cleared, fraud and manipulation should not be barred or, conversely, that logic would seem perversely to dictate that fraud and manipulation be permitted.\31\--------------------------------------------------------------------------- \29\ Johnson & Hazen, Derivatives Reg., section 1.18[6][B] at p. 332 (2004 ed.) ``[U]nlike excluded transaction, with exempt off-exchange transactions [, exempted transactions and swaps transactions], the CFTC retains its enforcement authority in case of fraud or market manipulation.'' Interpretation of CEA 2(c), 2(d) and 2(g). \30\ Patrick M. Parkinson, Statement of Testimony before the Committee on Agriculture United States House of Representatives on November 20, 2008, he stated that ``We [the CFTC, SEC, and Federal Reserve] have been jointly examining the risk management and financial resources of the two organizations that will be supervised by U.S. authorities against the `Recommendations for Central Counterparties,' a set of international standards that were agreed to in 2004 by the Committee on Payment and Settlement Systems of the central banks of the Group of 10 countries and the Technical Committee of the International Organization of Securities Commissions,'' available at http://agriculture.house.gov/testimony/110/h91120/Parkinson.pdf. \31\ [No citation in submitted testimony.] 3. Important Inconsistency between sections 6 and 9 of the Discussion Draft. As I read section 6(2)(A) of the Discussion Draft, it requires that the CFTC ``shall . . . establish limits on the amount of positions, as appropriate, other than bona fide hedge[rs] that may be held by any person with respect to . . . commodities traded . . . on an electronic trading facility as a significant price discovery contract.'' Section 6(B)(i) and (iii) mandate that these limits ``shall be established'' within set time periods for ``exempt commodities'' and ``excluded commodities.'' Exempt commodities include over-the-counter energy futures contracts exempt from regulation by 2(h) of the CEA. Excluded commodities cover swaps are exempt under 2(g). Therefore, it would seem that section 6 of the Discussion Draft mandates the imposition of position limits on OTC ``exempt'' and ``excluded'' trading. Moreover, section 6 seems, by the breadth of its language, to authorize implicitly the CFTC to impose aggregated limits across contract markets for specified commodities. On the other hand, section 9, by its terms, appears to require the CFTC to ``study'' each of these issues already addressed in section 6 and to report back to this Committee within 1 year of enactment. Given the overwhelming evidence that has been gathered about the impact of excessive speculation on the energy futures and energy swaps markets,\32\ for example, section 9 should be struck from that statute, because the time for study has long since passed. Moreover, I would urge this Committee to follow the bipartisan lead of Senators Reid, Lieberman and Collins \33\ and require--not simply authorize-- the CFTC to impose aggregated speculation limits upon U.S. traders and those trading in the U.S. across the energy and agriculture contract markets. It should be emphasized that on July 26, 2008 [check date] the Reid bill garnered 50 of 93 Senate votes in the last Congress in an unsuccessful attempt to sustain cloture in the last Congress.\34\ Again, given the heightened evidence of excessive speculation in the crude oil markets that post-date that July 26th vote, it could be expected that the 60 votes needed to bring the Reid aggregate spec limits bill to a vote on the merits will be reached in this Congress. My understanding is that this Committee will receive testimony from a broad coalition of industrial consumers of energy, including the airlines, truckers, farmers, heating oil dealers, and petroleum marketers, strongly backing the inclusion of aggregated spec limits for energy and agriculture in any bill reported out by this Committee.--------------------------------------------------------------------------- \32\ Supra at n. 3. \33\ See S. 3044, ``Consumer-First Energy Act'', 110th Congress, Sponsored by Sen. Henry Reid. See Also S. 3248, ``Commodity Speculation Reform Act'', 110th Congress, Sponsored Sen. Joseph Lieberman, Sen. Christopher Bond, Sen. Maria Cantwell and Sen. Susan Collins. \34\ Record Vote Number: 146, 110th Congress (June 10th, 2008). Cloture motion rejected--51 Yeas, 43 Nays, 6 Not voting. The four supporting republicans were, Collins (R-ME), Smith (R-OR), Snowe (R-ME) and Warner (R-VA). 4. Standards for Approving a Designated Clearing Organization. As stated above, I support the Discussion Draft's addition of three core principles to the statute's 14 criteria governing the approval of DCOs. I have also recommended above that the Commission--and not just the CFTC staff--make detailed pre- approval findings that the applicant for DCO status meets the criteria for clearing OTC derivatives. Again, the approval process is critical because it is universally recognized that a ``risk management failure by a [clearing facility] has the potential to disrupt the markets it serves and . . . [cause] disruptions to securities and derivatives markets and to payment and settlement systems, . . .'' A mistaken decision by the CFTC about the appropriateness of an applicant to serve as a DCO will simply recreate the instability of the present system where counterparties--even counterparties rated AAA at the commencement of the derivatives transactions--were ultimately downgraded and not able to fulfill their contractual obligations. The DCO approval decision requires great sophistication. Three years ago, many then AAA rated institutions, such as Lehman, Bear Stearns, or AIG, would have very likely been deemed strong DCO candidates. In short, today's AAA rated institution may be tomorrow's undercapitalized and overwhelmed entity whose failure will undermine the OTC derivatives settlement process; and possibly the Nation's economy as a whole. The Fed's and the SEC's reliance, for example, on the intricately detailed CPSS's ``Recommendation for Central Counterparties,'' raises the question whether the CFMA's generalized DCO approval criteria-- even as supplemented by the Discussion Draft's three additional criteria--are detailed enough to ensure that only the most prudent and stable entities to clear OTC derivatives. If the CPSS's recommendations are more thorough in this regard (they are certainly more detailed), adoption of the CPSS's standards by other Committees of Congress for their regulators, may become a pretext to seek the removal of the CFTC from clearing approval authority. The CPSS recommendations should be studied --------------------------------------------------------------------------- to ensure that that the DCO criteria are complete. It is for that reason that my preference would be to adopt exchange trading criteria to OTC derivatives as is required by S. 272. The New York Stock Exchange has also recently supported an exchange based approach.\35\ The statutory requirements for a designated transaction execution facility are more rigorous than those for a DCO even as those DCO criteria are upgraded by the discussion draft. DCOs are not expressly required to establish net capital requirements or financial integrity standards for counterparties; \36\ there is no regulation of DCO intermediaries as is true in the case of DTEFs; \37\ \38\ unlike DTEFs, the emergency authority of a DCO is expressly limited to withstanding ``disasters'' which in context of the statute is appears to be limited to natural disasters or Y2K types of information technology problems and not the threat of a systemic meltdown of the facility as a whole; \39\ and there is no requirement for self regulation of DCOs as is true of DTEFs.\40\ Finally, while it is true that DTEFs, unlike Designated Contract Markets (``DCM''), do not expressly have to establish dispute resolution mechanisms, this would be a worthy requirement to be applied to DCOs dealing with the highly volatile OTC derivatives markets.\41\--------------------------------------------------------------------------- \35\ Supra at n. 24. \36\ Compare 7 U.S.C. 7a(b)(3)(B)(iv) (2008) (stating the minimum net capital requirements for a party to trade on a registered DTEF) and 7 U.S.C. 7a(c)(4) (2008) (mandating that DTEF boards of trade must ``establish and enforce rules or terms and conditions providing for the financial integrity'' of both participants and transactions entered on or through the board of trade) to 7 U.S.C. 7a-1(c)(2)(C)(i) (2008) (merely requiring ``appropriate minimum financial requirements'' for admission and continued eligibility, but providing no explicit standards). \37\ Intermediaries, such as futures commission merchants, depository institutions, and Farm Credit System Institutions, must meet certain requirements in order to interact with a DTEF. 7 U.S.C. 7a(e)(1) (2008). The intermediary must be in good standing with the SEC or the Federal bank regulatory agencies (whichever is appropriate. 7 U.S.C. 7a(e)(2)(A) (2008). Additionally, if the intermediary holds customer funds for more than a day, it must be registered as futures commission merchant and must be a member of a registered futures association. 7 U.S.C. 7a(e)(2)(B) (2008). There is no statutory equivalent for DCOs concerning FCMs, depository institutions Farm Credit Institutions, or any other type of intermediary. See generally 7 U.S.C. 7a-1 (2008). \38\ See 7 U.S.C. 7a(d)(7) (2008) (stating that ``the board of trade shall establish and enforce appropriate fitness standards for directors, members of any disciplinary committee, members, and any other persons with direct access to the facility, including any parties affiliated with any of the persons described in this [statute].''). There is no comparable requirement for DCOs. See generally 7 U.S.C. 7a-1 (2008). \39\ 7 U.S.C. 7a-1(c)(2)(I)(ii) (2008) (requiring the maintenance of emergency procedures, a disaster recovery plan, and periodic testing of backup facilities, but not the establishment of a contingency plan to deal with economic emergencies). \40\ While both DTEFs and DCOs have various requirements that they are responsible for carrying out, it is only in the context DTEFs that the concept of ``self regulation'' is expressly addressed. See 7 U.S.C. 7a(b)(2)(E) (2008) (noting that the Commission will consider the entities history of this self regulation when determining if there is a threat of manipulation); see, e.g., 7 U.S.C. 7a(d)(2008) (explaining the core principles and explicit duties of a DTEF); 7 U.S.C. 7a-1(c)(2) (2008) (listing in broad terms the responsibilities of a DCO). \41\ However, it is worth noting that: a board of trade may elect to operate as a registered derivatives transaction execution facility if the facility is-- (1) designated as a contract market and meets the requirements of this section; or (2) registered as a derivatives transaction execution facility under subsection (c) of this section. 7 U.S.C. 7a(a)(1)-(2) (2008). If the DTEF chose to operation under section (1), it follows that the board of trade would be obligated to follow all of the requirements for a DCM. In sum, the Committee should be congratulated for the scope of its hearings on these critically important questions and for the thoroughness of the Discussion Draft. Appendix AMemorandum on Regulatory Reform of Credit Default SwapsJanuary 24, 2009Professor Michael Greenberger. While a litany of factors including lending and financial abuses led to the present economic meltdown, chief among them was the opaque nature of the estimated notional $596 trillion \1\ unregulated over-the-counter derivatives market. That market includes what is estimated to be the $35-$65 trillion credit default swaps (``CDS'') market.\2\ The over-the-counter derivatives market was, prior to December 20, 2000, conventionally understood to be subject to regulation under the Commodity Exchange Act (``CEA''). On that date, the Commodity Futures Modernization Act (``CFMA'') was passed. That legislation was, for the most part, rushed through Congress and enacted during a lame duck session as a rider to an 11,000 page omnibus appropriation bill.\3\ That statute removed swaps transactions from all meaningful Federal oversight.--------------------------------------------------------------------------- \1\ See, Bank for International Settlements, BIS Quarterly Review (September, 2008), available at http://www.bis.org/publ/qtrpdf/r_qa0809.pdf#page=108. \2\ Id. \3\ See, e.g., Johnson & Hazen, Derivatives Regulation, 1.17 at 41-49 (2009 Cum. Supp.)--------------------------------------------------------------------------- In warning Congress about badly needed reform efforts when it considered the bailout legislation in Senate hearings before the Senate Banking Committee in September, 2008, SEC Chairman Christopher Cox called the CDS market a ``regulatory blackhole'' in need of ``immediate legislative action.'' \4\ Former SEC Chairman Arthur Levitt and even former Fed Chair Alan Greenspan have acknowledged that the deregulation of the CDS market contributed greatly to the present economic downfall.\5\--------------------------------------------------------------------------- \4\ `` `The regulatory blackhole for credit-default swaps is one of the most significant issues we are confronting on the current credit crisis,' Cox said, `it is requires immediate legislative action.' '' O'Harrow and Denis, Downgrades and Downfall, Washington Post (December 31, 2008) A1. \5\ Goodman, The Reckoning: Taking Hard New Look at a Greenspan Legacy (October 9, 2008) A1; http://mobile.newsweek.com/detail.jsp?key=39919&rc=camp2008&p=0&all=1.--------------------------------------------------------------------------- In brief, the securitization of subprime mortgage loans evolved from simple mortgage backed securities (``MBS'') to highly complex collateralized debt obligations (``CDOs''), which were the pulling together and dissection into ``tranches'' of huge numbers of MBS, theoretically designed to diversify and offer gradations of risk to those who wished to invest in that market. However, investors became unmoored from the essential risk underlying loans to non-credit worthy individuals by the continuous reframing of the form of risk (e.g., from mortgages to MBS to CDOs); the false assurances given by credit rating agencies that gave misleadingly high evaluations of the CDOs; and, most importantly, by the ``insurance'' offered by CDO issuers in the form of CDS. The CDS ``swap'' was the exchange by one counterparty of a premium for the other counterparty's ``guarantee'' of the financial stability of the CDO. While CDS has all the hallmarks of insurance, issuers of CDS were urged not to refer to it as ``insurance'' out of a fear that CDS would be subject to insurance regulation by state insurance commissioners. By using the term ``swaps,'' CDS fell into the regulatory blackhole afforded by the CFMA. Because CDS was not insurance or any other regulated instrument, the issuers of CDS were not required to set aside adequate capital reserves to stand behind the guarantee of the financial stability of CDOs. The issuers of CDS were beguiled by the utopian view (supported by ill considered mathematical algorithms) that housing prices would always go up and that, even a borrower who could not afford a mortgage at initial closing, would soon be able to extract that appreciating value in the residence to refinance and pay mortgage obligations. Under this utopian view, the writing of CDS was deemed to be ``risk free'' with a goal of writing as many CDS as possible to develop cash flow from the ``premiums.'' To make matters worse, CDS was deemed to be so risk free (and so much in demand) that financial institutions began to write ``naked'' CDS, i.e., offering the guarantee to investors who had no risk in any underlying mortgage backed instruments or CDOs. Naked CDS provided a method to ``short'' the mortgage lending market, i.e., to place the perfectly logical bet for little consideration (i.e., the premium) that those who could not afford mortgages would not pay them off. The literature surrounding this subject estimates that more ``naked'' CDS instruments are extant than CDS guaranteeing actual risk. Finally, the problem was further aggravated by the development of ``synthetic'' CDOs. Again, these synthetics were mirror images of ``real'' CDOs, thereby allowing an investor to play ``fantasy'' securitization. That is, the purchaser of a synthetic CDO does not ``own'' any of the underlying mortgage or securitized instruments, but is simply placing a ``bet'' on the financial value of a the CDO that is being mimicked. Because both ``naked'' CDS and ``synthetic'' CDOs were nothing more than ``bets'' on the viability of the subprime market, it was important for this financial market to rely upon the fact that the CFMA expressly preempted state gaming laws.\6\--------------------------------------------------------------------------- \6\ Johnson & Hazen, Derivatives Regulation, 4.04[11] at 975 (2004 ed.) referencing 7 U.S.C. 16(e)(2).--------------------------------------------------------------------------- It is now common knowledge that: (1) issuers of CDS did not (and will not) have adequate capital to pay off guarantees as housing prices plummet, thereby defying the supposed ``risk free'' nature of issuing huge guarantees for the small premiums that were paid; (2) because CDS are private bilateral arrangements for which there is no meaningful ``reporting'' to Federal regulators, the triggering of the obligations there under often come as a ``surprise'' to both the financial community and government regulators; (3) as the housing market worsens, new CDS obligations are triggered, creating heightened uncertainty about the viability of financial institutions who have or may have issued these instruments, thereby leading to the tightening of credit; (4) the issuance of ``naked'' CDS increases exponentially the obligations of the CDS underwriters; and (5) the securitization structure (i.e., asset backed securities, CDOs and CDS) is present not only in the subprime mortgage market, but in the prime mortgage market, as well as in commercial real estate, credit card debt, and auto and student loans. As these latter parts of the economy falter, the toxicity of the underlying financial structure falls into a continuous destabilizing pattern. As a result, for example, the Fed is now spending $200 billion to buy instruments outside of the residential mortgage market.\7\--------------------------------------------------------------------------- \7\ GAO Report, supra note 17, at 31; Press Release, Federal Reserve, Nov. 25, 2008, available at http://www.federalreserve.gov/newsevents/press/monetary/20081125a.htm.--------------------------------------------------------------------------- Finally, while CDS and synthetic CDOs constitute the lit fuse that leads to the exploding financial destabilization we are experiencing today, the remainder of the over-the-counter derivatives market has historically led to other destabilizing events in the economy, including the recent energy and food commodity bubble (energy and agriculture swaps), the failure of Long Term Capital Management in 1998 (currency and equity swaps), and the Bankers Trust scandal and the Orange Country bankruptcy of 1994 (interest rate swaps). Because ``swaps'' are risk shifting instruments or, in their most useful sense, hedges against financial risk, they were almost certainly subject to the Commodity Exchange Act prior to the passage of the CFMA in 2000. The Commodity Future Trading Commission (``CFTC'') in 1993 exempted swaps from that CEA's exchange trading requirement if their material economic terms were individually negotiated and if they were not traded on a computerized exchange.\8\ However, the 1993 exemption did not satisfy the financial services sector and, by 1998, the market grew to over $28 trillion in notional value without utter disregard for the exchange trading requirements within the CEA.--------------------------------------------------------------------------- \8\ 17 C.R.F. Part 35 (1993).--------------------------------------------------------------------------- As a result in May 1998, the CFTC, under the leadership of then Chair Brooksley Born, issued a ``concept release'' inviting public comment on how that multi-trillion dollar industry might most effectively be covered by the CEA on a ``prospective'' basis.\9\ While that effort was blocked by the Executive Branch and Congress (including the passage of the CFMA in 2000), the CFTC concept release spelled out a menu of regulatory tools that have historically been applied to financial instruments, e.g., equities, bonds, and traditional futures contracts that have the financial force to destabilize the economy systemically.--------------------------------------------------------------------------- \9\ 63 Fed. Reg. 26114 (May 12, 1998).--------------------------------------------------------------------------- The classic indicia of regulation of financial instruments that have potential systemic adverse impacts on the economy include: 1. Transparency. These kinds of financial instruments are reported to, and, even often, registered with, a Federal oversight agency prior to execution. Transparency also requires that all transactions and holding be accounted for on audited financial statements. The present meltdown has been characterized by the use of off balance sheet investment vehicles, e.g., structured investment vehicles (``SIVs'') to house those instruments with potential systemic risk hidden from public view. 2. Record Keeping. Counterparties should be required to keep records of these transactions for 5 years. 3. Immediate Complete Documentation. Since August 2005, the Fed has complained that financial instruments pertaining to credit derivatives have been poorly documented with back offices being very far behind the execution of credit derivatives by sales personnel. 4. Capital Adequacy. Federal regulators traditionally require that parties to regulated transactions have adequate capital reserves to ensure payment obligations. 5. Disclosure. Federal regulators traditionally require full and meaningful disclosure about the risks of entering into the regulated transaction. 6. Anti-fraud authority and anti-manipulation. The regulated markets are governed by statutes that bar fraud and manipulation. The CFMA provided only limited fraud protection for counterparties by the SEC. The inadequacy of that protection is evidenced by both SEC Chairman Cox and former SEC Chairman Levitt calling regulation of these markets a ``regulatory blackhole.'' \10\ Fraud protection without transparency to the Federal regulator is meaningless. Moreover, no manipulation protection was included within the CFMA with regard to swaps. Effectively, the CFMA authorized this massive multi-trillion dollar worldwide swaps market without any provisions for protecting against fraud or manipulation. Fraud and anti-manipulation protections included within the securities and regulated futures laws should be restored to these markets.--------------------------------------------------------------------------- \10\ See Speech by SEC Chairman Christopher Cox: Opening Remarks at SEC Roundtable on Modernizing the Securities and Exchange Commission's Disclosure System (Oct. 8, 2008). 7. Registration of Intermediaries. ``Brokers'' of equity and regulated futures transactions are subject to registration requirements and prudential conduct. There is no such --------------------------------------------------------------------------- protection within the swaps market. 8. Private Enforcement. As is true in securities laws and laws applying to the regulated futures markets, private parties in the swaps markets should have access to Federal courts to enforce anti-fraud and anti-manipulation requirements, thereby not leaving enforcement entirely in the hands of overworked (and sometimes unsympathetic) Federal enforcement agencies. 9. Mandatory Self Regulation. As is true of the securities and traditional futures industries, swaps dealers should be required to establish a self regulatory framework, including market surveillance. 10. Clearing. Again, as is true of the regulated securities and regulated futures infrastructure, a strong clearing intermediary should clear all trades as further protection against a lack of creditworthiness of counterparties.The adoption of the traditional regulatory protections for swaps with systemic risk characteristics would essentially return these markets to where they were as a matter of law prior to the passage of the CFMA in 2000. The general template would be that swaps would have to be traded on a regulated exchange (which provides each of the protections outlined above) unless the proponents of a risk shifting instrument bear the burden of demonstrating to a Federal regulator that the instrument cannot cause systemic risk and will not lead to fraudulent or manipulative practices if traded outside an exchange environment. It is for that reason, for example, that, in 1993, the CFTC exempted from exchange trading requirements privately negotiated contracts not traded in standardized format. The Senate Chair of the committee of jurisdiction over swaps, Senator Harkin,\11\ has argued that trading in these instruments should be moved back onto regulated exchanges and he even posed the possibility of an outright ban on ``naked'' CDS. In other words, he has called for reversing the CFMA in this regard and returning to the regulated exchange trading environment with direct Federal oversight and self regulatory protections that existed prior to the passage of the CFMA.--------------------------------------------------------------------------- \11\ Lynch, Harkin Seeks to Force All Derivatives on Exchanges, Wall Street Journal, November 20, 2008 at http://online.wsj.com/article/SB122721812727545583.html. See also Hunton & Williams LLP, The Derivatives Trading Integrity Act--Beginning of the End for OTC Trading?, December 2008, available at http://www.hunton.com/files/tbl_s10News%5CFileUpload44%5C15843%5Cderivatives_trading_integrity_act.pdf (``Senate Agriculture Committee Chairman Tom Harkin (D-Iowa) introduced the Derivatives Trading Integrity Act of 2008 (`the bill'), hoping to end `casino capitalism' in the market for over-the-counter (OTC) derivatives. The bill amends the Commodity Exchange Act (CEA) to require that all contracts with future delivery trade on regulated exchanges similar to how commodity futures currently trade . . . The bill reverses [the CFMA], forcing swap transactions to be conducted on designated or registered clearing houses or derivatives clearing organizations.'').--------------------------------------------------------------------------- Three final points should be made. Simple Clearing Is Not Enough. The financial services industry and the Bush Administration have argued that clearing facilities for CDS will provide adequate regulation. Clearing proposals have been advanced to the FED, the SEC, and the CFTC, where they are in various stages of approval. As I understand it, the clearing is wholly voluntary. Second, clearing without each of the other regulatory attributes outlined above, while helpful, does not provide a systemic risk firewall. Stocks and traditional futures trading have a complete regulatory infrastructure built around the clearing process. For example, we would never settle for clearing, and clearing alone, as a substitute for the regulatory and self regulatory structure that surrounds the equities market. Moreover, clearing without other prudential safeguards just places an apparently sound financial institution as the guarantor of the counterparties. Five years ago, AIG might have convincingly advanced itself as such an institution. Similarly, a AAA entity that appears sound today may become unstable if the entire derivatives market is not adequately policed. In sum, the limited step of clearing by itself does not adequately protect against systemic risk. State Insurance Regulation. As mentioned above, CDS has all of the attributes of insurance. As a result, the New York Insurance Superintendant and the Governor of New York in September 2008 required that its insurance registrants trading CDS to those wanting to indemnify their own real risks in the mortgage market be subject to state insurance law by January 1, 2009 with corresponding capital adequacy requirements.\12\ In this vein, it is interesting to note that AIG, a New York insurance regulatee, had $20 billion in reserve for each of its regulated insurance subsidiaries at the time it was rescued by the U.S. on September 17, 2008, because of CDS trading in an unregulated portion of the company. That fact seems to be unanswerable vindication of the efficacy of state insurance regulation, which is even now not preempted by the CFMA. In November 2008, New York temporarily suspended the CDS mandate it had issued in September on the theory that the prospects for Federal regulation had improved.\13\ On January 24, 2009, the National Conference of Insurance Legislators is holding a hearing in New York City to discuss whether CDS should be subject to state regulation. My view is that state efforts in this should be encouraged as a further safeguard against systemic risk, especially insofar as the CFMA itself did not preempt state insurance laws. The CFMA limited its preemptive effect to state gaming and bucket shop laws.--------------------------------------------------------------------------- \12\ New York State Insurance Dept., Recognizing Progress By Federal Government In Developing Oversight Framework For Credit Default Swaps, New York Will Stay Plan To Regulate Some Credit Default Swaps, press release, November 20, 2008 (``Dinallo announced that New York had determined that some credit default swaps were subject to regulation under state insurance law and that the New York State Insurance Department would begin to regulate them on January 1, 2009.''). \13\ New York State Insurance Dept., Recognizing Progress By Federal Government In Developing Oversight Framework For Credit Default Swaps, New York Will Stay Plan To Regulate Some Credit Default Swaps, press release, November 20, 2008 (Superintendent Dinallo stating ``I am pleased to see that our strong stand has encouraged the industry and the Federal Government to begin developing comprehensive solutions. Accordingly, we will delay indefinitely regulating part of the market.'').--------------------------------------------------------------------------- As some commentators have also made clear, the New York Insurance Superintendant's proposed extension to of New York insurance law relating to those seeking to indemnify actual risks from the actual holding of CDOs is too limited. ``Naked'' CDS, or the guarantees to counterparties who hold no CDO risk and who just want to bet against mortgage commitments being fulfilled, are the kind of insurance that led to the creation of state insurance laws.\14\ Under state insurance laws, you cannot insure against someone else's risk. Insurance of that kind creates so-called ``moral hazard,'' or the creation of perverse and nonproductive incentives to take actions that will lead to the triggering of the insurance guarantee. For example, the holder of a ``naked'' CDS might want to interfere with mortgage ``work outs'' to avoid defaults on loans, thereby insuring that the ``guarantee'' against loan default within the naked CDS will be triggered. Accordingly, if states are to regulate here, they should bar ``naked'' CDS as the very kind of unlawful insurance that caused regulation in this area.--------------------------------------------------------------------------- \14\ Kimbal-Stanley, Arthur, Dissecting A Strange Financial Creature, The Providence Journal, April 7, 2008 (``Insurance contracts used to protect against the loss of property owned by the person buying the policy helped the buyer eliminate the consequences of calamity. Insurance contracts used to bet on whether or not calamity would befall someone else's property not only let the buyer place a bet, it gave the buyer incentive to make that calamity occur, to destroy the insured property he did not own, to sink the other guy's ship, in order to collect on an insurance contract. In 1746, Parliament passed the Marine Insurance Act, requiring anyone seeking to collect on an insurance contract to have an interest in the continued existence of the insured property. Thus was born the insured-interest doctrine . . . The doctrines have been part of insurance law in both England and the United States (which in 1746 were colonies under English common law) ever since.'').--------------------------------------------------------------------------- Finally, there is a strong ``regulatory reform'' movement to preempt some or all of state insurance law in favor of a Federal insurance regulator.\15\ If the states ``stand down'' on the CDS market, i.e., consciously decide not to regulate products that have all the elements of insurance, in favor of exclusive Federal regulation, that will be the first exhibit used by those advocating Federal regulation as to the purported inadequacy of state regulation. CDS represent class insurance products.\16\--------------------------------------------------------------------------- \15\ Insurance Journal, AIG Crisis Restarts Debate Over State vs. Federal Insurance Regulation, September 17 2008, available at http://www.insurancejournal.com/news/national/2008/09/17/93798.htm?print=1. \16\ [No citation in submitted testimony.]--------------------------------------------------------------------------- Structural Regulation Alone. A further school of thought, most clearly evidenced by the President's Working Group on Financial Markets ``regulatory reform'' proposal of March 2008, is that the present regulatory failures have been caused by structural inadequacies, e.g., too many regulators looking at huge institutions carrying out in a single structure a host of financial activities.\17\ The March 2008 proposal was intended to mimic the U.K.'s then extant unified regulatory structure that was premised on ``principles'' rather than ``rules.'' For example, the March 2008 proposal would merge the CFTC into the SEC, but have the SEC use the CFTC's ``principles'' based regulation. Moreover, the March 2008 proposal would hand over to the Fed considerable consolidated ``rescue'' powers. It may very well be that there needs to be a restructuring of the Federal regulatory system. However, the adverse lesson emanating from the creation of the Department of Homeland Security should be an object lesson in the dangers of governmental reorganization in a time of crisis. More importantly, it is not enough to improve Federal ``rescue'' capabilities. There are neither principles nor rules that govern the OTC derivatives market. It is a ``blackhole.'' Even the U.K. is ``reforming'' its regulatory structure, recognizing that it was inadequate to the task in the present meltdown.--------------------------------------------------------------------------- \17\ http://www.ustreas.gov/press/releases/reports/pwgpolicystatemktturmoil_03122008.pdf. " FOMC20050322meeting--3 1,MR. KOS.,"1 Thank you, Mr. Chairman. At the Committee’s last meeting I characterized markets in the preceding weeks as “more of the same,” inasmuch as trends, such as the gradual rise of short-term interest rates, a flattening yield curve, narrowing credit spreads, and low volatilities, were continuing their well-established patterns. In the past six weeks, some of those trends ceased, though it is too soon to declare that they have gone into reverse. Questions about the pace of tightening and prospects for inflation in the medium term became a more prominent source of concern among investors. The top panel on page 1 of your handout graphs eurodollar deposit contracts maturing in June 2005, December 2005, and June 2006. What had been a steady rise in futures rates accelerated after the Chairman’s semiannual monetary policy testimony, especially for contracts beyond the front month. The spreads between the June ’06 and June ’05 contracts widened to reflect this more aggressive expected path of tightening. And while some traders ran to their dictionaries to look up the meaning of “conundrum,” perhaps the more important event with regard to the testimony was the expectation among many market participants that the Chairman would use the occasion to signal a pause in tightening or to elucidate the factors that could lead to a pause. Receiving no clarification on either point, the market pushed out the length of the tightening cycle and, at times, even the pace—with both anecdotal comments and some fed funds futures reflecting a stronger sense that the Committee might at some point ratchet up the pace of tightening to 50 basis points. Yields moved higher at both the short and long ends of the curve. As shown in the middle left panel, the two-year Treasury yield, which had been treading water earlier in the tightening cycle, increased about 40 basis points—thus widening the spread to the target funds rate. As shown in the middle right panel, 10-year yields rose from roughly 4.10 percent at the time of the February meeting to more than 4½ percent today. Besides revised expectations of policy and increased worries about inflation, there were also periodic bouts of anxiety about foreign central bank actions to diversify away from dollars and/or Treasury securities. The 10-year yield is now back to roughly the level it was last summer when the tightening cycle began. March 22, 2005 4 of 116 Until the last few weeks, the combination of a gentle rise in short-term rates and an immovable 10-year yield had substantially flattened the yield curve. The recent price moves did not reverse that trend but did, as shown in the bottom panel, stabilize the shape of the curve, which stopped flattening at about 80 basis points. The last few weeks also featured an increased preoccupation among traders and investors with the prospects for inflation. Several inflation reports were higher than expected, and commodity prices continued to rise. For example, the top panel of page 2 shows the CRB [Commodity Research Bureau] index since January 2004. Unlike other popular commodity indexes, the CRB does not have a large energy component and was more contained during 2004. The recent breakout had contributions from nearly every segment of the index. Focusing on energy, the middle panel depicts the oil futures curve out to two years for West Texas intermediate [WTI] as of two dates. The green line shows the curve as of October 26, 2004, the day oil prices hit their highs last fall and when the front-month contract topped $55 per barrel. The curve sloped downward by more than $10, and, for contracts at the end of that two-year horizon, oil was trading below $45. The blue line graphs the WTI curve as of this past Friday. The front-month contract was trading at about $57, but the curve has only a small downward slope; and the contract 24 months out is trading near $53, suggesting that market participants do not expect much softening in oil prices. The bottom panel graphs in blue the five-year TIPS [Treasury inflation-protected securities] breakeven inflation rate, which has been rising the past few weeks and is up substantially from a year ago. This rise in the breakeven rate has been contemporaneous with the most recent increase in oil prices. During last fall’s oil price rise, the breakeven was falling. Higher oil prices were seen more as a restraint on activity than as a catalyst for inflation. The situation has now reversed, though there are lots of caveats one needs to consider when interpreting breakeven rates. Other market-based measures of inflationary expectations are tame. For example, the five-year breakeven five years ahead has remained in a narrow range, as shown by the red line, and, in fact, is very little changed from a year ago. One question that has occupied market participants is whether risk is being mispriced. The narrowing of spreads over the past two years and the fall of volatility suggest that investors have been in risk-seeking mode. In the intermeeting period, that trend did not reverse, though it did moderate somewhat. March 22, 2005 5 of 116 specific corporate events. Though sudden, the recent widening was modest compared to other widening episodes during the last two years and relative to the previous narrowing episodes. Of course, the widening did not affect all issuers equally. The bottom left panel graphs the spreads of investment-grade issuers by credit rating. The AA, A, and BBB sectors are all narrower than they were a year ago, but in the past few weeks the BBB sector underperformed, as investors got nervous about the auto sector in general and General Motors in particular after that company reported disappointing earnings. The bottom right panel graphs the auto sector in green and representative 10-year GM and GMAC bond spreads. GM credit default swaps widened as well. The pessimist will take this price action as suggesting that risks are mispriced and that market participants have not been adequately anticipating deteriorating outlooks. The optimist will conclude from the GM news that markets are discriminating among issuers as new information becomes available and are repricing accordingly. Turning to page 4, the top panel depicts the EMBI+ [Emerging Markets Bond Index Plus] spread, which also widened in recent weeks but only to levels observed in January. The conclusion of the Argentine debt package, with its large haircuts, did not appear to have a contagion effect on the spreads of other large issuers. Parts of the outer rim of the risk spectrum did feel a chill, as shown in the middle and bottom panels. The middle panel graphs movements of a select group of emerging-market currencies against the dollar in the period between October and March 7. Several of these currencies had rallied by more than 10 percent. The green bars show the depreciations of the past two weeks. The bottom panel shows the same set of relationships for the broad equity market indexes of the same group of countries. Yes, there has been some unwinding of these positions in both currencies and equities. But, to date, the retracing has been mild and represents only a fraction of the appreciation observed in previous months. In short, if this is the beginning of a more general unwinding, there is far more to go. I should also note that the dollar has been firmer against the euro and other major currencies the past few days, which may suggest a bit of risk aversion, as the possibility of a more aggressive tightening cycle is causing a reassessment among the large contingent of dollar shorts. Mr. Chairman, there were no foreign operations in the intermeeting period. I will need a vote to approve domestic operations. Bob and I will be happy to take any questions about markets or about the memo I circulated last week regarding some changes we are planning to make to the yen reserves portfolio." FinancialCrisisReport--400 In internal documents, Goldman described itself as “the leader and principal driver in the creation of” the ABX Index. 1615 In July 2006, Joshua Birnbaum, Rajiv Kamilla, David Lehman, and Michael Swenson from the Mortgage Department nominated Goldman’s role in the creation of both the ABX and CMBX – a similar index based on Commercial Mortgage Backed Securities – for an internal Goldman award, called the “Mike Mortara Award for Innovation.” 1616 That award “recognize[d] the creative, forward-looking, and entrepreneurial contributions of an individual or team” within the equities or fixed income divisions. 1617 The Mortgage Department personnel wrote that the new indices “enable[d] market participants to trade risk without ownership of the underlying SP [structured product] security – thereby permitting market participants to efficiently go short the risk of these securities.” 1618 They also wrote that “Goldman Dominates Client Trading Volume” with “an estimated 40% market share,” and also “dominates the inter-dealer market.” 1619 In 2007, Rajiv Kamilla, the ABS trader who spearheaded Goldman’s efforts to launch the ABX Index, wrote that he “[c]ontinued to enhance our trading dominance in ... ABX indices.” 1620 While Mr. Kamilla led Goldman’s efforts to develop the ABX Index, the firm’s day-to-day ABX trading was conducted primarily by Joshua Birnbaum on the Mortgage Department’s Structured Products Group (SPG) Trading Desk. 1621 Mr. Birnbaum had a negative view of the 1615 6/20/2006 email from David Lehman, “Mortara Nomination – ABX/CM BX Indices,” GS MBS-E-014038810 (attached file, “2006 Mike Mortara Award for Innovation Nomination Template for ABX & CMBX Indices,” GS MBS-E-014038811 at 6 (hereinafter “Mortara Award Submission ”)). 1616 1617 Id. at 8. 6/20/2006 email from “Equities and FICC Communications” to “All Equities and FICC,” Mike Mortara Award for Innovation,” GS MBS-E-010879020 [original email]. 1618 1619 Mortara Award Submission at 2. Id. at 3-4. See also 8/30/2006 Fixed Income, Currency and Commodities Individual Review Book for Rajiv K. Kamilla, at 20, GS-PSI-04064 (hereinafter “Kamilla 2006 Review ”); 9/6/2007 Fixed Income, Currency and Commodities Individual Review Book for Rajiv K. Kamilla, at 19, GS-PSI-04100 (hereinafter “Kamilla 2007 Review ”). 1620 1621 Kamilla 2007 Review at 19. In 2007, Mr. Kamilla was named a Managing Partner at Goldman. Daniel Sparks, the Mortgage Department head, viewed Mr. Birnbaum as a talented trader, writing in October 2006: “Josh for EMD [Extended Managing Director] – he is an extraordinary commercial talent and a key franchise driver. ... He will make us a lot of money. ” 10/17/2006-10/18/2006 emails from Daniel Sparks, “3 things,” GS MBS-E-010917469. Other Goldman senior executives also relied on his trading skills. See, e.g., 2/21/2007 email from David Lehman, “ACA/Paulson Post, ” GS M BS-E-003813259 (before approving the Abacus CDO, Mr. Lehman asked Mr. Tourre to “[w]alk josh through the $, if that makes sense, let ’s go ”); 6/29/2007 email from David Lehman, “ABS Update, ” GS M BS-E-011187909 (during exceptionally bad trading day, Mr. Lehman asked M r. Swenson, “Is Josh in? Mr. Swenson replied “No he is in Spain – don ’t worry I am fine. ”). subprime mortgage market, and favored the firm’s building a net short position. 1622 However, during 2006, Goldman’s overall ABX position was net long, not net short. CHRG-111shrg53176--22 Chairman Dodd," Senator Schumer. Senator Schumer. Thank you, Mr. Chairman. Thank you for holding the hearing, and thank you to the witnesses for being here today. My first question deals with executive compensation. It has become clear that something is out of whack with executive compensation. I think we all believe that people should be rewarded for good performance. That is not the problem. But what we have seen in many instances, that has enraged Americans, is a ``heads, I win, tails, you lose'' system, in which executives are rewarded for flash-in-the-pan short-term gains, or even worse, rewarded richly when the company does poorly and the shareholders have been hammered. I think that is what most confounds people--bad performance, higher salary. Corporate boards are supposed to keep an eye on compensation. They are supposed to keep it aligned with shareholder interests. Lately, they seem to have more interest in keeping the CEOs and top management happy than in carrying out their fiduciary responsibilities, so I think we have to address that. We have learned a lot about this in the last while. Last year, when he was a Senator, President Obama sponsored an advisory say on pay proposal. I think we have to look at this. I am for it. But for say on pay to have teeth, it seems pretty clear it requires shareholders to have a stronger voice in regard to corporate management. This obviously means shareholders need to have a real voice in the election of directors. Right now, given the fact it is so hard to get access to the proxy materials for nonmanagement shareholders, this isn't true, so I was encouraged to hear in your testimony you don't believe the SEC has gone far enough in this area. First, how are you proceeding to correct this, and do you agree with me that, in conjunction, real proxy access along with say on pay would have some real impact on compensation practices and on enhanced board responsibility more generally? Ms. Schapiro. Senator, I agree with everything you have said---- Senator Schumer. Oh, well maybe we should stop right now. [Laughter.] Ms. Schapiro. I could stop right there in the interest of time. Let me say quickly, I think there has been a lot of effort to link pay to performance, but there has been a nonsuccessful effort to link pay to risk taking and that is a responsibility for boards, to understand the appetite for risk within the organization and to control it, and one way to control it is through linkage to compensation practices for senior management. We will move ahead this spring to propose greater access to the proxy for shareholders as a mechanism both to empower shareholders, who are, in fact, the owners of the corporation, but also as a mechanism to help provide greater discipline with respect to compensation and risk taking. Senator Schumer. Thank you, and I look forward to working with you on this area. I think we need to move forward. Second is enforcement funds. We know--everyone knows about the Madoff case, but it is emblematic of a broader trend of fraud that I believe is going to be uncovered in the aftermath of this financial crisis. Back in the S&L crisis, I helped push a law that would get special prosecutors, FBI agents, and bank examiners to go after that fraud. Mr. Breeden is shaking his head because we worked together on that. And we need to do that again, particularly now. If you saw yesterday's newspaper, the administration, correctly, doesn't want to reduce antiterrorism efforts in the Justice Department, but that squeezes new needs, such as financial investigators. In conjunction with my colleagues on this Committee, we are trying to increase the SEC enforcement budget. I proposed legislation to do that with Senator Shelby, which we are going to try to do in the Appropriations Committee. Can you give us a sense of what improvements you could make with a stronger enforcement budget? Ms. Schapiro. I would be happy to, and we---- Senator Schumer. Or an increased budget in general, too. Ms. Schapiro. We would be grateful recipients of an increased budget and particularly an increased enforcement budget. We have a new Enforcement Director beginning on Monday. He spent 11 years as a prosecutor and head of the Securities and Commodities Fraud Task Force in the Southern District of New York. He is coming in with a renewed commitment to the SEC's focus on bringing the most important cases, the most meaningful cases, in the quickest time possible in order to protect investors more effectively. We are also looking at technology improvements to support our enforcement and examination staff. The SEC's technology is light years behind Wall Street, and frankly, light years behind everybody else. Senator Schumer. OK. Ms. Schapiro. We have enhanced our training programs. We have a number of people who are now taking the Certified Fraud Examiner Program, as well as enhancing dramatically our internal training programs. And we are actively seeking new skill sets, including in financial analysis, forensic accounting, trading, and other areas, so that we are better able to keep up with what is going on and what the fraudsters are up to. Senator Schumer. Thank you. So I see you need the money. Could I ask one more, Mr. Chairman? Quickly, just on derivatives clearing. For a while, I have been advocating that derivatives ought to be traded whenever they can be--some are very complicated and there is no market--in either a clearinghouse, or for me, preferably, an exchange. I know that this morning, Secretary Geithner is going to mention that in his testimony, at least as I understand it, on the House side. What steps is the SEC encouraging to take to encourage the use of central counterparties? Do you have the authority to require clearing of certain types of derivatives now? If you don't, is it the kind of authority that you want, and if not, what other kinds of authority do you need? Ms. Schapiro. I believe that---- Senator Schumer. Do you agree with the general thrust? Ms. Schapiro. Yes. CDS should be centrally cleared. We do not have the authority right now to require that. We have facilitated the approval of three central counterparties for CDS clearing that we have done jointly with the Fed and with the Commodities Futures Trading Commission and we would strongly recommend that Congress require central clearing of CDS. I am not a big believer in voluntary regulation and I think that this is an area where we need authority. Senator Schumer. Thank you, Mr. Chairman. " CHRG-111shrg51290--16 Chairman Dodd," Thank you very much, Ms. Seidman. Ms. McCoy?STATEMENT OF PATRICIA A. McCOY, GEORGE J. AND HELEN M. ENGLAND PROFESSOR OF LAW, UNIVERSITY OF CONNECTICUT SCHOOL OF LAW Ms. McCoy. Chairman Dodd and members of the Committee, thank you for inviting me here today to discuss restructuring financial regulation. My name is Patricia McCoy and I am a law professor at the University of Connecticut. I also had the pleasure of living in Alabama where I clerked for Judge Vance some years ago. I applaud the Committee for exploring bold new approaches to this issue. In my remarks today, I propose transferring consumer protection for consumer credit from Federal banking regulators to one agency whose sole mission is consumer protection. We need this to fix three problems. First, during the housing bubble, fragmented regulation drove lenders to shop for the easiest regulators and laws. Second, this put pressure on banking regulators, State and Federal, to relax credit standards. Finally, banking regulators often dismiss consumer protection in favor of the short-term profitability of banks. During the housing bubble, risky subprime mortgages and non-traditional mortgages crowded out safer, fixed-rate loans. Between 2003 and 2005, the market share of non-prime loans tripled, from 11 percent to 33 percent. Over half of them were interest-only loans and option payment ARMs. These loans seemed appealing to many borrowers because their initial monthly payments were often lower than fixed-rate loans, but they had many hidden risks that many borrowers did not suspect. So borrowers flocked to the loans with the lower monthly payments, causing dangerous loans to crowd out the safer loans. Conventional lenders then decided, well, if we can't beat them, let us join them, and they expanded into dangerous loans, as well. Meanwhile, lenders were able to shop for the easiest laws and regulators. There was one set of laws that applied to federally chartered depository institutions and their subsidiaries. There is a wholly different set of laws that applied to independent non-bank lenders and mortgage brokers. At the Federal level, of course, we all know that we have four banking regulators plus the Federal Trade Commission. The States add another 50 jurisdictions on top. Because lenders could threaten to change charters, they were able to play off regulators against one another. This put pressure on regulators to relax their standards in enforcement. For example, in 2007, Countrywide turned in its charters in order to drop the Federal Reserve and the OCC as its regulators and to switch to OTS. The result was a regulatory race to the bottom. We can see evidence of regulatory failure by the Federal Reserve, the OTS, and OCC. As the Committee knows, the Federal Reserve refused to exercise its authority under HOEPA to regulate unfair and deceptive mortgages under Chairman Greenspan. The Fed did not change its mind until last summer under the leadership of Chairman Ben Bernanke. Meanwhile, OTS allowed thrifts to expand aggressively into option payment ARMs and other risky loans. In 2007 and 2008, five of the seven largest depository failures were regulated by OTS, including IndyMac and WaMu. In addition, Wachovia Mortgage FSB and Countrywide Bank FSB were forced into shotgun marriages to avoid receivership. By the way, none of this happened on my colleague Ellen Seidman's watch. She was a leader in fighting mortgage abuses when she was Director of OTS. Finally, how about the OCC? During the housing boom, the OCC allowed all five of the largest banks--Bank of America, JPMorgan Chase, CitiBank, Wachovia, and Wells Fargo--to expand aggressively into low-doc and no-doc loans. The results were predictable. Today, as a result, the country is struggling with how to handle banks that are too big to fail as a result. Bottom line, when you look at all types of depository charters, State banks and thrifts had the best default rates. Federal thrifts had the worst, and national banks had the second worst. Placing consumer protection with bank regulators turned out to be no guarantee of safety and soundness. Having it in a separate agency would counteract the over-optimism of Federal banking regulators at the top of the credit cycle. To fix these problems, we need three reforms. First, Congress should adopt uniform minimum safety standards for all providers of consumer credit, regardless of the type of entity or charter. This should be a floor, not a ceiling. First of all, that is necessary to make sure that the entity, the regulator, does not have too weak of a standard. And second, we have seen that States are closer to people at home and more responsive to their problems. Second, the authority for administering these standards should be housed in one Federal agency whose sole mission is consumer protection. This agency could either be a new agency or the Federal Trade Commission. All responsibility for oversight of consumer credit should be transferred from Federal banking regulators to this agency. And then finally, to avoid the risk of agency inaction, Congress should give parallel enforcement authority to the States and allow consumers to bring private causes of action to recover for injuries they sustain. I would be glad to take any questions. Thank you. " FOMC20080625meeting--67 65,MR. HOENIG.," Mr. Chairman, I will begin my remarks this afternoon with a brief update on the conditions in our District. Overall, District economic activity continues to expand moderately, with strengthened energy, agriculture, and export manufacturing more than offsetting the softness in our housing, retail sales, and other types of manufacturing activity. District labor markets continue to perform reasonably well. While job growth has slowed over the past few months, unemployment remains very low, and many sectors continue to have difficulty finding workers, especially skilled ones. Evidence on wage pressures is mixed. Although wage pressures have moderated somewhat in our Beige Book survey, some recent labor union contracts have built in rising profiles for hourly wage increases over the term of the contract. Rising energy and commodity input prices are continuing to negatively affect our District economic activity. Reports from businesses suggest that higher energy and food prices are being quickly passed on to the customer now. However, businesses are having mixed success in passing on other cost increases, resulting in some severe erosion in margins and profitability in some of the firms. To illustrate some of the cost�price dynamics, I would like to take just a minute and relate the recent experience of one of our Branch directors, who operates a multi-line manufacturing firm. I mention this because I am hearing it more and more. In addition to rising fuel prices, his business has seen a doubling in steel costs since January, with July quotes on steel tubing up an additional 25 percent. In response, his company recently announced a price increase of 16 to 18 percent across a range of products. Competitors immediately matched or exceeded his price increases. Notably, he made these price increases despite a decline in new orders in May. He also noted that import prices from China that he has seen have risen 28 percent this year and that ocean freight prices have risen about 20 percent. As a result, customers who previously bought Chinese products are now purchasing U.S.-manufactured goods. It is interesting--I talked with some of the folks at Union Pacific, and their shipments into the Midwest have dropped slightly, but their shipments out have increased about 3 to 4 percent. So that is what is going on in the region. More broadly, turning to the national economy, I have revised up my growth estimate for the first half of 2008, but it has made little change in my longer-run outlook. Compared with the Greenbook, I see somewhat stronger growth in the second half of this year and somewhat weaker growth next year and in 2010. Most of the difference from the Greenbook in 2009 and 2010 comes from the policy path assumptions. I assume that policy accommodation is removed at a more rapid pace than does the Greenbook. Recent economic data suggest that, although downside risks to growth remain, they have diminished. I continue to judge that the potential spillover effects from the financial distress have understandably been overestimated in this Committee's recent decisions and in Greenbook forecasts in recent months. In my view, the greater risks to the outlook come from rising energy and commodity prices and less from the financial distress as we go forward. In my view, current policy accommodation is greater than needed to address these risks. As I indicated at the last meeting, I believe that the upside risks to inflation have increased considerably over the past several months. Like the Greenbook, I expect both overall and core PCE inflation to move higher in the second half of this year. If this happens and we maintain the current level of the funds rate, I believe we are likely to see further erosion in inflation expectations, which will undermine our credibility with financial markets and the public. In this event, I judge we will greatly increase the likelihood that we will need to raise rates more aggressively, taking rates above neutral, in order to achieve our longer-run inflation objectives; and that is of significant concern to me, Mr. Chairman. Turning to the issue of long-term projections, let me comment that I have felt somewhat constrained by the current three-year horizon for our quarterly projections. Of the options presented by the subcommittee, I am most comfortable with providing estimates of the values for total inflation, output growth, and unemployment at which the economy is likely to converge. I am not sure, however, how we want to label these estimates, if they are included in the table. I understand that putting these estimates out might be interpreted as a move closer to inflation targeting, but I think that this is a bridge we are ready to cross since we adopted the enhanced projections process. The other options seem less desirable. Given the resources required, by my staff at least, I doubt that we could provide a meaningful forecast at a four-year or five-year horizon, and I am not sure how projections for average values over a period of five to ten years ahead would be interpreted by the public. In my view, appropriate policy should be expected to return the economy to its long-run equilibrium over a three-to-five-year period, with the length of the period depending on the nature of the shock. Setting out a five-to-ten-year horizon could be construed as a weakening in our commitment to achieve our mandate in a timely manner. Thank you. " CHRG-110shrg50369--74 Chairman Dodd," Great questions, too, and we will come back to those maybe in a little bit. Senator Reed was raising with me privately the issue as well, and I think it is worth exploring. The issue of the question of the value of the dollar, the rising price of oil, the dollar denomination oil pricing, whether or not that can shift in these commodities generally is an interesting issue. But let me turn to Senator Bayh. Senator Bayh. Thank you, Mr. Chairman. Mr. Bernanke, thank you for you--Chairman Bernanke, I should say. Thank you for your presence today, and thank you for your service to our country. I think you have your priorities right. You mentioned that the risks in the forecast are to the downside and that our principal concern at this moment--you have to strike a balance, but our principal concern should be avoiding an economic downturn of severity and duration while continuing to focus on inflation in the longer term. As you and some of my colleagues have pointed out, the genesis of much of this originated in the housing sector, particularly with some of the subprime type mortgages. And it seems to me that you, in setting monetary policy, erred on the side of--not erred, but you have been more aggressive than less and tried to minimize the downside risk to the economy. And that is as it should be. My question to you is: Should not Congress do the same in addressing the housing problem? The President has the voluntary Hope Now initiative you have outlined. I think it would be charitable to say that the results of that have been modest to date. You indicate there is not a lot of data, but it certainly does not seem as if it has had much of an impact. There are some proposals, fairly narrowly circumscribed ones before us, that would focus on this issue, allowing bankruptcy courts, only with regard to outstanding subprime mortgages, to revisit some of these issues, only when the borrowers have passed a strict means test. The interest rates would be set at prime plus a risk premium, and if the homes were ever resold, the lenders would participate in the upside, any potential upside, if the property would revalue. Now, the President has threatened to veto this initiative, and some have claimed that it would add as much as 2 percent to the cost of a mortgage. I find that to be not a credible analysis when it, by definition, does not apply to future mortgages. This is a one-off event, the greatest housing downturn in the last 50 years, fairly narrowly circumscribed. So my question to you is: Just as you have emphasized being more aggressive at this moment, should not we? And as an economist, is it credible to think that this would add 2 percent to the cost of a mortgage moving forward in this narrowly circumscribed manner? " FOMC20050809meeting--145 143,MR. GUYNN.," Thank you, Mr. Chairman. Consistent with incoming data on the national economy, business conditions in our part of the Southeast have remained positive since our last meeting. In fact, I found it more difficult than usual to answer the questions: “What has changed?” and “What are we seeing and hearing in the region that might help inform national trends in our policy discussion?” So, uncharacteristically, I will highlight just one regional issue—one I’ve talked about a great deal and one which I still think is especially important—and that is the extraordinary pace of home building and sales in some of our markets in the Southeast. It may be wishful thinking on my part, but one gets the sense that things may—and I emphasize may—have begun to show some signs of cooling. Although home building remained at high levels over the most recent period, reports from builders in our area were a bit more mixed, and some modest deceleration was noted in a few Florida markets. Most interesting, our bank examiners are now reporting that some of the large regional banks are beginning to exercise a new caution in their real estate lending, and some have gone so far as to actually stop development and construction lending in certain areas of Florida. I find this appropriate and encouraging. Of course, the fact that permanent mortgage rates remain relatively low, even with the recent uptick, is probably still the greatest stimulus to the extraordinary and prolonged housing boom. But I hope my sense of August 9, 2005 48 of 110 Turning to the national economy, I’ll also focus on just a couple of areas and their policy implications, and I think all of those have already been referenced in the question period or by others. The first is that the growth in output has, if anything, been somewhat stronger recently than I expected, even though the NIPA revisions tell us that the economy was on a somewhat lower growth path than we had thought. Others may not share my view, but I think that I, and probably we, have more often than not tended to underestimate and underforecast output growth. We may be acknowledging that again based on the fact that most forecasts, including the Greenbook, have been revised up for the remainder of the year. I believe it was President Stern, and I think he just confirmed this, who reminded us once—and maybe more than once earlier in the expansion when we were getting uneasy—to have faith, and he seems to have been right. I’m also perhaps more sensitive than some to what we now know from the data revisions that show us the higher levels of inflation in the recent quarters. I recognize that the upward revisions on the core PCE series were in the imputed prices. Nonetheless, the level of measured inflation has gotten closer to the upper bounds of my comfort level, as well that of others, and I think we should be more sensitive to forces that could, despite the most recent monthly data that have been encouraging, exert upward pressure on prices in the period ahead. Although I did not go back and check, I would guess that the adjustment in the estimated output gap reflected in today’s Greenbook was one of the largest between-meeting adjustments in quite some time. Although I don’t find the output gap framework especially helpful, the rapid closure in that measure suggests to me that upward inflation pressures could be more imminent. Of course, the Greenbook’s “more room to grow” alternative scenario could give one comfort, but I do not find that possibility compelling, because such an outcome hinges critically August 9, 2005 49 of 110 participation rate. I’m not convinced that is a reasonable view. I’m concerned for two reasons. First, it is not clear that the failure of labor force participation rates to rebound following the recession means that slack in the economy is greater than is reflected currently in the unemployment rate. Our Atlanta staff’s recent research indicates—when one controls for changes in worker characteristics, changes in individual behavior and preferences, and for differences in the economic environment—that labor force participation rates are not likely to return anytime soon to the peak level seen in 2000. Second, looking at the upcoming changes in labor market demographics that will hit the economy as soon as next year, we will have to change substantially how we think about labor markets and job creation in our economy. If I read the data correctly, projections by the BLS [Bureau of Labor Statistics] and Social Security Administration show that nearly 400,000 more workers will retire in 2006 than will enter the labor market. That trend will accelerate year by year, as more and more baby boomers reach retirement age. It is unlikely to be completely offset by increases we might see in older worker labor force participation. The cumulative deficit in workers could reach nearly two million in 2009 and four million in 2011. I think we all know our economy will find ways to deal with these significant changes. But given this forward-looking perspective, I am not terribly worried about slack in the labor market. Further, not far down the road I think we will find ourselves concerned about where the workers will come from, especially if the economy continues to create jobs—even at the current pace. Not only do we have to revamp some aspects of how we think about the economy, but we also must be mindful of the pressures that will bring to do things differently. August 9, 2005 50 of 110 When it comes to the policy discussion, I think we should be sure that we’re comfortable, after taking account of the very latest information on growth, productivity, and inflation that we’ve gotten over the last couple of weeks, with the phrase in the alternative B draft statement that characterizes labor market conditions as continuing to improve only “gradually” and the phrase that says “core inflation has been relatively low.” It seems to me that we should not do or say anything today that could counter market expectations that we now have a somewhat greater upside risk to inflation and that we still have unnecessary policy accommodation to remove. Thank you, Mr. Chairman." FOMC20060920meeting--59 57,MR. STOCKTON.," Thank you, Mr. Chairman. I cannot recall the precise baseball analogy employed by David Wilcox at the last FOMC meeting, but I have a vague recollection he speculated that I was either due for a forecasting hit or due to be hit by the forecast. [Laughter] In any event, since the Greenbook was completed last Wednesday, we have made several trips to the plate with consequential economic statistics on the mound. And how is the team doing? I guess I=d say, better than the Washington Nationals, not as well as the New York Mets. Last Thursday, we received retail sales figures for August. As you know, we focus on the retail control component of spending, which strips out sales at auto dealers and building material and supply stores. The August increase in this category was 0.2 percent, a bit stronger than we had expected. But both June and July were revised down, and on net these data were a touch weaker than those incorporated in the September Greenbook. Retail inventories for July also were a bit below our expectation. Housing starts for August were released yesterday. In line with our forecast, single-family starts dropped nearly 6 percent, to 1.36 million units, and the permits data point to some further declines in the months ahead. But multifamily starts declined somewhat more that we had expected. If we had to redo the forecast today, we would probably lower the increase in real GDP in the second half of this year to 1½ percent at an annual rate. Last Friday=s report that both headline and core consumer prices increased 0.2 percent in August was right in line with our forecast. The major components of yesterday=s PPI actually came in below our expectations, most especially the core finished goods index, which declined 0.4 percent in August. The only sour note was an increase in the PPI for medical services. The PPI for medical services is used by the BEA in constructing the core PCE price index, and it caused our estimate of core PCE prices for August to revise up from a high 0.2 percent to a low 0.3 percent. All in all, however, the incoming data over the past week left our forecast pretty much unscathed. I am relieved about that, because, if I do say so myself, it=s a beautifully constructed forecast. [Laughter] After all, with no further tightening of monetary policy, the economy eases into an extended period of slightly below-trend growth led by a retrenchment in the housing sector. That slower growth of activity opens a small output gap by the middle of next year but does not trigger a more precipitous cyclical contraction. Then, as the downturn in housing wanes and the associated multiplier and accelerator effects largely play out, the growth of real GDP picks back up toward potential in 2008. Meanwhile, the output gap that develops over the next year or so, in combination with inflation expectations that remain well anchored and a near flattening out of oil and other commodity prices, is projected to impart a mild tilt down in core inflation—to 2¼ percent in 2007 and 2 percent in 2008. So, what should you make of this forecast? Is it a construction as elegant and durable as say the Eiffel Tower in Paris, or is it more like the Eiffel Tower in Las Vegas—it looks pretty good a few blocks away but isn=t that impressive upon closer inspection? [Laughter] In that regard, you could not be faulted for wondering whether this forecast represents our averaging of two possibly more plausible outcomes that we simply didn=t have the courage to choose between. One view could be that this forecast is far too pessimistic. After all, our projection for growth in the second half of this year and in 2007 is now well below the consensus. Most of the available measures of aggregate activity remain solid. Real GDP is estimated to have increased 3½ percent over the year ending in the second quarter, about in line with its pace over the past several years. More recently, despite some notable month-to-month swings, manufacturing industrial production is up at a 5 percent annual rate over the three months ending in August. An even more timely economic indicator, the level of initial claims for unemployment insurance, has moved sideways through the middle of this month and does not yet suggest any inflection point in activity. Moreover, oil prices are down, the stock market is up, and financial conditions in the corporate sector remain favorable. These developments could cast doubt on our projected slowdown in real GDP. The other view might be that our forecast is too optimistic. Cyclical contractions are often precipitated by large imbalances in the economy that cause a great deal of pain and extensive damage when they get rectified. Certainly, housing is looking increasingly like a sector that could play that role. Starts and sales have dropped sharply in recent months, inventories of unsold homes are still soaring despite cutbacks in production, and prices are rapidly decelerating. This jolt is occurring while households are still dealing with the substantial hit to their purchasing power from the higher energy prices that they have encountered over the past several years. Yet all of this results, in our forecast, in only a very modest and gradual rise in the unemployment rate over the forecast period. I must admit that there were times over the past several weeks when I felt as though I=d seen this forecast before—specifically, in the summer of 1990 and in the autumn of 2000. At those times, the staff saw that forces of restraint were in place, and we projected a noticeable shortfall of growth from potential. But we failed to anticipate much in advance the impending cyclical downturn in the economy—and I doubt that we will when such an event occurs again in the future. I can assure you that we spent a great deal of time examining both of these possible critiques of our forecast, but in the end, we still view something like our projection as more likely than either of these two alternatives. So let me lay out the logic of the forecast and along the way address some of these concerns. As I noted earlier, we are now projecting the growth of real output in the second half of the year to be around 1½ percent at an annual rate, about ½ percentage point less than in the August Greenbook. The lower scheduled vehicle assemblies announced by the automakers were part of the downward adjustment. But the major source of the projected weakness in aggregate demand lies in residential construction, which is now expected to lop off nearly 1½ percentage points of growth in real GDP in the second half. If it doesn=t really feel to you like an economy that is growing as slowly as 1½ percent, there may be a good reason. Our assessment is that, except for the housing sector, the economy is growing at a pace of roughly 3 percent. So far the collateral damage from the downturn in housing has been limited, and for the most part, we expect it to remain that way, at least for a time. A pickup in nonresidential construction activity has offset some of the weakness in residential construction. Moreover, the recent declines in energy prices seem likely to cushion some of the near-term effects of the housing contraction by restoring some lost purchasing power to households and by helping to support consumer spending. With overall business sales holding up reasonably well so far, the cost of capital still low by historical standards, and financial conditions solid, outlays for equipment should move forward at a fairly rapid clip for the remainder of the year. But it seems implausible to us that the downturn in housing will not have multiplier-accelerator consequences that hold down growth going forward. Along those lines, we expect employment growth to slow more noticeably by the end of the year. Slower job gains and a further deceleration in housing wealth should damp consumer spending as we move into next year. The result is a steady, though gradual, rise in the personal saving rate over the next two years of about 2 percentage points. With the usual lags, slower growth of sales and output cause a mild deceleration in equipment spending. At the same time, fiscal policy is becoming progressively less stimulative over the forecast period. These forces are attenuated, but not offset, by the boost to spending generated by a higher estimated level of labor income and by a lower trajectory of consumer energy prices in this forecast. All told, we see these influences as likely to hold the growth of real GDP below potential over the next two years. Still, we are not anticipating the weakening in activity to cumulate into outright recession. In our forecast, the fact that the implications of the housing downturn for the broader economy are relatively limited rests importantly on two suppositions, both of which are open to question. The first is that the slump in housing produces a sharp slowdown in house prices but not a large nationwide decline in those prices. In the past, housing prices have been relatively sticky on the downside, with homeowners resisting price cuts and keeping their homes on the market longer. Our forecast envisions something similar occurring in this episode. The second assumption is that housing wealth affects consumer spending like other forms of wealth and that there are no other channels of influence of house prices and housing finance on consumption. For example, we have not incorporated any significant negative effects on consumer sentiment that might accompany a rapid deceleration of house prices. We have also made no special allowance for the decline in mortgage equity withdrawal to restrain consumption because we find the empirical evidence of such a connection to be fragile. Previous Greenbook simulations have demonstrated that turning on any of these channels would amplify the effects of a weak housing market on the aggregate economy. Their absence in our baseline forecast is one of the reasons that the economy bends but doesn=t break in response to our projected housing slump. As you know from reading the Greenbook, not all of the action was on the demand side of our forecast. In fact, we revised down aggregate supply by virtually the same amount that we revised down aggregate demand, leaving the output gap nearly unchanged from the August Greenbook. I would not be surprised if some of you were suffering a little reverse “sticker shock” from the low rates of GDP growth that we are now projecting, much of which can be traced to the downward adjustments that we made to potential output in each of the last two projections. The growth of potential is estimated to be about 2¾ percent this year and next and 2½ percent in 2008. Although we still could be characterized as productivity “optimists” with our projection of gains in structural productivity of 2¾ percent per year—a figure that is above many of the outside forecasts that we monitor—we are increasingly looking like potential output “pessimists” because of our expectation of only meager gains in available labor input. As you know, we are projecting a steepening downtrend in labor force participation and a slowing in the working-age population as the front edge of baby-boom retirements arrives late in the projection period. Our views are significantly below the consensus here. However, as we have noted in the past, if potential GDP ultimately proves stronger than we are forecasting, actual GDP will likely be stronger as well. So to a first approximation, the GDP gap and the assumed accompanying path of the funds rate would be largely unaffected by errors in our forecast of potential labor input. Much like the real side of the projection, our inflation forecast had some large moving pieces that, on net, left us pretty much in the same place as our August projection. On the favorable side of the ledger, oil prices are projected to average around $10 per barrel below our previous forecast. Taken in isolation, this development would have led us to revise down our projection of core PCE prices about 0.1 percentage point next year. But there was news on the unfavorable side of the ledger as well. On the basis of unemployment insurance tax records, the BEA revised up the growth in hourly labor compensation to an annual rate of 13¾ percent in the first quarter of the year. Once again, we are confronted with a huge difference between the signal provided by nonfarm business compensation and the employment cost index (ECI) measure of compensation, which increased at a rate of just 2½ percent in that quarter. Such wild discrepancies have led some inflation forecasters to employ reduced-form price equations that circumvent measures of labor compensation altogether. We are sympathetic to that approach, and those types of models are in our stable of forecasting equations. But we think it unwise to ignore entirely the issue of labor costs, given that they constitute two-thirds of business costs. So what do we make of this first-quarter jump in hourly labor compensation? As you know, one of the principal differences between the two major measures is that stock option exercises are included in the nonfarm business measure of hourly compensation but not in the ECI. Our colleagues at the New York Fed have been monitoring data on option exercises by company insiders, and those data suggest that an outsized jump in exercises in the first quarter probably helps to explain an appreciable fraction of the jump in hourly compensation. But that doesn=t seem to be the full story, as wages and salaries were revised up in categories, such as construction, where options probably do not figure prominently in employee compensation. In our forecast, we have assumed that stock option exercises and other nonrecurring nonwage payments provided a temporary boost to the level of income in the first quarter, about half of which will be reversed by the third quarter. What about the consequences of these higher measured labor costs for prices? Models that take the data simply at face value want to revise up the forecast of core consumer price inflation forecast between ¼ and ½ percentage point in 2007. However, these data should not be taken entirely at face value, at least as a measure of incremental business costs. As we have argued in the past, option exercises are not likely to represent a marginal cost of production and, at the very least, are probably misleading with regard to the timing of any such cost increase. Thus we have discounted the price implications of the first-quarter surge in compensation per hour, adding just a tenth to our inflation forecast for this factor. This exactly offsets the negative effects of the lower energy prices and leaves our projection of core PCE inflation unchanged at 2¼ percent in 2007. After that, a further waning of energy and other commodity cost pressures, the emergence of a small output gap, and the assumption that long-term inflation expectations continue to be reasonably well behaved cause inflation to drop to 2 percent in 2008. In that regard, the better core inflation figures of the past two months, the fall in oil prices, and the drop in various readings on inflation expectations over the intermeeting period provide us with some encouragement that inflation pressures will gradually fade over the projection period. But we would hasten to note that none of these developments cinch the case that we have turned the corner on inflation. Karen will continue our presentation." FOMC20080130meeting--199 197,MR. KOHN.," I thought we needed some insurance, and I also assumed some fiscal stimulus as in the Greenbook. I still see, despite these policy responses, risks around my outlook for activity as skewed to the downside, and it's because of the potential further increases in required compensation for risk and tightening standards for extending credit and the feedback on demand. Although inflation has been running higher than expected of late, and that is troubling, I expect it to ease back even with my more accommodative policy. The combination we've seen of slower income growth and higher inflation suggests elements of a supply shock, and that's obviously coming from the energy sector and its spillover into food. It is true, as President Fisher pointed out, that some of those increases in food and energy prices are coming from demand from emerging-market economies, but to the extent that such demand is putting upward pressure on our prices and it's not really sucking exports from the United States at any great rate, I think that it acts more like a supply shock on the U.S. economy than a demand shock. Energy and other commodity prices should level off in an environment of slower global growth, and they've started to do that. They have at least showed signs of leveling off recently. Greater slack in resource utilization and product markets should discipline increases in costs and prices. At least some of the reports about airlines suggest that they have tried to pass through fuel surcharges and have been unable to do so, and I think that's an encouraging sign from the inflation perspective. Any easing of inflation pressure does require that inflation expectations not begin to ratchet higher. I agree with everyone else. I'm persuaded that the balance of evidence is that they have not, despite the rise in five-yearforward inflation compensation and despite the persistently higher rate of increases of total headline than of core inflation. But this is something we will need to monitor very carefully. I interviewed Paul Volcker yesterday afternoon for our oral history project. The discussion with him reminded me again of the high cost of reversing a rise in inflation once higher inflation expectations become entrenched. Thank you, Mr. Chairman. " FOMC20080625meeting--167 165,CHAIRMAN BERNANKE.," Thank you very much. In April, we signaled that, following our aggressive rate actions and our other efforts to support financial markets, it was going to be a time to pause and to assess the effects of our actions. That was not that long ago, and I think it is appropriate to continue our watchful waiting for just a bit longer. I talked yesterday about the balance of tail risks as opposed to the balance of risks. I think that, although the tail risks on the growth and financial side have moderated somewhat, they are still quite substantial. I agree with the Vice Chairman on that point. They arise from two separate but related sources. The first is that, notwithstanding the stronger-than-expected performance in the second quarter, I think there is an excellent chance that we will still see a recessionary dynamic with the associated strong movements in employment and production. Second--again as the Vice Chairman mentioned--I do not agree that systemic risk has gone away. I think it is in abeyance. There is perhaps, if anything, excessive confidence in the ability of the Fed to prevent a crisis situation from metastasizing. Even if we don't have a failure of a major firm, we still have the possibility of a significant adverse feedback loop as credit conditions worsen and banks come under additional pressure. So if I could try to think about this--I don't want to say ""mathematically""--a lot of our discussion has implicitly suggested that there has been a linear model, which is that we are just trying to balance on the scales this risk against that risk. Again, if you are worried about preventing bad outcomes, you have to worry more about nonlinear or discontinuous changes. I think that, at this point, we still have significant risk of a nonlinear, discontinuous change in the financial markets or in the real economy. Tail risks have risen for inflation. There is no question about it. I take what has been said around the table extremely seriously, and I am quite anxious about it, I have to concede. If I were making a comparison of tail risks to tail risks, I still think that the inflation tail risks have not yet reached the level of the concerns I have about the financial crisis. In particular, some important indicators--such as wages, inflation expectations, and core inflation--have not yet signaled a major shift. That being said, I do think we need to acknowledge the relative change in those risks, and we need to begin to prepare the market for the normalization that is going to have to come. Both President Fisher and President Stern talked about the rhetorical aspects of our policy and the effects on policy expectations, and I think we are all in agreement that words mean nothing unless they are eventually backed up by actions. On the other hand, actions may be better if they are preceded by words, if you will. We do need to begin to prepare the markets and to communicate clearly so that people will know what's coming and that the system will be better able to deal with that. If I thought for sure that we were going to begin renormalizing very soon, I would propose doing it today. Why wait? But I think enough uncertainty and enough risks are on both sides that there is some benefit from waiting just a bit longer to see, first, how the financial markets evolve and, second, whether we continue this stronger-than-expected growth pattern or whether we begin to see a more recessionary-type of pattern. In particular, between now and the next meeting, we have two employment reports, a lot of other relevant information, and a lot of insight from the financial markets. At the same time, on the inflation side, we will see how commodity prices evolve, whether we have any kind of relief from what we saw in the last intermeeting period, how the dollar behaves, and how inflation expectations behave. All those things will give us a better sense of where we are and how we should proceed. So I think we should try to be nimble. We should try to respond to the information as it comes in. We should be focused particularly on tail risks. I think we should begin to move, or should maintain, market expectations toward tightening. President Fisher, I think I have to note for the record that I don't think we should let political considerations affect our decisions in any way, and I am not concerned about that. I think we are all prepared to do what is necessary. I don't know what we are going to do in the next meeting or the meeting after that. But my expectation now is that, as others have mentioned, we will begin normalizing interest rates relatively soon, and we should, if possible, begin to prepare the markets for that. For today, as I have indicated, I recommend no change in the federal funds rate target and alternative B for the statement. I think alternative B captures the facts pretty well on the whole. I won't go into it, but I think the inflation paragraph is a little more hawkish. It drops the discussion of a leveling-out of commodity prices. It doesn't refer to core inflation, which we have taken before as sort of a reassuring element. I'm disappointed that President Fisher is going to vote against his own language in alternative B, paragraph 4, which we have adopted and which I think is a very good expression of the risks. " FOMC20060510meeting--83 81,MS. YELLEN.," Thank you, Mr. Chairman. Incoming data on the pace of economic activity surprised me slightly to the upside, although the indications are that housing is continuing to cool. Such an upside surprise is of concern, given that we are probably in the neighborhood of full employment and inflation is already on the high side of a range I consider consistent with price stability. I have also been slightly surprised, and unpleasantly so, by incoming data on core inflation. Beginning on the real side, recent data might signal greater underlying momentum in aggregate demand, portending more of the same going forward. But other developments during the intermeeting period portend slower growth this year. In particular, energy prices and longer-term interest rates have risen surprisingly and substantially. Taking all these factors into account, we have marked down our forecast for real GDP growth a bit for the latter half of 2006 and for 2007. We see growth coming in slightly below trend starting in the second half of this year and the unemployment rate moving up toward 5 percent. This forecast assumes that policy is tightened at this meeting and once more over the next several meetings. One development on which I would like to comment briefly is the rise in long-term interest rates. Since the beginning of this year, the nominal ten-year Treasury rate is up about 75 basis points. About 50 basis points of this increase is accounted for by a rise in the real component, at least as measured by TIPS rates. It seems natural to assume that this increase in real long rates will restrain future growth, but the outcome for economic activity is not unambiguous: It depends on what caused real rates to rise in the first place, and the causation is far from obvious. For example, higher long-term rates could reflect rational market expectations of a significantly stronger domestic economy over the next few years. But such an explanation does not strike me as particularly plausible because, although recent data are slightly on the strong side, they are not dramatically strong. Moreover, the uptick in real rates appears to be especially pronounced in implied yields at the long end of the curve—in the distant future, in periods well beyond a plausible forecast horizon. A second possibility is that higher U.S. interest rates reflect a shift in global capital flows away from the United States, perhaps due to the unwinding of the carry trade or growing concern about the U.S. current account deficit. Such a shift might account for the sharp drop in the dollar over the same period. In simple models, such a shift in portfolio preferences has ambiguous effects on domestic demand because the depreciation in the dollar could stimulate aggregate demand by more than higher yields depress it. It’s not my intention to overemphasize the risk that growth will not slow. My point is simply that, although the rise in bond rates seems likely to help slow the economy, we should not take it for granted. Turning briefly to inflation, I’m uncertain whether the recent bulge reflects various special factors, as David mentioned, some pass-through of energy and commodity prices, or pressures from resource utilization. Parsing the CPI report, I found it difficult to discern evidence that the uptick does reflect pass-through of energy and commodity prices into core inflation. I would be quite concerned if the uptick reflects pressures from resource utilization and turns out to be persistent. However, half a dozen measures of slack that we monitor suggest no noticeable change in slack since late March. These measures also suggest that we are in the vicinity of full employment and not noticeably beyond it. Data on both productivity and labor compensation are largely reassuring. My final comment concerns the rise in inflation compensation since our last meeting. While the possibility of some loss of Fed credibility certainly can’t be dismissed, I believe we should not overreact. First, the rise we’ve seen is not out of line with the typical volatility in this series. Second, we must remember that inflation compensation includes not only expected inflation but also an inflation risk premium. Of course, both of these elements could be higher because of a lessening of credibility. But the inflation risk premium could also be higher because the world now strikes market participants as a riskier place, perhaps because of geopolitical concerns that have nothing to do with credibility. Indeed, a growing perception that the world is riskier could explain both the uptick in inflation compensation due to a rise in the inflation risk premium and some of the rise in TIPS yields due to higher real interest rate risk. Factor analysis performed by our staff suggests a strong correlation with the common factor for the term premium and longer-horizon, but not shorter-horizon, breakeven inflation rates and TIPS yields. My point is that determining what has caused inflation compensation to go up is not an easy matter, and concluding that it’s due to a lessening of credibility may be premature. So overall, while we have revised our core inflation forecast up slightly, we continue to be fairly optimistic that inflation will remain reasonably well contained going forward. Inflation in the core PCE price index of around 2 percent over the next year or so seems like the most likely outcome to us." FOMC20080625meeting--129 127,MS. YELLEN.," Thank you, Mr. Chairman. I favor alternative B with the proposed wording. Given the forecast and the risks around it, our next move on the funds rate is likely to be up, and the question is when. Assuming that the data on growth and inflation come in roughly as I and the Greenbook expect, I would envision beginning to remove policy accommodation toward the end of this year, similar to the assumption in the Greenbook. As I mentioned, I'm not very confident that the outlook for growth and employment has improved as much as the Greenbook assumes. I'm concerned that households and firms are in a python squeeze of an intensifying credit crunch and a continuing decline in housing wealth as well as pressures from surging food and energy prices. I think the economy has shown resilience so far, and that's reassuring, but I don't think it's assured for the future. The aggressive policy actions that we have put in place since January are actually working to cushion the blow, and that's part of the reason that we haven't seen a greater unraveling so far. I mentioned yesterday that, with respect to inflation, the behavior of both core inflation and wages thus far makes me optimistic that headline inflation will come down if commodity prices finally level off. But I think there's no doubt that the risks with respect to inflation are not symmetrical at this point, and they have definitely increased. I still see inflation expectations as reasonably well anchored, but there's no doubt that a wage�price spiral could develop, and dealing with it would be a very difficult and very painful problem for the Committee. So while I feel that we are essentially credible now, I wouldn't want to take absolutely for granted that this is something that we can count on going forward. At this point, the federal funds rate remains well below the recommendations of most versions of the Taylor rule. I have viewed this as appropriate, not largely as insurance against downside risk but simply in refection of the unusually severe pressures from collapsing wealth and tight credit and financial constraints. But it does seem to me to be appropriate going forward to at least take out some insurance against the development of a wage�price spiral mentality, and that could take the form of gradually removing that discrepancy from what, for example, a Taylor rule recommends. But before we begin to do that, it does seem to me that we should wait to get a somewhat clearer picture of where the real side is going. " CHRG-111shrg54589--3 STATEMENT OF SENATOR JIM BUNNING Senator Bunning. Thank you, Mr. Chairman. I appreciate all of our witnesses coming here today for this very important hearing. It is important for everyone to understand the financial nature of derivatives and, thus, the Banking Committee's interest in overseeing them. Let me say at the beginning that I do not know what regulations and restrictions we should put on these products. Figuring that out is the purpose of this hearing. But it should be clear to everyone that the current regulations are not enough. I understand the desire of firms to hedge their risks, whether those risks are interest or exchange rates, commodity prices, credit exposure, or something else. Genuine hedges that are accurately priced can provide the risk management that firms need. But it is not clear that all derivative products are genuine hedges or accurately priced. In fact, some look a lot more like a way to get around regulations and proper risk management, or just plain gambling. Regulators in the public need a better understanding of all the exposures of firms to eliminate uncertainty and the justification for further bailouts. Increased transparency and standardization of derivative contracts will help and must be accomplished. How far standardization requirements should go depends on whether there are true economic benefits to the custom products that outweigh the costs and risks associated with them. So far, specific and credible evidence on that point is thin. Credit derivatives may present the toughest questions. Should these products be treated as insurance with proper reserves? Should the buyer have an insurable interest and have to suffer actual losses or deliver the reference assets? How do we make sure credit protection does not undermine credit research or lead creditors to push debtors into bankruptcy? Should they even exist if not traded on an exchange? Someone has to bear the risk of every financial transaction so we must not allow the wizards of finance to pretend it has disappeared. Finally, just like with banks, we must eliminate the opportunity to avoid or choose favorable regulators or regulations. Similar activity must be regulated the same way by the same regulator. Otherwise, firms will be able to game the system, and regulators will not be able to effectively enforce the rules. Thank you, Mr. Chairman. " FOMC20051101meeting--73 71,MS. JOHNSON.," The staff forecast for real GDP growth and inflation abroad is little changed this time from the forecast in the September Greenbook. This is the case despite additional hurricanes, volatile energy prices, and a notable rise in long-term interest rates in several foreign industrial countries during the intermeeting period. The futures path for WTI [West Texas intermediate] crude oil prices retraced somewhat in October. Accordingly, we have incorporated into this forecast global oil prices through 2007 that are about $2 per barrel lower than in the previous forecast. Nevertheless, the outlook for global crude oil prices remains elevated at about $60 per barrel for WTI and is more than $8 above the level six months ago. Clearly, factors related to crude oil supply have contributed at times to upward pressure on global crude oil prices. In addition to disruptions as a result of the hurricanes, there are market concerns about the change in leadership in Saudi Arabia, politics in Iran, Venezuela, and Russia, and reduced production as a result of violence in Iraq. However, the trend increase since 2003 in not only spot prices but also in far futures prices occurred despite expansion of global oil production, evidence that underlying global demand for crude oil is also importantly responsible for the price pressures. This persistent, strong, underlying demand for energy reflects fundamental robustness in global economic activity—perhaps more than has been generally recognized. As a consequence, we have observed during this year further moves up in energy prices and in prices for nonfuel primary commodities along with average real growth abroad that has remained moderately strong, although a bit below the rapid pace of 2004. As in September, we are calling for real GDP abroad on average to expand at about 3 percent in the current quarter, following growth at that pace in the third quarter, and to accelerate a bit in 2006 and 2007. This favorable picture incorporates a return to steady expansion in Japan and solid, albeit slightly moderating, growth in the emerging Asian region. In addition, real growth in Mexico should recover from a disappointing outcome during the first half of this year. November 1, 2005 18 of 114 mixed, but in Germany industrial orders have come in strong and the October Ifo measure of business climate jumped to a five-year peak. Among the emerging- market economies, Chinese industrial production accelerated through September, and retail sales growth remained above 12 percent. Korean real GDP growth rose to 7.5 percent in the third quarter, and Brazil continues to enjoy very strong export sales. The mix of sustained global growth and upward shifts in commodity prices, particularly crude oil prices, naturally heightens concerns about higher consumer price inflation. Headline inflation rates abroad have moved up significantly with the rise in crude oil prices. Our outlook, however, is for these prices to decelerate over the forecast period given our projection (and that of the futures markets) that crude oil prices will be about flat next year and edge down in 2007 and given that the effects of previous increases in crude prices on inflation will wane and then end. Such an outcome depends upon an absence of significant second-round effects of oil prices on domestic prices and wages abroad. To date, core inflation in the major foreign countries confirms this is the case. The combination of continued growth and contained inflation pressures sounds optimistic. Rest assured, we have found numerous risks about which to worry. The elevated energy prices could sap consumer demand more than we expect, undermining the pace of real growth. In the face of higher costs, business spending on new capital could falter, particularly in emerging Asia where few countries have petroleum production sectors. Wage demands could react to the increase in headline inflation and threaten to ignite a set of second- and third- round effects. We do not see evidence of these developments at this time, but it is too soon to conclude that the danger of such actions has passed. A second feature of the international forecast that merits a few minutes is the approximately neutral contribution of real net exports to U.S. real GDP growth in the third quarter, following a positive contribution in the second quarter. The third-quarter NIPA [national income and product accounts] data released last Friday imply a slightly smaller, less positive, contribution than we had incorporated in the Greenbook baseline forecast or in the September forecast. However, in the current quarter, compared with the September forecast, we are assuming a greater rebound in exports and have reduced our assessment of the extent to which the external sector will provide a drag on GDP growth. Accordingly, we expect that on a four-quarter change basis, the external sector will record a slightly positive contribution to U.S. real GDP growth for the year— the first annual positive contribution since 1995. However, we are not ready to declare that external adjustment has arrived, and we expect a return to a small drag on U.S. growth from the external sector in the current quarter and on balance over the forecast period. November 1, 2005 19 of 114 imports. But recently we have experienced weakness in other components of real imports. During this intermeeting period, imports again surprised us on the downside, with August data for nominal imports much weaker than expected. This negative surprise included both goods and services, and within goods, it was particularly the case for imports of consumer goods and industrial supplies. For the near-term forecast we have included some effects as a result of the hurricanes and the disruption to general trade they caused. As a result, there is some implicit payback in the forecast for real imports in the fourth quarter. Nevertheless, compared with the September Greenbook, we have lowered the growth of real imports in 2006 and 2007 in response to the somewhat softer outlook for U.S. activity and to a higher path for import prices. Growth of third-quarter real exports was also revised down, although not by enough to offset weaker imports. Hurricane effects also figure in our estimate for third-quarter exports. More significant has been the recent strike at Boeing. We judge that the strike had a more pronounced impact on September=s exports than we previously thought, leading us to weaken real exports for last quarter. But the rapid conclusion of that strike also led us to strengthen real exports for the current quarter. For 2006 and 2007, we expect export growth will average a bit above 5 percent per year, consistent with our outlook for steady real output growth abroad. In sum, actual trade data through August, our estimates of how the turbulent weather of recent months has affected exports and imports, and our projections of global primary commodity prices, particularly crude oil, combine to imply unusual quarter-to-quarter fluctuations in growth of real exports and real imports. Some of these developments have surprised us since the September Greenbook. Going forward, however, we expect that the transitory weather effects will fade by early 2006. We look for real exports and imports to expand at similar rates on balance in 2006 and 2007. With imports substantially greater than exports, this outcome implies a negative contribution from the external sector of about ⅓ percentage point each year. David and I will be happy to take your questions." CHRG-111hhrg52397--10 Mr. Scott," Thank you very much, Mr. Chairman. I want to thank you and Ranking Member Garrett for holding this hearing. As over-the-counter derivatives have been cause for concern with AIG's near collapse, caused in large part by its portfolio of credit default swaps, the American taxpayer now owns most of this company as AIG has access now to nearly $200 billion in taxpayer support. I also understand the frustrations with my constituents, and the constituents of every one of us on this committee and in Congress, that our constituents are feeling as their money continues to go towards propping up Wall Street firms, all the while they are simply trying to stay afloat with unemployment numbers rising and people continuing to lose their homes. However, today, I am interested to hear what the witnesses have to say about the varying regulatory proposals to reign in these financial services products. I am looking forward to hearing their thoughts on proposals for mandatory clearing of all standardized over-the-counter contracts and reporting of trades from non-standardized contracts to a qualified trade information repository. Furthermore, as a member of both the Financial Services Committee and the Agriculture Committee, I am interested to hear the opinions on legislation that would end the exemptions for swaps adopted in the Commodities Futures Modernization Act and assert new authority over the over-the-counter derivatives. And I would also like to hear their opinions and thoughts on the bill we passed in this committee in February, which would requiring clearing for all over-the-counter derivatives. Our economy continues to be extremely turbulent as weakening trends envelops us and the experts predict that the downturn might not end any time soon, or at least not until the end of next year. So the bottom line with this hearing is we must seriously discuss strengthening regulations, specifically over these over-the-counter derivatives, but I would put in there strengthening them but with flexibility so that this system can work with greater transparency and effectiveness. We must address concerns regarding current regulatory practices and how to further restructure them in a way that will provide for real reform. And, Mr. Chairman, while I have this opportunity, I would also like to welcome from Atlanta, Georgia, Mr. Jeffrey Sprecher, who is from my area in Atlanta, Georgia, as well as Mr. Price's area. He is the chief executive officer of IntercontinentalExchange, which we refer to as ICE, from Atlanta, Georgia. Thank you, Mr. Chairman. I look forward to the testimony from our distinguished witnesses. " FOMC20071211meeting--40 38,MR. SHEETS.," Our reading of the recent data suggests that economic activity abroad decelerated toward the end of the third quarter and has remained on a decelerating path thereafter. In the euro area, the United Kingdom, and Canada, this softening of activity appears to reflect—at least in part—increasing drag from the ongoing financial turmoil. Notably, in the euro area, business and consumer confidence have weakened some in recent months, PMIs for both the services and manufacturing sectors have declined, and recent readings on retail sales and industrial production have softened. In the United Kingdom, indicators of sentiment and retail sales also have slipped of late, and a slowdown in the housing sector is now under way—with declines in net mortgage lending, mortgage approvals, and major indexes of house prices. In response, the Bank of England late last week cut its key policy rate 25 basis points, to 5½ percent. The Bank of Canada also lowered its policy rate a notch last week, citing concerns about financial market turmoil. In assessing the impact of the financial turbulence, we continue to see little evidence that the emerging-market economies are being significantly affected. Over the past month or so, debt spreads for many of these economies have risen, and their equity markets have given back some ground, but these moves are relatively mild when viewed from a longer-term perspective. All told, foreign growth is projected to step down from an average rate of nearly 4½ percent during the first three quarters of this year to below 3 percent in the current quarter and early next year. In addition to headwinds from the financial turmoil, this slowing reflects policy actions in some countries (particularly China) to rein in above-trend growth, as well as the softer pace of activity in the United States. Thereafter, we see foreign growth rising back to a rate of 3¼ percent. This outlook is weaker over the next few quarters than in our October projection, in line with the lower U.S. forecast. In addition, given the renewed market turbulence, we now see the drag from financial developments as likely to be larger and more protracted than we had previously assumed. We continue to believe that these effects will be felt mainly in the advanced economies, but an important downside risk to our forecast is the possibility that the emerging-market economies may be more affected than we now expect. On Friday, we received revised Japanese GDP data for the third quarter. The latest estimate cuts growth in the quarter to 1.5 percent at an annual rate, down 1 percentage point from the initial reading. Notably, this growth can be attributed entirely to net exports, as domestic demand contracted for the second consecutive quarter. Residential investment plunged in the third quarter, as new building regulations temporarily weighed on spending. Our forecast calls for domestic demand to bounce back quickly, but downside risks are increasingly evident; for example, the profitability of small and medium-sized companies has recently deteriorated, labor market conditions seem to be softening, and wages continue to contract. The spot price of West Texas intermediate approached $100 per barrel in late November, but mounting concerns about the near-term outlook for global activity have since pushed the price back below $90 per barrel. At that level, spot WTI is down a few dollars per barrel since the last FOMC meeting. Continued concerns about the longer-term supply-demand balance, however, have kept the far-futures price at its late-November level, near $87 per barrel—up about $7 since the last FOMC meeting. Nonfuel commodity prices fell sharply in the third quarter and have continued on a downward trajectory. The prices of copper and nickel have plunged, driven by concerns that rising inventories may signal a softening of global demand for these commodities. The price of zinc has fallen as well. Notably, however, the prices of food commodities, including wheat, corn, and soybeans, have continued to rise. This run-up in food prices, coupled with high oil prices, has stoked inflation in a number of countries. For example, in the euro area, twelve-month headline inflation has jumped from 1.7 percent in August to 3 percent in November, led by food and energy prices, thus prompting the ECB to leave policy on hold at its meeting last week. Going forward, this rise in inflation may continue to limit the ECB’s willingness to ease policy, as fallout from the financial turmoil weighs on activity. In the United Kingdom, however, a recent rebound in inflation to slightly above the Bank of England’s 2 percent target—driven in part by rising food prices—did not deter last week’s policy move. Indeed, in cutting rates, the BoE noted that “higher energy and food prices are expected to keep inflation above the target in the short term.” In China, food price inflation is running at more than 15 percent and has pushed overall inflation to 6.9 percent in November. The pace of inflation has elicited a range of policy responses from the authorities, including a move over the weekend to further increase reserve requirements. Our forecast sees global food and oil prices soon leveling off in line with quotes from futures markets, and this would contribute to a welcome moderation of inflationary pressures in a number of countries. Since the last FOMC meeting, the dollar has strengthened on balance, rising 1 percent on average against the major currencies and ½ percent in broad nominal terms. Notwithstanding this reprieve from dollar depreciation, we continue to see the current account deficit—which still exceeds 5 percent of GDP—as a key factor that is likely to weigh on the exchange rate going forward. Thus our forecast incorporates some modest further real depreciation of the dollar. Notably, this depreciation comes entirely against our emerging-market trading partners, and we have slightly raised our projections for the pace at which the renminbi and several other emerging Asian currencies appreciate against the dollar. I conclude with a few words about the U.S. external sector. We expect that export growth, following its red-hot 19 percent performance in the third quarter, will moderate to a still-strong pace of around 7 percent in the current quarter and through the next two years, as exports are supported by past declines in the dollar and still- solid foreign activity. Import growth in the current quarter will be sustained at its moderate third-quarter rate by a seasonal rebound in oil imports, but import growth is expected to fall off during the first half of next year, in line with the softer pace of U.S. activity. Thereafter, imports are projected to gradually accelerate, as growth in the United States firms. All told, we see net exports making positive arithmetic contributions to growth of 0.1 percentage point in the fourth quarter of this year, 0.5 percentage point in 2008, and a little over 0.1 percentage point in 2009. That concludes our prepared remarks, and we are happy to take questions." FOMC20071031meeting--204 202,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. I think the economy is slowing. Even the nonhousing part of the economy is slowing a bit. Housing prices are still obviously sliding down. We don’t really claim to know much about where they’re going to end up or where we are in that process, but it seems that they are falling and probably at an accelerating rate. Our modal forecast—“our” meaning from the submissions—is for an economy that slows further and runs below trend over several quarters. But if you just look at the size of the bars on the submissions, the size of that bar about downside risk to growth is very high, much higher than the bar about upside risk to inflation. There is a huge amount of uncertainty about what equilibrium is and where short-term interest rates should be over time. But I think it is fair to say that we are now at the high end of, if not slightly above, most of those estimates of where equilibrium is. Therefore, it seems to me sensible that most of our submissions had a downward slope to the path of the fed funds rate going forward over this period. The question then is not principally whether to move but when and what signal of a change or no change should come. I think it is a very close call, and everything that I say I say with a lot of unease and discomfort. If the choice is to stay firm but to signal more explicitly than we did in September that we’re likely to move further, that seems to me just a bad choice. I think it is likely to amplify many of the risks that you are all worried about and it probably would make people more tentative about coming in and doing what they’re going to do to let this thing work through the markets because they will be living with our acknowledgement of substantial downside risk without action and uncertainty about whether we’re going to move. I think you might argue that a decision not to move with an explicit asymmetry in the balance of risks to growth would lower the path going forward and add to that uncertainty in some sense. I do not think that the markets are so fragile now that they could not take an adverse surprise of this magnitude, even though it is a very, very large adverse surprise relative to recent history. I don’t think that’s a good argument for moving. I think the best argument is that we’re still in the midst of what is a very delicate and consequential asset-price adjustment in the U.S. economy with a fairly dense, thick, adverse tail on the potential implications about the evolution in housing. The Chairman spoke eloquently early in the year—I think it was early in the year, but maybe it was late last year—about the pattern of history and the acknowledgement that weakness tends to cumulate, and you don’t really have a lot of experience with sustained periods of below-trend growth without falling into a more substantial rise in unemployment rates. Those risks have to be substantially greater when you have an economy going through this kind of asset-price adjustment. I found these charts discouraging, not reassuring, in the sense that we’re anticipating a slowdown in the rate of growth of credit for the economy as a whole that’s comparable to ’01. I think the pressure on bank balance sheets is probably—it’s hard to make these statements with any certainty—greater than it was in ’01. At least a reasonable expectation is that it’s going to be bigger than it was in hindsight in ’01, and I think you have a much more substantial impairment to the functioning of what Kevin calls debt capital markets—the industry around the design of securitization and structured finance, et cetera, which has been so important to the way credit gets originated and moved. That disruption could take a long time to resolve, and I think that just has to amplify the density of the adverse tail and the growth outcome, certainly with more uncertainty at this time. I think that it is hard, but the better course of valor is to move today, and I like the language in alternative A. Let me just go quickly through the arguments against it that I find most compelling. The best argument against is the fear that many of us spoke about—that even though the inflation numbers have been reasonably reassuring and we haven’t seen substantial erosion in inflation expectations that we can measure, there is a bit of deterioration in the feel, in the psychology. We have to be very careful that we don’t add to that through our actions or people’s expectations about how we’re going to behave going forward. But we should take some comfort from the fact that the market is pricing in more than 100 basis points of easing over the next two years. You have to believe that a fair amount of that is already reflected in breakevens, reflected in what people are willing to pay for insurance against adverse inflation outcomes, and reflected in the dollar. It doesn’t mean that if we validate part of those expectations you won’t see erosion, but we should take some comfort from that. Just one more thing. We have been through three years of very substantial relative price shocks in energy prices, commodity prices, and some other things. Those hit an economy that was growing over the period above most estimates of potential, and we have had pretty good performance of underlying inflation and inflation expectations in that context. So even though we look forward and we see what’s happening in commodity prices, energy prices, and the dollar as posing some potential risk of upside pressure on input costs, that is hitting the economy in a very different state. The experience of those last couple of years should give us a fair amount of confidence in the judgments we bring as to how we think about inflation going forward. I think we have less uncertainty around an inflation forecast than we would have had two or three years ago and still substantial uncertainty around the growth forecast inevitably given what the economy is going through. The balances suggest that it is better to move today because of that. As I said, I’m comfortable with the language in alternative A. I would be comfortable with Governor Mishkin’s amendment to A—I think that helps a bit. I have a lot of sympathy for all the arguments against the first sentence in alternative A in any form, but on balance, I would say that we just don’t want to take the risk that, by omitting some statement like it, we cause people to price in a steeper slope to that path going forward. It is something that we should try to avoid, and the best way to achieve that is the language in A. Thank you." FOMC20080318meeting--61 59,MR. EVANS.," Thank you, Mr. Chairman. Clearly, the incoming data on activity have been weaker than we expected. I think they point to a downturn in GDP in the first half of the year similar to that in the Greenbook. While the February CPI report was welcome news, on balance I think the inflation picture continues to be troubling. I noticed a marked change in the sentiment of my business contacts this round. Many more are now telling me that the problems on Wall Street are affecting their financing. Credit availability is now an issue. With regard to borrowing from banks, these reports seem consistent with the Senior Loan Officer Opinion Survey. Credit is an issue for those tapping nonbank sources as well, as in the comments that President Yellen made. As an example, back in December a major shopping center developer indicated that, even though the commercial-mortgage-backed security market had dried up, he was still able to obtain financing on reasonable terms from other sources, such as life insurance companies. Last week he told me that these sources had dried up, too. He's now trying to raise equity funding, which he considers very costly and an unappealing alternative. Many contacts also expressed increased nervousness over the economic situation and its likely impact on demand for their products. Manpower's CEO told me that their business had deteriorated in recent weeks. Some of his clients were trimming staff because of a lower current demand, and many others were being cautious and cutting back in expectation of future weakening. Still, even though restrictive financing and heightened caution are weighing on households and businesses, there is a sense from my contacts that spending is not collapsing at this point, and exports of capital equipment in the agricultural sector continue to do well, similar to President Hoenig's comments. Another common theme I heard from my contacts is that, while the Fed's innovative response has helped, they do not expect that these measures will do a lot to solve the financial sector's fundamental problems. I doubt that any of us disagree with that. As one of my directors put it, ""Monetary policy is not enough. We need a solution to the subprime mess. Once that happens, the contagion will run in reverse."" I believe our innovative policies are helpful for facilitating market functioning, but they don't address the root problem. Markets want a firmer sense of where prices for stressed assets will bottom out and of the magnitude of the portfolio losses that will be taken by major financial players. Unfortunately, it will take a good deal of time before these uncertainties will be resolved, and I'm not sure what we can do to speed the process. After all, a number of these losses are going to stem from mortgage delinquencies that have not yet occurred and perhaps from homeowners who have not even contemplated that outcome. This means that financial headwinds likely will be weighing on the real economy for some time, as President Stern said. I agree with his comments there. The substantial uncertainty over the length and breadth of this process adds uncertainty to the medium-term outlook for growth. So while I am hopeful that the economy will begin to recover in the second half of the year, I'm a lot less confident of that outcome than I'd like to be. Turning to inflation, Friday's CPI report was about the only good news I heard during the intermeeting period (I think last time the reports weren't very good either, President Yellen), although as the Greenbook Supplement points out, the less favorable translation to PCE prices takes out some of the luster. It's no surprise that many of my contacts pointed to increasing pressures from higher costs for food, energy, and other commodity inputs. I also heard numerous reports of higher costs being passed downstream. One notable case was for wallboard. Even though demand is weak and the industry had plenty of excess capacity, higher costs for energy inputs were resulting in the first increase in wallboard prices in 20 months. The director who reported this was concerned that pricing behavior is moving toward a cost-plus mentality. This is, after all, his industry. If so, this would have negative implications for inflation expectations. However, I see this as a risk and not a base case scenario because the resource gaps opening up in the economy should bring inflation down. Firms will find it difficult to pass through cost increases in an environment of weak demand. Businesses and financial market participants will be aware of this difficulty in passing through costs, which should help keep down their inflation expectations. That said, even in a weak economy, firms will have only so much room to absorb costs, and pressures from higher prices for energy and other commodities and for imported goods pose a risk to the outlook. In addition, while I expect inflation expectations to be contained, there are risks on this front, too. Some can see a low fed funds rate path, such as that assumed by the Greenbook, as an indication of a lack of resolve on inflation. I don't agree with that assessment, but it's an increasing risk that we will be running, particularly if the inflation news breaks in the wrong way. Thank you, Mr. Chairman. " FOMC20060328meeting--72 70,MS. JOHNSON.," I’m not so sure exactly—we will give it thought. There’s a fair amount of literature developing about global capacity utilization. Is it defined? We don’t talk, for example, about capacity utilization in Oklahoma. We assume that if Oklahoma needs stuff from the rest of the United States, it just gets the stuff, and vice versa. Why is the global economy any different? Is the United States small enough relative to the whole world that it can just do that? That’s sort of the epitome of the small open economy model whereby it can buy anything it needs at the going world price and it can sell all it wants at the going world price. But if I take that model as my benchmark, it really does that all through prices. It says that the small open economy can buy imported products, resources, inputs, whatever, just by knowing the prices, and sells to an infinitely elastic demand curve for its output. So it is certainly true that we have paid attention to things like global commodity prices and global energy prices, as the activities elsewhere in the world have shifted global demand and have moved those prices. It is no end of frustrating to me that the futures markets always say that, however much those prices have gone up—or maybe even occasionally down—over the past so many weeks or months, they are going to flatten starting tomorrow. You just get very little dynamic out of those futures prices. No one is out there thinking about the global economy over the next three years, looking ahead at this, that, or the other thing. On the other hand, we’ve talked about not using those futures prices, and I don’t know whether on our own we have the capacity to do better than those prices. So I’m stuck. But I understand the point, and it is certainly the case that huge changes—supply shocks to the global economy—are in some sense part of what’s happening and that they ought to have some repercussions for us. Partly, I think, that’s a little bit of what’s going on in this notion of whether pass-through has declined over time. But we’ll give the subject some more thought, and we’ll see if we can come up with some other sorts of indications, such as bottlenecks, as when the shipping industry was having problems, whether it was just port congestion, huge prices on capacity, or something else. You could trace back bottlenecks, and you could think about the consequences of them for the U.S. forecast, say. But something that is more inclusive than particular bottlenecks for particular kinds of goods is a tougher question." FOMC20080805meeting--159 157,MR. KOHN.," Thank you, Mr. Chairman. I support keeping the federal funds rate at 2 percent for now. I think that is consistent with bringing inflation down over time. I agree that we're going to have to tighten at some point. I agree with your analysis, Mr. Chairman--I don't think we have a highly accommodative policy right now. Not only would I cite the interest rates that you cited, but I would cite the behavior of households and businesses, which aren't acting as if they're looking at very low real interest rates by making purchases of durable goods, capital equipment, et cetera. The cost of capital is not perceived to be low right now, and I think it's for the reasons you cited. In my view, over the intermeeting period the inflation risks have narrowed just a bit. The damper on inflation risk comes from the decline in oil and commodity prices, the steadiness of the dollar, and my perception that we can count on a more negative output gap going forward, which will provide some discipline on prices and wages. This is a difficult situation. There are no ideal outcomes when you have this change in relative prices. We will have to live with higher inflation and higher unemployment temporarily. We have to keep our eye on the second-round effects, not just the pass-throughs but the spillovers, and I think so far so good. That's a tenuous situation, I agree, but my read of the incoming information is that we can be a little more patient than we thought we could be six or seven weeks ago. As for the wording of the statement, I could live with President Yellen's rewording, but I think that this language Brian suggested is okay as well. I'm actually not sure how the markets will react to this. Some of the commentary I read over the last couple of weeks thought that we were tilted toward inflation last time because of the way we worded things. I don't think that the market reaction will be large to this, and I agree that the first choice would be not to change market expectations substantially. I think they're aligned pretty well right now, but I think the reactions will be small, and I can live with the alternative B wording. Thank you, Mr. Chairman. " FOMC20081216meeting--106 104,MR. AHMED.," I will be referring to the exhibits that follow the blue International Outlook cover page. Financial markets in foreign economies remain stressed but have not suffered further pronounced deterioration since the October FOMC meeting. As shown at the top of your first exhibit, government bond yields in major industrial economies have dropped, likely reflecting further expected monetary policy easing, lower inflation expectations, and a firming of the belief that economic recoveries are not around the corner. Equity markets, shown in the middle left, have changed only moderately, on net, since your last meeting, compared with large declines in previous months. The emerging-market aggregate CDS spread, shown in the middle, has been volatile but remains elevated. As shown to the right, gross private capital inflows to emerging markets through debt and syndicated loans have continued to trend downward. The exchange value of the dollar against the major foreign currencies (the black line in the bottom left panel) has moved down a little since the last FOMC meeting. Some bilateral exchange rate movements were substantial, however, with the dollar appreciating markedly against the pound and depreciating against the yen. As shown to the right, the dollar has appreciated somewhat against the currencies of our other important trading partners, driven by movements in the Mexican peso and the Brazilian real. Earlier this month, the dollar registered one of its biggest daily increases against the Chinese renminbi in recent years, although this shows up only as a tiny blip in the chart. We believe that Chinese authorities will allow the renminbi to depreciate somewhat in the coming months; NDF (nondeliverable forward) contracts also imply an expected depreciation of the renminbi against the dollar over the next year or so. Incoming evidence on economic activity abroad continues to be grim. As shown in line 1 of the table in exhibit 2, we now estimate that foreign economic growth was below 1 percent in the third quarter. Although growth in Canada (line 7) and Mexico (line 12) surprised on the upside, readings elsewhere were generally weaker than expected, with real GDP contracting in the United Kingdom, the euro area, and Japan (lines 4 through 6). As shown by the red bars in the middle left panel, net exports made significant negative contributions to growth in these three economies. Domestic demand (the blue bars) was also soft. Growth in emerging Asia (line 9) was barely positive in the third quarter, reflecting subdued growth in China (line 10) and substantial contractions in most of the newly industrialized economies (shown in the middle right). With data from the current quarter pointing to greater weakness than we expected and a substantially more pessimistic U.S. outlook, we have further slashed our forecast for total foreign growth to minus 1� percent in the current quarter and minus 1� percent in the next, before a recovery to a positive but still relatively weak average pace of about 1 percent through the remainder of next year. The widespread nature of the economic slowdown in large part seems to reflect trade linkages. As depicted at the bottom, in recent years U.S. economic growth (the black line) and the growth of total real exports of our major trading partners (the green line) have been significantly related. Although foreign exports are affected by many factors in addition to U.S. GDP, the relationship shown and the gloomy outlook for U.S. economic activity through next year paint a bleak near-term picture for foreign exports. Your next exhibit focuses on the advanced foreign economies in more detail. Data from Europe point to a sharp slowing in the current quarter. The timeliest indicators are PMIs (purchasing managers' indexes), which, as shown in the top left panel, have plummeted in recent months in both the United Kingdom and the euro area, reaching levels well below those observed during the 2001 downturn. As depicted to the right, in Japan, exports (the black line) and industrial production (the blue line) have contracted during the current quarter, and conditions in the labor market have deteriorated further, as manifested by the decline in the ratio of job openings to applicants (the red line). Indicators from the current quarter in Canada, shown in the middle left, point to weakness in real exports and a continued drop in housing starts. Authorities in advanced foreign economies are attempting to shore up aggregate demand through fiscal stimulus. As listed in the middle right panel, many countries have announced stimulus packages, including Germany, France, and the United Kingdom. We estimate that the actual stimulative content of the packages announced so far is likely to be small but expect that additional measures will be introduced next year. The total fiscal stimulus that we are assuming should boost growth in the advanced foreign economies by � to � percentage point at an annual rate from mid-2009 through 2010. The possibility of bigger fiscal initiatives is an upside risk to our outlook for foreign growth. Many of the foreign central banks have become more aggressive in easing monetary policy, as can be seen at the bottom left. Since the last FOMC meeting, the Bank of England and the ECB have slashed policy rates by a total of 250 basis points and 125 basis points, respectively, and the Bank of Canada and the Bank of Japan have lowered rates by smaller amounts. More rate cuts are expected in all of these economies, which could bring rates in Japan back down to the zero lower bound. As shown on the bottom right, inflation in the advanced foreign economies is now expected to recede at a faster rate than previously projected, reflecting sharp declines in commodity prices as well as diminished resource utilization. Turning to emerging-market economies, as shown in the top left panel of exhibit 4, the recent behavior of Chinese industrial production, total exports, and imports from Asia is now reminiscent of developments during the year 2001. The plunge in imports from Asia casts doubt on the notion that China has become an independent engine of growth in the region. As depicted to the right, Korean exports and aggregate industrial production in Korea, Singapore, and Taiwan are plummeting. In Mexico, third-quarter output was bolstered by expansion in the agricultural sector, but as shown in the middle left, exports have moved down sharply, and consumer confidence has dropped below 2001-02 levels. In Brazil, too, shown on the right, there has been some softening in exports (the black line), which had been supported by high commodity prices, although industrial production (the blue line) has held up a bit better. With prospects for exports in the doldrums, policy stimulus has become all the more important to the outlook for emerging-market economies. As noted in the bottom left, monetary easing has continued, with interest rate cuts in many emerging Asian economies, including China and Korea. China, Malaysia, and Brazil have also lowered bank reserve requirements. In addition, fiscal stimulus packages have been announced in a number of economies, most notably China. China's 16 percent of GDP spending package considerably overstates the ultimate effects on growth as it includes some previously announced projects, its implementation may take longer than announced, and the federal government is slated to pay for only 30 percent. Discounting the headline number, we estimate that the Chinese package could boost growth 1 to 1� percentage points per year. Other countries, such as Korea and Mexico, have introduced smaller but still sizable packages, which we expect will give some impetus to growth. In sum, our near-term forecast calls for total foreign growth to be the weakest since 1982, and as sketched out in our alternative simulation in the Greenbook, there would appear to be downside risks even to this forecast. Your final exhibit focuses on the U.S. trade outlook. Weak global demand has contributed to falling prices for food and metals, which have led a sharp decline in nonfuel commodity prices (the blue line in the top left panel). Oil prices (the black line) also have continued to move down rapidly, but futures prices project some recovery ahead. The fall in commodity prices has exerted downward pressure on U.S. trade prices (shown in the top middle panel); both core import prices and core export prices dropped markedly in October and November, which for import prices were the largest monthly declines in the fourteen-year history of the index. A sense of the extent of weakness in global demand can also be seen in shipping rates (shown to the right), which have taken a nosedive. As in the 2001 recession, U.S. real exports and imports of goods (shown in the middle left) are now trending down. Imports (the red line) have been moving down all year. The falloff in exports (the black line) is a more recent development and, in part, reflects hurricane-related disruptions and the strike at Boeing. As shown in the table, growth of both real exports of goods and services (line 1) and real imports (line 3) was noticeably weaker in the third quarter than we had previously estimated. For the current quarter, we see both real exports and real imports contracting sharply, reflecting the slowdown in global demand. Looking ahead, our projections for a stronger broad real dollar (shown in the middle right) along with our weaker outlook for foreign growth have led us to revise down sharply our forecasts for exports, especially in 2009. In the near term, our projections for imports have also been marked down considerably. As shown in line 5, the contribution of net exports to U.S. growth is expected to swing slightly negative in the current quarter, following large positive contributions earlier this year. The current quarter's contribution is considerably weaker than projected in both the October and the December Greenbooks, as last week's export data surprised us on the downside. Next quarter, with a substantially greater step-down in imports than in exports, we expect the contribution of net exports to U.S. growth to jump back up, before returning to negative territory for the remainder of the forecast period. That concludes our presentation. " FOMC20081029meeting--296 294,MR. KROSZNER.," Thank you very much. Well, I've not been able to convince myself not to agree with President Evans. As everyone has said, we have this very significant global shift that has stepped down real activity and financial activity. The inflation environment has changed dramatically from a number of months ago with the change in commodity prices, the change in the value of the dollar, and the change in not just U.S. but also global resource utilization. I think we've seen just an enormous change there. Also, when you look at the expected federal funds rate path-- we have to be careful in looking at anything in the markets these days because of liquidity, risk premiums, or term premiums that we're not quite sure about--the markets are expecting significant cuts from us. They are not expecting any immediate or near-term significant increases in inflation, and I think all of the indications are that it will be going down. In a cost�benefit analysis, the costs seem relatively low in terms of the potential for inflation of doing this. Now, we have to think about it in terms of benefits, and a number of people have touched on the transmission mechanism. I do think that there are forces that mute the extent to which a 50 basis point cut translates into 50 basis points or lower on costs, but I don't think they completely offset it. It still has the effect of reducing the cost of liquidity, reducing many people's borrowing costs. I think it still does have an effect even if there's an offsetting risk spread and even if there's an offsetting bank action that affects that. So in terms of costs and benefits, at this time it seems that the costs are relatively low or muted, and the benefits are positive and potentially high. In particular, as I mentioned before, I'm concerned about the confluence of forces that may make things very difficult around the end of the year. If you look at a lot of these LIBOR or forward markets, they're not coming down either in the United States or around the world. We have a lot of uncertainties with hedge funds, with the potential for other institutions getting into trouble, and with just the implementation of our policies--in particular, as I mentioned, the way the FDIC guarantee program and the TARP program work may end up singling out institutions and bringing them down more quickly than otherwise. So I think it makes sense in terms of cost�benefit analysis, even more so given the tail risk around the end of the year, to act now. We have another opportunity to act in December and obviously an opportunity to act at any point if we do see a dramatic change. We are getting near as much as we can do, but I don't see the costs of acting more aggressively and more quickly here outweighing the benefits. So I support alternative A with the language as drafted. Thank you. " FOMC20080625meeting--69 67,MS. YELLEN.," Thank you, Mr. Chairman. The intermeeting period has been full of surprises. Real-side data came in considerably stronger than I anticipated, so like the Greenbook I have adjusted up my forecast for growth in the current quarter. At the same time, the adverse fundamentals that will weigh on household and business spending going forward have grown somewhat heavier overall, and that has prompted me to revise down my growth forecast for the second half. On the inflation front, readings on core inflation surprised to the downside. Nonetheless, given that the prices of many commodities have continued to rise more rapidly than I anticipated and that some measures of inflation expectations have turned up, I have adjusted up my inflation forecast for 2008, considerably up for headline inflation and modestly up for core inflation. The strong incoming data on spending eased my fears that we are in or are approaching a recession regime of the sort embedded in the last two Greenbooks. However, given the numerous large and worsening drags on spending, a couple of months of data aren't enough to convince me that we are on a solid trajectory. Moreover, the spending data may well fail to reflect the real underlying strength of consumer demand because of the effects of the tax rebates. Spending patterns could easily be distorted by small differences between what we projected that households would spend each month out of rebate checks and what they actually spent. In monthly spending data, a swing of just a few billion dollars looks enormous. Perhaps households who were already paying through the nose for food and gas and are increasingly credit constrained have put their rebate checks to work a bit early this time. After all, households knew in advance that the checks were going out. For example, Google searches related to tax rebates peaked in April. We actually kept track of the data on that. So I will be closely watching the data over the next few months, hoping to get a cleaner read on the underlying state of consumer demand. As I said, the adverse fundamentals are still with us and in some part are worsening. Evidence that the credit crunch is ongoing is all too clear. Bank asset quality continues to deteriorate. Banks continue to deleverage, and they are tightening lending standards as they do so. The market for private-label securitized mortgages of even the highest quality remains moribund. Spreads on agency-backed mortgage-backed securities have risen during the intermeeting period, which are likely to spill over to the primary mortgage market with a lag. Anecdotal reports suggest that the constraints on household borrowing continue to tighten. For example, two of my most senior bank supervisors--both with FICO scores in the stratosphere-- have had their home equity lines slashed. One has deferred a planned home renovation project as a consequence. If that is happening to them, I can only imagine how hard it must be to get a loan if you have a merely average credit rating. Housing prices have also fallen at a somewhat faster rate than the Greenbook previously anticipated. Given the overhang of homes for sale, the recent rise in mortgage rates, and the fact that the homeownership rate is likely to continue trending lower, I think the downward pressure on home prices and construction will persist, as the Greenbook suggests. The Greenbook is actually at the conservative end in its estimates of the wealth effect. It assumes a marginal propensity to consume out of housing wealth of about 3� cents on the dollar. In contrast, a number of recent estimates in the literature are in the 6 cent to 9 cent range. There is a clear risk, then, that the combination of declining housing wealth and tightening credit could lead households to restrict spending more, and more persistently, than anticipated. But the big adverse shock since the last meeting is oil prices, which are up $25 a barrel from the already elevated April levels. Empirically, since the mid-1980s, the estimated responses to relatively exogenous increases in the relative price of oil have tended to look qualitatively like the simulations in the Bluebook and the Board staff's special memo on oil prices, in which we are credible in our commitment to long-term price stability. Most notably, the empirical estimates suggest at most a modest effect on core inflation. Nominal wages barely respond; by some estimates they even fall slightly. The model results suggest that the outcomes we have seen in the actual data are crucially dependent on our having credibility. With substantial target drift, workers demand higher wages, which firms pay and then pass on. Fortunately, the anecdotes I hear are more consistent with credibility than with an upward wage�price spiral. In particular, my contacts uniformly report that they see no signs of wage pressure. There also is no evidence of real wage rigidity in response to energy prices. When energy prices have risen, real wages--in product as well as consumption terms--have generally fallen. In other words, real wages have been depressed in the 2000s, at least in part reflecting rising energy prices. But there is no sign that workers have over a number of years tried to recoup these losses at the bargaining table. Given the importance of credibility, the substantial increase in expected inflation in the Michigan survey is concerning but not yet alarming. I discount these readings somewhat because of analysis by my staff that suggests that, at either the one-year or the five-to-ten-year horizon, consumers have always tended to react strongly to contemporaneous inflation data. Changes in credibility are fundamentally about changes in the process by which people form expectations. But as far as consumer expectations are concerned, that process appears remarkably stable. For example, if you use data through the early 2000s to estimate equations that link inflation expectations to contemporaneous inflation, you will find that those relationships fit remarkably well out of sample. They don't show the systematic underprediction of inflation expectations one might expect if the Fed had suffered a significant loss of credibility at this point. The dependence of consumer inflation expectations on recent data also leads me to believe that they will fall if, in fact, headline inflation comes down as we are predicting as commodity prices level off. Furthermore, I don't think that households' elevated expectations will make it harder to achieve our projections. Earlier research suggested that surveys did, in fact, provide useful information about future inflation. But during the past 15 or 20 years, the actual inflation process has become much less persistent even though households appear to assume otherwise. There is, thus, a notable divergence between the actual inflation process and the one that is embodied in consumers' inflation forecasts. As a result, inflation forecasts incorporating consumer expectations have been a lot less than stellar over this recent period. So it does not appear unreasonable to believe that the effects of recent commodity price shocks will wear off faster than consumers are expecting. An unresolved question is, Whose expectations matter for the dynamics of inflation? I take some solace from the fact that 10-year inflation expectations in the Survey of Professional Forecasters have been relatively stable since the late 1990s and from the fact that five-to-ten-year breakeven rates on TIPS are below their peaks from earlier in the year. Taken all together, I think inflation expectations remain reasonably well anchored. The oil price increases have led me to raise my projections for overall PCE inflation sharply. Cost pressures are likely to push core inflation up a bit, though I see less pass-through than the Greenbook does. Higher oil prices and interest rates and lower housing prices have led me to modestly reduce my forecast of growth in the second half of this year and next year. My forecast is predicated on fed funds rate increases that begin in December of this year, gradually bringing the funds rate to 4� percent in 2010. Briefly, on the issue of long-term economic projections, I welcome greater transparency about our long-term objectives. I think that would be beneficial, and there is a good reason, as you have articulated, to try to do that now, given that for many of us--certainly for me--2010 is not long enough for me to project that the economy will have converged to a steady state. My preference is to provide projections of the average values for output growth, unemployment, and total inflation that are expected, say, five to ten years out. I think that these values can communicate the necessary steady-state information without burdening us with forecasting every year of the transition to the steady state. Also, I would favor conducting a trial in October. " CHRG-111hhrg54868--199 Mr. Bachus," And then there are other arguments that you made that I am not sure that most Members, including me, have considered, and that is many of the members were concentrating not only in real estate, which obviously was a major problem, but were also concentrating in California, those institutions that failed. And that was just as Atlanta--the other earlier conversations--Atlanta was a boom area, and your institutions happened to be in those areas that went up very fast and came down very fast. Ms. Waters. Thank you very much, Mr. Bachus. I will recognize myself for 5 minutes. Let me thank our panelists for being here today. Thank you for your patience. I would like very much to talk about the Consumer Finance Protection Agency, and I would also like to talk about the plight of small banks and regional banks, but I don't have enough time to do so. So I have decided that I am going to spend some time talking about the plight of minority banks, and before I do that, let the record show that my husband is an investor in a minority institution, and also let me disclose for the record that our broker, Merrill Lynch, has been taken over by a systemically important bank, the Bank of America. So I guess I better disclose that also. Now, having said that, the OTS and the FDIC are required to provide assistance to minority-owned banks under section 308 of FIRREA. The law requires banking regulators to preserve the present number of minority banks; preserve the minority character--or preserve the minority character of these banks in cases involving mergers or acquisitions of minority banks; provide technical assistance to prevent the insolvency of institutions that are not currently insolvent; promote and encourage the creation of new minority banks; and provide the training, technical assistance and education programs. The Federal Reserve and the OCC are not statutorily required to assist minority-owned banks, but you do have policies and programs to assist minority-owned banks. This appears to me to be opportunities that may be missed. Given what I have just read, what I have just indicated, I don't understand what you do to assist minority-owned banks in the ways that are described by law. And I would like to ask each of you if you could tell me if this is an area that perhaps you would just like to improve, if you haven't done a lot, or that you have done a lot, and I just don't know about it. I will start with Ms. Sheila Bair. Ms. Bair. We have an annual conference for minority depository institutions. We bring together technical experts and sources of capital investment, regulators speak, and we provide technical assistance. We have a program at Historically Black Colleges to help train bank management and to support careers with minority depository institutions. In terms of a resolution function, again, the resolution process is governed by Prompt Corrective Action, which is triggered by capital levels at banks, and is a very strict process. There is not a lot of flexibility there. Ms. Waters. What do you do to promote and encourage the creation of new minority banks? Ms. Bair. We don't charter banks, but as part of the deposit insurance application process, we would weigh heavily in the balance of serving unmet needs in particular communities. We have had a few minority depository institution (MDI) failures and have actively recruited other MDIs to bid. We let them know about these situations. Acting Director Bowman and I personally intervened with Dwelling House in Pittsburgh to try to stabilize the situation and made some calls, and unfortunately we couldn't find an MDI acquirer. But it is something I have a personal interest in and a commitment to. And certainly if there are other ways we should be addressing this, I would be open to suggestions. Ms. Waters. I would like to know--while I am talking with you, let me talk a little bit about the opportunities that are being created as you dissolve and take over banks. You have some way by which you are selling off or asking the management of assets of those banks. You have other things that you are doing. Is there anything included in your efforts to include minority-owned banks in any way? Ms. Bair. Well, if there is a minority depository institution that will be closed, our resolution staff will get on the phone and actively recruit other minority depository institutions and ask them to review the institution to bid. I think there were two situations where we had an MDI failure and were able to sell it to another MDI. Ms. Waters. What about nonminority-owned banks that are being taken over? How do you outreach to banks or organizations that would like to take over failed banks? Ms. Bair. Well, I personally have had several meetings with those who have a particular interest in investing in MDIs. As part of our preresolution marketing process, we actively reach out to other MDIs to bid on MDIs that are going to fail. Somewhat related, we also have a good contractor outreach program. We have a very good record on minority contractors. Through a variety of outreach tools, we do have a strong commitment in this area. And again, if there are other things we can do, I would be open to suggestions. Ms. Waters. I think I have heard you talk about this before. This week we have the annual legislative conference of the Black Caucus in town, and we have money managers and minorities and financial services, various financial service organizations, and this is the number one topic because of the bailout, because of the $700-and-what billion that the citizens have made available to save the financially--the systemically important institutions. Minorities are complaining about a lack of involvement and opportunities across-the-board, from the Treasury to the FDIC to--you name it, and I just wish we had something to tell them this weekend. Ms. Bair. Congresswoman, we do have a good record. I have gotten a lot of positive feedback on our programs. If there are individuals who are complaining that they don't think there is appropriate access or education, I would like to know that, because I have gotten a lot of good feedback about our programs, and I think we have a very good story to tell on our minority contracts. We are happy to give those numbers to you. Again, if there are other things we can be doing, we are open to suggestions, but I have gotten a lot of positive feedback on our outreach efforts. " CHRG-109shrg30354--32 Chairman Bernanke," Thank you. Mr. Chairman and Members of the Committee I am pleased to be here again to present the Federal Reserve's Monetary Policy Report to the Congress. Over the period since our February report, the U.S. economy has continued to expand. Real gross domestic product is estimated to have risen at an annual rate of 5.6 percent in the first quarter of 2006. The available indicators suggest that economic growth has more recently moderated from that quite strong pace, reflecting a gradual cooling of the housing market and other factors that I will discuss. With respect to the labor market, more than 850,000 jobs were added, on net, to nonfarm payrolls over the first 6 months of the year, though these gains came at a slower pace in the second quarter than in the first. Last month, the unemployment rate stood at 4.6 percent. Inflation has been higher than we has anticipated in February, partly as a result of further sharp increases in the prices of energy and other commodities. During the first 5 months of the year, overall inflation, as measured by the price index for personal consumption expenditures, averaged 4.3 percent at an annual rate. Over the same period, core inflation--that is, inflation excluding food and energy prices--averaged 2.6 percent at an annual rate. To address the risk that inflation pressures might remain elevated, the Federal Open Market Committee continued to firm the stance of monetary policy, raising the Federal funds rate another three-quarters of a percentage point to 5.25 percent in the period since our last report. Let me now review the current economic situation and the outlook in a bit more detail, beginning with developments in the real economy and then turning to the inflation situation. I will conclude with some comments on monetary policy. The U.S. economy appears to be in a period of transition. For the past 3 years or so, economic growth in the United States has been robust. This growth has reflected both the ongoing reemployment of underutilized resources as the economy recovers from the weakness of earlier in the decade, and the expansion of the economy's underlying productive potential, as determined by such factors as productivity trends and the growth of the labor force. Although the rates of resource utilization that the economy can sustain cannot be known with any precision, it is clear that, after several years of above-trend growth, slack in resource utilization has been substantially reduced. As a consequence, a sustainable, noninflationary expansion is likely to involve a modest reduction in the growth of economic activity from the rapid pace of the past 3 years to a pace more consistent with the rate of increase in the Nation's underlying productive capacity. It bears emphasizing that, because productivity growth seems likely to remain strong, the productive capacity of our economy should expand over the next few years at a rate sufficient to support solid growth in real output. As I have noted, the anticipated moderation in economic growth now seems to be underway, although the recent erratic growth pattern complicates this assessment. That moderation appears most evident in the household sector. In particular, consumer spending, which makes up more than two-thirds of aggregate spending, grew rapidly during the first quarter but decelerated during the spring. One likely source of this deceleration was higher energy prices, which have adversely affected the purchasing power of households and weighed on consumer attitudes. Outlays for residential construction, which have been at very high levels in recent years, rose further in the first quarter. More recently, however, the market for residential real estate has been cooling, as can be seen in the slowing of new and existing home sales and housing starts. Some of the recent softening in housing starts may have resulted from the unusually favorable weather during the first quarter of the year, which pulled forward construction activity, but the slowing of the housing market appears to be more broad-based than can be explained by that factor alone. Home prices, which have climbed at double-digit rates in recent years, still appear to be rising for the Nation as a whole, though significantly less rapidly than before. These developments in the housing market are not particularly surprising, as the sustained run-up in housing prices, together with some increase in mortgage rates, has reduced affordability and thus the demand for new homes. The slowing of the housing market may restrain other forms of household spending as well. With homeowners no longer experiencing increases in the equity value of their homes at the rapid pace seen in the past few years, and with the recent declines in stock prices, increases in household net worth are likely to provide less of a boost to consumer expenditures than they have in the recent past. That said, favorable fundamentals, including relatively low unemployment and rising disposable incomes, should provide support for consumer spending. Overall, household expenditures appear likely to expand at a moderate pace, providing continued impetus to the overall economic expansion. Although growth in household spending has slowed, other sectors of the economy retain considerable momentum. Business investment in new capital goods appears to have risen briskly, on net, so far this year. In particular, investment in nonresidential structures, which had been weak since 2001, seems to have picked up appreciably, providing some offset to the slower growth in residential construction. Spending on equipment and software has also been strong. With a few exceptions, business inventories appear to be well aligned with sales, which reduces the risk that a buildup of unwanted inventories might act to reduce production in the future. Business investment seems likely to continue to grow at a solid pace, supported by growth in final sales, rising backlogs of orders for capital goods, and high rates of profitability. To be sure, businesses in certain sectors have experienced financial difficulties. In the aggregate, however, firms remain in excellent financial condition and credit conditions for businesses are favorable. Globally, output growth appears strong. Growth of the global economy will help support U.S. economic activity by continuing to stimulate demand for our exports of goods and services. One downside of the strength of the global economy, however, is that it has led to significant increases in the demand for crude oil and other primary commodities over the past few years. Together with heightened geopolitical uncertainties and the limited ability of suppliers to expand capacity in the short-run, these rising demands have resulted in sharp rises in the prices at which these goods are traded internationally, which in turn has put upward pressure on costs and prices in the United States. Overall, the U.S. economy seems poised to grow in coming quarters at a pace roughly in line with the expansion of its underlying productive capacity. Such an outlook is embodied in the projections of Members of the Board of Governors and the Presidents of Federal Reserve Banks that were made at around the time of the FOMC meeting late last month, based on the assumption of appropriate monetary policy. In particular, the central tendency of those forecasts is for real GDP to increase about 3.75 percent to 3.5 percent in 2006 and 3 percent to 3.25 percent in 2007. With output expanding at a pace near that of the economy's potential, the civilian unemployment rate is expected to finish both 2006 and 2007 between 4.75 percent and 5 percent, close to its recent level. I turn out to the inflation situation. As I noted, inflation has been higher than we expected at the time of our last report. Much of the upward pressure on overall inflation this year has been due to increases in the prices of energy and other commodities and, in particular, to the higher prices of products derived from crude oil. Gasoline prices have increased notably as a result of the rise in petroleum prices as well as factors specific to the market for ethanol. The pickup in inflation so far this year has also been reflected in the prices of a range of nonenergy goods and services, as strengthening demand may have given firms more ability to pass energy and other costs through to consumers. In addition, increases in residential rents, as well as the imputed rent on owner-occupied homes, have recently contributed to higher core inflation. The recent rise in inflation is of concern to the FOMC. The achievement of price stability is one of the objectives that makes up the Congress's mandate to the Federal Reserve. Moreover, in the long-run, price stability is critical to achieving maximum employment and moderate long-term interest rates, the other parts of the Congressional mandate. The outlook for inflation is shaped by a number of factors, not the least of which is the course of energy prices. The spot price of oil has moved up significantly further in recent weeks. Futures quotes imply that market participants expect petroleum prices to roughly stabilize in coming quarters; such an outcome would, over time, reduce one source of upward pressure on inflation. However, expectations of a leveling out of oil prices have been consistently disappointed in recent years, and as the experience of the past week suggests, possible increases in these and other commodity prices remain a risk to the inflation outlook. Although the cost of energy and other raw materials are important, labor costs are by far the largest component of business costs. Anecdotal reports suggest that the labor market is tight in some industries and occupations and that employers are having difficulty attracting certain types of skilled workers. To date, however, moderate growth in most broad measures of nominal labor compensation and the ongoing increases in labor productivity have held down the rise in unit labor costs, reducing pressure on inflation from the cost side. Employee compensation per hour is likely to rise more quickly over the next couple of years in response to the strength of the labor market. Whether faster increases in nominal compensation create additional cost pressures for firms depends in part on the extent to which they are offset by continuing productivity gains. Profit margins are currently relatively wide, and the effect of a possible acceleration in compensation on price inflation would thus also depend on the extent to which competitive pressures force firms to reduce margins rather than pass on higher costs. The public's inflation expectations are another important determinant of inflation. The Federal Reserve must guard against the emergence of an inflationary psychology that could impart greater persistence to what otherwise would be a transitory increase in inflation. After rising earlier this year, measures of longer-term inflation expectations, based on surveys and on a comparison of yields on nominal and inflation-index Government debt, have edged down and remained contained. These developments bear watching, however. Finally, the extent to which aggregate demand is aligned with the economy's underlying productive potential also influences inflation. As I noted earlier, FOMC participants project that the growth in economic activity should moderate to a pace close to that of the growth of potential both this year and next. Should that moderation occur as anticipated, it should also help to limit inflation pressures over time. The projections of the Members of the Board of Governors and the Presidents of the Federal Reserve Banks, which are based on information available at the time of the last FOMC meeting, are for a gradual decline in inflation in coming quarters. As measured by the price index for personal consumption expenditures excluding food and energy, inflation is projected to be 2.25 percent to 2.5 percent this year, and then to edge lower, to 2 percent to 2.25 percent, next year. The FOMC projections, which now anticipate slightly lower growth in real output and higher core inflation than expected in our February report, mirror the somewhat more adverse circumstances facing our economy, which have resulted from the recent steep run-up in energy costs and higher-than-expected inflation more generally. But they also reflect our assessment that with appropriate monetary policy and in the absence of significant unforeseen developments, the economy should continue to expand at a solid and sustainable pace and core inflation should decline from its recent level over the medium-term. Although our baseline forecast is for moderating inflation, the Committee judges that some inflation risks remain. In particular, the high prices of energy and other commodities, in conjunction with high levels of resource utilization that may increase the pricing power of suppliers of goods and services, have the potential to sustain inflation pressures. More generally, if the pattern of elevated readings on inflation is more protracted or more intense than is currently expected, this higher level of inflation could become embedded in the public's inflation expectations and in price-setting behavior. Persistently higher inflation would erode the performance of the real economy and would be costly to reverse. The Federal Reserve must take account of these risks in making its policy decisions. In our pursuit of maximum employment and price stability, monetary policymakers operate in an environment of uncertainty. In particular, we have imperfect knowledge about the effects of our own policy actions as well as of the many other factors that will shape economic developments during the forecast period. These uncertainties bear importantly on our policy decisions because the full influence of policy actions on the economy is felt only after a considerable period of time. The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choice on the longer-term outlook for both inflation and economic growth. In formulating that outlook, we must take account of the possible future effects of previous policy actions--that is, of policy effects still ``in the pipeline.'' Finally, as I have already noted, we must consider not only what appears to be the most likely outcome but also the risks to that outlook and the costs that would be incurred should any of those risks be realized. At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts demand. Thus, policy must be flexible and ready to adjust to changes in economic projections. In particular, as the Committee noted in the statement issued after its June meeting, the extent and timing of any additional firming that may be needed to address inflation risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by our analysis of the incoming information. Thank you. I would be happy to take questions. " CHRG-109hhrg31539--9 Mr. Bernanke," Thank you. Mr. Chairman, and members of the committee, I am pleased to be here again to present the Federal Reserve's Monetary Policy Report to the Congress. Over the period since our February report, the U.S. economy has continued to expand. Real gross domestic product is estimated to have risen at an annual rate of 5.6 percent in the first quarter of 2006. The available indicators suggest that economic growth has more recently moderated from that quite strong pace, reflecting a gradual cooling of the housing market and other factors that I will discuss. With respect to the labor market, more than 850,000 jobs have been added, on net, to nonfarm payrolls in the first 6 months of the year, though these gains came at a slower pace in the second quarter than in the first. Last month the unemployment rate stood at 4.6 percent. Inflation has been higher than we anticipated in February, partly as a result of further sharp increases in the prices of energy and other commodities. During the first 5 months of the year, overall inflation, as measured by the price index for personal consumption expenditures, averaged 4.3 percent at an annual rate. Over the same period, core inflation, that is, inflation excluding food and energy prices, averaged 2.6 percent at an annual rate. To address the risk that inflation pressures might remain elevated, the Federal Open Market Committee continued to firm the stance of monetary policy, raising the Federal funds rate another three-quarters of a percentage point to 5\1/4\ percent in the period since our last report. Let me now review the current economic situation and the outlook in a bit more detail, beginning with developments in the real economy and then turning to the inflation situation. I will conclude with some comments on monetary policy. The U.S. economy appears to be in a period of transition. For the past 3 years or so, economic growth in the United States has been robust. This growth has reflected both the ongoing reemployment of underutilized resources as the economy recovered from the weakness of earlier in the decade and the expansion of the economy's underlying productive potential as determined by such factors as productivity trends and growth of the labor force. Although the rate of resource utilization that the economy can sustain cannot be known with any precision, it is clear that after several years of above-trend growth, slack in resource utilization has been substantially reduced. As a consequence, a sustainable noninflationary expansion is likely to involve a modest reduction in the growth of economic activity from the rapid pace of the past 3 years to a pace more consistent with the rate of increase in the Nation's underlying productive capacity. It bears emphasizing that because productivity growth seems likely to remain strong, the productive capacity of our economy should expand over the next few years at a rate sufficient to support solid growth in real output. As I have noted, the anticipated moderation in economic growth now seems to be under way, although the recent erratic growth pattern complicates this assessment. That moderation appears most evident in the household sector. In particular, consumer spending, which makes up more than two-thirds of aggregate spending, grew rapidly during the first quarter, but decelerated during the spring. One likely source of this deceleration was higher energy prices, which have adversely affected the purchasing power of households and have weighed on consumer attitudes. Outlays for residential construction, which have been at very high levels in recent years, rose further in the first quarter. More recently, however, the market for residential real estate has been cooling, as can be seen in the slowing of new and existing home sales and housing starts. Some of the recent softening in housing starts may have resulted from the unusually favorable weather during the first quarter of the year which pulled forward construction activity, but the slowing of the housing market appears to be more broad-based than can be explained by that factor alone. Home prices, which have climbed at double-digit rates in recent years, still appear to be rising for the Nation as a whole, though significantly less rapidly than before. These developments in the housing market are not particularly surprising as the sustained run-up in housing prices, together with some increase in mortgage rates, has reduced affordability and thus the demand for new homes. The slowing of the housing market may restrain other forms of household spending as well. With homeowners no longer experiencing increases in the equity value of their homes at the rapid pace seen in the past few years, and with the recent declines in the stock prices, increases in household net worth are likely to provide less of a boost to consumer expenditures than they have in the recent past. That said, favorable fundamentals, including relatively low unemployment and rising disposable incomes, should provide support for consumer spending. Overall, household expenditures appear likely to expand at a moderate pace, providing continued impetus to the overall economic expansion. Although growth in household spending has slowed, other sectors of the economy retain considerable momentum. Business investment in new capital goods appears to have risen briskly, on net, so far this year. In particular, investment in nonresidential structures which had been weak since 2001 seems to have picked up appreciably, providing some offset to the slower growth in residential construction. Spending on equipment and software has also been strong. With a few exceptions, business inventories appear to be well aligned with sales, which reduces the risk that a build-up of unwanted inventories might actually reduce production in the future. Business investment seems likely to continue to grow at a solid pace, supported by growth in final sales, rising backlogs of orders for capital goods, and high rates of profitability. To be sure, businesses in certain sectors have experienced financial difficulties. In the aggregate, however, firms remain in excellent financial condition, and credit conditions for businesses are favorable. Globally, output growth appears strong. Growth of the global economy will help support U.S. economic activity by continuing to stimulate demand for our exports of goods and services. One downside to the strength of the global economy, however, is that it has led to significant increases in the demand for crude oil and other primary commodities in the past few years. Together with heightened geopolitical uncertainties and the limited ability of suppliers to expand capacity in the short run, these rising demands have resulted in sharp rises in the prices of which these goods are traded internationally, which in turn has put upward pressure on costs and prices in the United States. Overall, the U.S. economy seems poised to grow in coming quarters at a pace roughly in line with the expansion of its underlying productive capacity. Such an outlook is embodied in the projections of members of the Board of Governors and the presidents of Federal Reserve Banks that were made around the time of the FOMC meeting late last month, based on the assumption of appropriate monetary policy. In particular, the central tendency of those forecasts is for real GDP to increase about 3\1/4\ percent to 3\1/2\ percent in 2006, and 3 percent to 3\1/4\ percent in 2007. With output expanding at a pace near that of the economy's potential, the civilian unemployment rate is expected to finish both 2006 and 2007 between 4\3/4\ percent and 5 percent, close to its recent level. I turn now to the inflation situation. As I noted, inflation has been higher than we expected at the time of our last report. Much of the upward pressure on overall inflation this year has been due to increases in the prices of energy and other commodities, and in particular to the higher prices of products derived from crude oil. Gasoline prices have increased notably as a result of the rise in petroleum prices as well as factors specific to the market for ethanol. The pickup in inflation so far this year has also been reflected in the prices of a range of goods and services as strengthening demand may have given firms more ability to pass energy and other costs through to consumers. In addition, increases in residential rents as well as in the imputed rent on owner-occupied homes have recently contributed to higher core inflation. The recent rise in inflation is of concern to the FOMC. The achievement of price stability is one of the objectives that make up the Congress' mandate to the Federal Reserve. Moreover, in the long run, price stability is critical to achieving maximum employment and moderate long-term interest rates, the other parts of the Congressional mandate. The outlook for inflation is shaped by a number of factors, not the least of which is the course of energy prices. The spot price of oil has moved up significantly further in recent weeks. Futures quotes imply that market participants expect petroleum prices to roughly stabilize in coming quarters. Such an outcome would, over time, reduce one source of upward pressure on inflation. However, expectations of a leveling out of oil prices have been consistently disappointed in recent years, and as the experience of the past week suggests, possible increases in these and other commodity prices remain a risk to the inflation outlook. Although the costs of energy and other raw materials are important, labor costs are by far the largest component of business costs. Anecdotal reports suggest that the labor market is tight in some industries and occupations, and that employers are having difficulty attracting certain types of skilled workers. To date, however, moderate growth in most broad measures of nominal labor compensation and the ongoing increases in labor productivity have held down the rise in unit labor costs, reducing pressure on inflation from the cost side. Employee compensation per hour is likely to rise more quickly over the next couple of years in response to the strength of the labor market. Whether faster increases in nominal compensation create additional cost pressures for firms depends in part on the extent to which they are offset by continuing productivity gains. Profit margins are currently relatively wide, and the effect of a possible acceleration in compensation in price inflation would also depend on the extent to which competitive pressures force firms to reduce margins rather than to pass on higher costs. The public's inflation expectations are another important determinant of inflation. The Federal Reserve must guard against the emergence of an inflationary psychology that could impart greater persistence than what could otherwise be a transitory increase in inflation. After rising earlier this year, measures of expectations, based on surveys and on a comparison of yields on nominal and inflation-indexed government debt, have edged down and remain contained. These developments bear watching, however. Finally, the extent to which aggregate demand is aligned with the economy's underlying productive potential also influences inflation. As I noted earlier, FOMC participants project the growth in economic activity should moderate to a pace close to that of the growth of potential both this year and next. Should that moderation occur as anticipated, it should help to limit inflation pressures over time. The projections of the members of the Board of Governors and the presidents of the Federal Reserve Banks, which are based on information available at the time of the last FOMC meeting, are for a gradual decline in inflation in coming quarters. As measured by the price index for personal consumption expenditures excluding food and energy, inflation is projected to be 2\1/4\ percent to 2\1/2\ percent this year and then to edge lower to 2 percent to 2\1/4\ percent next year. The FOMC projections, which now anticipate slightly lower growth in real output and higher core inflation than expected in our February report, mirror the somewhat more adverse circumstances facing our economy which have resulted from the recent steep run-up in energy costs and higher-than-expected inflation more generally. But they also reflect our assessment that with appropriate monetary policy, and in the absence of significant unforeseen developments, the economy should continue to expand at a solid and sustainable pace, and core inflation should decline from its recent level over the medium term. Although our baseline forecast is for moderating inflation, the committee judges that some inflation risks remain. In particular, the high prices of energy and other commodities in conjunction with high levels of resource utilization that may increase the pricing power of suppliers of goods and services have the potential to sustain inflation pressures. More generally, if the pattern of elevated readings on inflation is more protracted or is more intense than currently expected, this higher level of inflation could become embedded in the public's expectations and in price-setting behavior. Persistently higher inflation would erode the performance of the real economy and would be costly to reverse. The Federal Reserve must take into account these risks in making its policy decisions. In our pursuit of maximum employment and price stability, monetary policymakers operate in an environment of uncertainty. In particular, we have imperfect knowledge about the effects of our own policy actions as well as of the many other factors that will shape economic developments during the forecast period. These uncertainties bear importantly on our policy decisions because the full influence of policy actions on the economy is felt only after a considerable period of time. The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth. In formulating that outlook, we must take into account the possible future effects of previous policy actions, that is, of policy effects still in the pipeline. Finally, as I have noted, we must consider not only what appears to be the most likely outcome, but also the risks to that outlook and the costs that would be incurred should any of those risks be realized. At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all of our forecasts as provisional and subject to revision as the facts demand. Thus, policy must be flexible and ready to adjust to changes in economic projections. In particular, as the committee noted in the statement issued after its June meeting, the extent and timing of any additional firming that may be needed to address inflation risks will depend on the evolution of the outlook for both inflation and economic growth as implied by our analysis of the incoming information. Thank you. I would be happy to take questions. " FOMC20050630meeting--250 248,MR. LEAHY.," The top left panel of exhibit 11 presents our outlook for foreign real GDP growth. We forecast total foreign growth to move back up this quarter from a soft first-quarter pace and to rise a bit further going forward. The pickup is modest and reflects our assessment of the balance between some opposing forces. On the one hand, higher oil prices, while supportive for some economies, are expected to damp activity, on balance, for our foreign aggregate, which is weighted by U.S. exports. On the other hand, financial conditions appear to be more uniformly supportive of growth abroad. Many foreign currencies have depreciated against the dollar since the beginning of the year and, as shown on the right, stock prices in emerging-market and industrial economies have moved up since the middle of last year. Emerging-market bond spreads, shown in the bottom left panel, backed up a bit from their lows earlier this year but are still tight by historical standards. And benchmark long-term interest rates abroad have moved substantially lower, as shown by the red line in the bottom right panel. The widespread decline of long-term rates has been a prominent topic of discussion recently, and many hypotheses have been offered to explain it. I do not propose to resolve that debate. [Laughter] However, the extent to which rates have declined has varied across countries. Why this might be so is the subject of your next exhibit. As shown in the top left panel, the yield on the German government bond was essentially equal to the 10-year Treasury yield in October 2003, a date that falls before any of the central banks discussed on this page began tightening monetary policy. Since then, the bund yield has declined about 120 basis points and is currently just off its record low of 3.10 percent. The yield on the Canadian bond, shown in the next column to the right, has declined nearly as much, at 110 basis points over the 20-month period. These developments contrast with the smaller net decline of 80 basis points in the United Kingdom, and the much smaller net declines of 40 basis points in the United States, and 20 basis points in Japan. The size of the decline may have been more limited in Japan than in the other economies because of the proximity of the zero lower bound on nominal interest rates. June 29-30, 2005 89 of 234 The relative size of these real and nominal yield movements appears to reflect monetary policy actions taken during the period as well as expected future actions. With the exception of Japan, long-term rates have fallen more in economies where tightening has been the least. None of the major foreign central banks has tightened monetary policy as much as the FOMC has over this period. As shown in the first panel of the bottom row, monetary policy in the euro area, where the largest decline in bond yields occurred, has been on hold since June 2003. Market expectations that the ECB might soon raise rates, a view heavily promoted in ECB rhetoric of only a month ago, have all but vanished. In Canada, where bond yields have declined substantially also, the Bank of Canada has lowered policy rates on net since October 2003, but markets appear to expect the tightening that occurred in September and October of last year to resume in future months. In contrast, the Bank of England, the first of these central banks to start tightening, in November 2003, has raised its policy rate 125 basis points over the period, and at this point markets appear to expect that the next move for the Bank will be to lower the policy rate. Nonetheless, long-term rates are down whereas short-term rates are up. Monetary policy at the Bank of Japan (BOJ) has not changed significantly. The BOJ has continued to pursue quantitative easing, and reserve balances stepped up over the period. The low level of real long-term interest rates in the euro area and Japan should help smooth the way for more robust expansion of activity in those economies. Other financial factors, presented in your next exhibit, should also lend support. Positive equity earnings forecasts, shown at the top left, should help lift stock prices and reduce the cost of equity finance for firms. Forecasts of earnings per share, drawn from surveys of equity analysts in mid-June, put earnings this year above last year’s, and forecasts for 2006 show further increases. BBB corporate bond spreads, shown to the right, are relatively low, which implies that corporate bond financing costs have generally followed government yields down. And the recent depreciation of the euro and yen in foreign exchange markets, shown in real effective terms in the middle left panel, should provide some boost to net exports going forward. June 29-30, 2005 90 of 234 Your next exhibit examines the potential implications of recent changes in the behavior of Chinese trade. The top left panel shows a 12-month moving sum of China’s merchandise trade balance over the past 20 years. In recent months, the Chinese trade surplus has jumped to record levels. As shown on the right, exports have continued to grow along trend, but imports appear to be decelerating. The counterpart of the lower import growth is showing up elsewhere in Asia as a slowing of exports to China. As shown in the middle left panel, the growth of exports to China from Taiwan, Korea, and Japan, three of the region’s largest economies and also three of China’s top trading partners, has dropped from very rapid rates to near zero. We see two developments that are consistent with this shift. One is that economic activity in China is decelerating. Policy measures adopted a year ago to restrain runaway investment spending, which had increased more than 40 percent over the four-quarter period immediately prior to the implementation of the measures, may be beginning to show through to GDP. Our forecast for growth in China, shown in the middle right, has growth stepping down to 7½ percent by the end of this year, as we regard the double-digit GDP growth rates of the recent past as unsustainable. The other development is that China may be turning inward for some items that it had been importing, including heavy industry items like iron and steel and road vehicles. As shown at the bottom left, exports of road vehicles have ramped up since 2002, and exports of iron and steel rocketed up last year, as capacity to produce steel internally came on line. As shown in the bottom right panel, China’s extraordinary growth does not seem to have triggered broad-based inflation pressures. The consumer price inflation bulge in 2004 came almost entirely from increases in food prices, and they have not persisted. Your final exhibit presents our outlook for commodity prices and the U.S. external accounts. As shown by the black line in the top left panel, prices of nonfuel primary commodities have increased substantially in the past three years, boosted in part by global growth but lifted also by the depreciation of the dollar, shown at the right. The metals price component of this index (the red line) has registered the largest price gains. Over the next year and a half, primary commodity prices are forecast to change little, as world demand is expected to stay strong and supply response comes on line. The spot price of oil, shown in the middle left panel, has continued to rise, as has the price implied by futures contracts maturing about six years out, shown by the red line. Increasing doubts about future supply from Russia, Venezuela, Iran, and Iraq have apparently cooled expectations that oil prices will retreat much from their current, elevated levels. Potential supply shortfalls are of particular concern because OPEC has little spare capacity and world oil demand is expected to continue to be strong. June 29-30, 2005 91 of 234 $960 billion, or about 7¼ percent of U.S. GDP, by the fourth quarter of 2006. With the dollar projected to depreciate only modestly from its current level, U.S. GDP growth on a par with or above aggregate foreign growth, and oil prices remaining high, the trade balance, shown at the bottom left, deteriorates $113 billion further over the forecast period. The projected decline in net investment income is almost as large, at $79 billion. The growing negative contribution of net investment income to the deficit reflects expanded net holdings of U.S. liabilities and an assumed increase in U.S. short-term interest rates." FOMC20061212meeting--103 101,MR. KROSZNER.," Last time several of us noted that there would be an avalanche of data between the last meeting and this one [laughter]—two employment reports, two rounds of ISM, GDP, ECI, compensation revisions, all of that. But it seems from the discussion here that we’ve actually gotten very little new information, with one exception, and that relates to Dave Stockton. We heard that not long ago he was on the psychiatrist’s couch dealing with a schizophrenia issue of whether the economy is going up or going down. But now we know that he is on his death bed. [Laughter] I hope this does not bode ill for the economy going forward, but I did want to note that one very important change, Mr. Chairman. We’ve had the same discussion of a two-tiered economy, with housing and autos being slower and the rest of the economy moving forward, and continuing concerns about the risk of spillovers; but the central tendency seems to be that we’ll be moving ahead perhaps a little below potential, with some reasonable chance of getting back to something closer to potential by the end of next year. Continuing the discussions of labor market tightness and some concerns about shortages in certain areas, I think that we certainly have seen some softness in construction, but that’s an area for which we’ve probably underestimated employment growth and perhaps employment falloff because, as I think many of us know, many of the subcontractors in residential as well as nonresidential housing have a lot of undocumented workers, and they tend to be undercounted both on the upside and on the downside. So there may be a little more softness in the labor market than we’re seeing, at least in the construction sector; however, in the higher-skilled sectors, we’re seeing continued tightness. Consumer spending continues to be strong. There has been just an amazing persistence of consumer spending, no matter what has happened over the past five years. Whether the stock market has crashed, whether the housing market has boomed, whether we’ve had September 11, or whether we’ve had concerns about spillover effects, the consumer seems to have been very, very persistent, and it seems as though that’s the case now. We’ve talked about challenges in the energy markets, and we did see a little slowing. Energy prices were higher, and energy prices are lower, but these aspects of the macroeconomy seem still to have little effect on consumer spending. We continue to have concerns about some upside risks to inflation. So I’ll just mention quickly a few issues and then talk about some international issues that Dino and Tim touched on earlier. Regarding housing, we know we have terrible price data, but it seems as though there’s a little more flexibility and nimbleness in the housing market than there was in the past. So the past data on housing may not be too useful. Although we know we don’t get good data on effective prices, we do seem to be seeing more evidence that people, rather than just holding things on the market longer, are providing the marble bathroom, the Lexus, the Hyundai, the Kia, the Yugo, or whatever they’re providing. In New Jersey, where I grew up, it would be a Yugo. [Laughter] So I think there’s more flexibility on that side. Also, because of the way the housing market has developed, a lot of residential construction is no longer at just the local level. The large national builders are better diversified and, as has been discussed, have options on land, and then, if they see the market turning down, they give up those options. So they have a much greater ability to shift both down and up in production much more quickly. Prices, too, are a little more flexible, which is one reason that we’ve seen a sharper correction in the housing market. But that flexibility, with the recent data indicating that certain things may be flattening out, may mean that, though the correction may have been sharper, it won’t necessarily persist— that the correction has occurred in a shorter time, rather than being dragged out longer and having more potential for negative spillover, confidence effects, and so forth. Well, what has changed? As Governor Kohn mentioned, inventory accumulation is a bit of concern: It seems to be ticking up. It always seems a bit odd when a positive effect on GDP results from businesses being unable to sell the things that they’ve purchased. That doesn’t strike me as necessarily a positive thing for a GDP report. We’ve gotten some more, probably confusing, numbers on productivity. Is productivity slowing or not? We are getting some data that may be suggesting that it is, although I would agree with Dave and the staff that it’s much too early to say. I think the evidence both anecdotally, as a number of people have mentioned, and more broadly is that productivity is likely to continue to go forward. Another thing that changed, as Dino and others discussed, was the yield curve. But this phenomenon is very much an international one. Long rates have come down more—since the last meeting, they have fallen a fair amount and not just in the United States. The three-month versus the ten-year in Europe has fallen about 40 basis points, so the spread is about 7 basis points now. On average, since the euro has been around, it has been about 40 to 50 basis points. In the United Kingdom, which tends on average to have very flat yield curves, the inversion has steepened about 25 basis points to 65 basis points. Japan is little changed, but Japan is sui generis. Emerging markets have also seen this. In Mexico, for example, the ten-year versus the three-month has dropped about 60 basis points. Clearly, this is not just a U.S. phenomenon, and I think it’s telling us not just about U.S. growth, unless you think that U.S. growth is driving world growth and so it’s really all about the United States. I think that’s a bit extreme, even though, as was mentioned, some correlations suggest that when the United States goes down, there is a lagged effect and the rest of the world tends to go down. But I think it’s suggesting that some other factor is occurring and that we shouldn’t read too much into it. Also, interestingly, if you look at the real short and long rates around the world—at least for the industrial countries—real rates tend to be about 1½ to 2½ percent, which is very much where we are. Thus there has been a convergence of real rates around the world. So I would be wary of taking too much information from the bond market as referring to something that’s specific to the United States rather than to some factors that are common worldwide. Just quickly on inflation—we’ve talked about how energy prices have gone up and down but core inflation hasn’t been affected that much. Labor market tightness doesn’t seem to have had much of an effect. As for output gaps—if you like output gaps—when you look at the data, it’s hard to find much evidence of an effect of output gaps on core inflation. Also, given the discussion that we’ve had, it doesn’t seem that the gap will be too wide or, even if you believe it will be wide, that you’d be getting much effect from it in the near term. We talked about some temporary factors like owners’ equivalent rent that may have boosted measured inflation for a while and is now coming down. I don’t think there will be much effect on inflation from the dollar. The United States still is just not that open an economy. Even to the extent that it is open, the pass-through of exchange rate changes to domestic prices is very slow and very partial—typically, over a three-year to five-year period, barely 50 percent. The evidence suggests that the pass-through is decreasing. Even if the dollar went down further, I don’t see much of an effect there. That said, it’s hard to see exactly what forces are moving inflation in one way or another right now. A reasonable scenario is that it could drift down slowly, but it’s hard to point to clear evidence of where it’s going to go. To the extent that there is information in the yield curve, the markets clearly do not expect inflation to take off, and it’s likely that inflation will be moving lower or at least staying contained where it is. So we have much data and relatively little information. I see risks on both the upside and the downside to growth and have continuing concern about upside risks to inflation precisely because I don’t see an easy path to lower core inflation going forward. I think that lower core inflation in the future is reasonable but uncertain, particularly given that it’s hard to see a lot of systematic evidence of factors that are occurring now that would be correlated with that result. Thanks." FOMC20060920meeting--153 151,CHAIRMAN BERNANKE.," Thank you. Let me just summarize quickly what I heard around the table, and then I’d like to make some additional comments of my own on the economy. The sense is that, on the real side, there’s a two-tier economy. There’s the housing sector and maybe autos, and there’s everything else. On housing, there’s agreement that a significant correction is occurring, but the views of the risks vary among participants. In particular, some feel that this still could be a quite deep correction, and others say that the fundamentals, such as incomes, interest rates, and so on, will ultimately support housing. With respect to the rest of the real economy, there were some mixed reports; but on the whole, people characterized it as a full employment economy. We’re generally more optimistic than the Greenbook both for later this year and for 2007. In particular, people noted higher incomes and stock prices and lower oil prices, which should support consumption growth and business activity. At least for now, I heard only a few participants being particularly concerned about the possible knock-on effects of housing on consumption and investment. The labor market remains solid, and as we’ve been noting for a number of meetings, attracting more highly skilled workers remains difficult. On inflation, some noted somewhat better intermeeting news, with the possible exception of the higher compensation data. But a lot of uncertainty was expressed about where inflation will go, reflecting in part our incomplete knowledge of the determinants of inflation and also some mixed anecdotal evidence. However, I hear very clearly a definite unhappiness with the level of core inflation and with the amount of time that is projected to return it to a level of less than 2 percent. The principal concern is that our credibility will be damaged if inflation remains too high for too long. So I would summarize the discussion—I hope reasonably accurately—by saying that inflation remains the predominant risk but there is still quite a bit of uncertainty about the evolution of the economy in the next few quarters. Let me add a few comments to this—first about inflation and then about the real economy. I do believe that the intermeeting news on inflation was more good than bad, particularly relative to the fact that inflation is a lagging indicator and that it would not have been incredibly surprising if we had gotten 0.3 readings the past two months. I’ll talk first about some of the positive news, and then I’ll address some of the risks going forward. First, there is evidence that the momentum of inflation has reversed. When I gave my speech on June 5, which many of you followed up on, I emphasized the three- and six-month rates of inflation as indicating that an acceleration, a rising inflation pattern, was occurring. It now appears that the three-month rate of inflation peaked in May. So, for example, in May, the core PCE was 3.06 on a three-month basis; in July, it was 2.24. The market-based core PCE was 3.00 in May, and in July it was 2.11. The core CPI was a high 3.79 in May, and as of the last reading in August, it was 2.95. So in some sense the direction has turned, and the momentum has been broken, and I think that has been reflected in views in the marketplace. Now, there hasn’t been much discussion of the details of this inflation report, and I think it’s actually quite significant. In particular, a very important factor in both the level and the change in inflation is owners’ equivalent rent (OER); we’ve discussed this issue before. OER is 41 percent of core CPI and 19 percent of core PCE. Although OER has been decelerating recently, it’s still at a three-month rate of 4.4 percent, relative to an annual rate of 2.66 percent in 2005. So that difference accounts for a great deal of the change between where we are today on a three-month basis versus where we were in 2005. The good news is that OER and other measures of rent of shelter have been coming down more quickly than many outside economists expected but in line with what our staff more or less expected; indeed, the number was 3 percent for August. So if it just stayed there or came down a bit more, we would see better short-term numbers for inflation going forward. Other positive news on inflation obviously includes energy and commodity prices. For energy the dominant factors are supply-side factors over which we have no control—hurricanes or the lack thereof and geopolitical factors. But it’s also interesting that metals and some other commodities are off their peaks. That suggests to me that, at least on the margin, some prospect of slowing economic activity and rising interest rates around the world may have taken a bit of the pressure off the commodity prices. We also have had some indication since the last meeting that the economy will be slower than we thought. Clearly, the news on autos and housing was in a negative direction, and granting the flatness of the Phillips curve, all else being equal, that will take some pressure off utilization and pricing power. Finally, I would argue that expectations are, in fact, really quite well contained. Around this table, we’re getting used to talking about core inflation. The inflation that people see, of course, is headline inflation, and ultimately that should be our target as well. Over the past year or two, headline inflation has gone well above what we would consider reasonable levels, and yet TIPS indicators, survey indicators, and outside forecasters have not markedly changed their long-term inflation forecast. So I take the credibility issue very seriously, but I don’t think that there is much evidence yet that our credibility has been seriously impaired. On the negative side, the main piece of news was the higher compensation in the first and second quarters. There is not yet much evidence that labor costs are affecting inflation. We’ve already discussed the issues with the measurement of compensation per hour. Let me just note that, if you look at the components of inflation that have moved the most, you get things like rent, airfares, used cars, and things of that sort. You don’t see much movement in services, for example, which are more labor intensive. So I don’t think that labor costs have yet infected the inflation rate; indeed, we know there’s a weak correlation between these labor cost measures and inflation. However, and let me be clear about this, I think that the key risk to our inflation forecast is that markets will be tighter, labor markets will be tighter, and wages will grow more quickly, and that will produce more inflation than we would like. So I would summarize the inflation situation as having had some modest improvement, some encouragement, but I certainly agree with the general sentiment around the table that the level of core inflation is certainly too high. On the real side, we paused at the last meeting to observe the lagged effects on real activity of our previous interest rate moves. The evidence suggests that, indeed, interest- sensitive sectors did worsen over the intermeeting period. We saw the second significant markdown in a row by the Greenbook for housing, and we’ve seen autos decline as well. To this point, I agree that the economy except for housing is reasonably strong and that there are factors supporting consumption particularly, going forward. So as we look forward, I think there are two issues. The first is how severe the contraction in housing will be. To be honest, we don’t really know. We’re talking, again, about an asset price correction, and it’s difficult, in principle, to know how far that will adjust. The second issue is how much spillover there will be from any housing correction to the rest of the economy. I don’t have quite as much confidence as some people around the table that there will be no spillover effect. Any spillover effect would be a lagged effect, and it remains to be seen how much effect there might be. But I agree that the economy except for housing and autos is still pretty strong, and we do not yet see any significant spillover from housing. Please look at the figure that was distributed.2 I want to talk a bit about the risks in both directions as we think about policy. Let me just describe the two panels to you and then draw a conclusion from them. The top panel shows the four-quarter difference in the unemployment rate—that is, the unemployment rate in the fourth quarter of this year minus the unemployment rate in the fourth quarter of last year, going back to about 1950. The blue bars show recession periods. The dashed line is at zero, and the solid horizontal line is at 0.3 percentage point. What you see is that, without exception, every time since 1950 that the unemployment rate has risen as much as 0.3 percentage point over a year, it has continued to rise, and we’ve seen a recession. That suggests that having unemployment rise just a few tenths and keeping it there is not quite so easy as our linear models might suggest. In the bottom panel, you see four-quarter changes in the growth of real GDP. The dotted line shows zero, and the solid line arbitrarily shows 2 percent real growth. Again, these are four-quarter differences. With the minor exception of 1956, again in no case was real GDP growth below 2 percent sustained for four quarters without an NBER recession. I think a very interesting case is 1995-96—the famous soft landing that was engineered in the mid-1990s. You’ll notice the line just touches the 2 percent zone without crossing it. [Laughter] 2 The figure to which Chairman Bernanke refers is appended to this transcript (appendix 2). So what am I saying here? I’m only saying that, if we believe that we need to have output below potential to help arrest inflation pressures, it is a delicate operation, and we may have a very narrow channel to navigate as we go forward. We should pay very close attention to how the economy is evolving at this particular moment because I think the uncertainty and the potential nonlinearity at this juncture are greater than what we normally face. I’ll stop there, and we can begin our second round. Oh, I’m sorry—Vincent. [Laughter]" FOMC20060808meeting--74 72,MS. BIES.," Thank you, Mr. Chairman. I think our decision today is going to be a close call because of the recent information we’ve gotten both on inflation and on the growth of the economy. We know that, as President Poole and others have mentioned, wage and price inflation has been accelerating and is fairly broadly based. The recent NIPA revisions also concern me because of the faster growth in core PCE prices that those data show. The business surveys, in fact, show that companies feel they have more pricing power than they have had in the past. We know that we are going to have some continuing feed-through of the higher prices of oil. After talking to some folks in the oil industry, I am concerned about the recent Alaska situation. It clearly shows that maintenance of equipment and the efficiency of the operations of some of these companies may be under stress with the high volumes of capacity at which they have been running. We pray that it doesn’t extend much further in additional surprises. What also concerns me about the NIPA revisions are the changes in the productivity numbers. The fact that with the NIPA revisions we are seeing lower productivity and faster- rising labor costs has implications for our forward expectations on inflation. We also see that business investment in equipment and software was much lower. That downward revision worries me because it implies that less capital deepening has occurred, and that would have been a strong base to support productivity going forward. Now we apparently cannot rely on it as a base as much as we could before the revisions. In terms of the housing markets, the rapid escalation of home sale cancellations clearly has been very surprising. Again, the gross sales figures don’t show this, but the information we’ve got on the cancellations indicates a much more pronounced slowdown than we might have expected. In looking through other housing cycles and in talking to bankers and lenders, one of the good things I find is that the industry learned in the 1980s. Because those in the industry are more sophisticated in the way they manage their land costs and their inventory, I think the length of the cycle is unlikely to be as long. In the 1980s, bankers made plenty of funds available for companies to continue to develop land and to put in infrastructure. When the housing bubble burst, all of a sudden we had unsold housing units. They had to be sold before builders could start building on the developments that had already been laid out, and it took us several years to work through that. This time we don’t have the unfinished inventory of developments that we had in the ’80s. So I think that the cycle is likely to be much shorter than it was then and that it will put some firmness in that market. At the same time, this is the sector, aside from energy and commodities, that had a very rapid rise in prices, and it’s good that we’re seeing some correction in those prices right now. The other good trend that I take comfort in is the one that Dino mentioned earlier—that we’re seeing central banks around the world raising rates. When we started raising our rates a couple of years ago, there weren’t too many moving at the same time we did. We know that today monetary policy has global effects: Excessive accommodation in some countries clearly can affect investments in other countries. So I think we now have support in what we’re doing to remove accommodation. We’re seeing that support more broadly across the world; and in the aggregate, then, it will help to moderate inflation in the period going forward. Finally, I’m reminded that we do have long lags in monetary policy, and we still have to see the full impact of what we have already put in train. Thank you, Mr. Chairman." CHRG-111shrg54589--121 PREPARED STATEMENT OF SENATOR MIKE CRAPO Recent events in the credit markets have highlighted the need for greater attention to risk management practices and the counterparty risk in particular. The creation of clearinghouses and increased information to trade information warehouses are positive steps to strengthen the infrastructure for clearing and settling credit default swaps. While the central counterparty clearing and exchange trading of simple, standardized contracts has the potential to reduce risk and increase market efficiency, market participants must be permitted to continue to negotiate customized bilateral contracts in over-the-counter markets. Many businesses use over-the-counter derivatives to minimize the impact of commodity price, interest rate, and exchange rate volatility in order to maintain stability in earnings and predictability in operations. If Congress overreaches and bans or generates significant uncertainty regarding the legitimacy of decisions to customize individual OTC derivatives transactions there will be enormous negative implications on how companies manage risk. At this time I would like to highlight a few examples from end users about what are the possible effects of severely restricting access to customized over-the-counter derivatives on companies' ability to manage risk and on the prices they charge customers.v David Dines, President of Cargill Risk Management: ``While margining and other credit support mechanisms are in place and utilized every day in the OTC markets, there is flexibility in the credit terms, credit thresholds and types of collateral that can be applied. This flexibility is a significant benefit for end users of OTC derivatives such as Cargill in managing working capital. Losing this flexibility is particularly concerning because mandatory margining will divert working capital from investments that can grow our business and idle it in margin accounts. While it depends on market conditions, the diversion of working capital from Cargill from margining could be in excess of $1 billion. Multiply this across all companies in the U.S. and ramifications are enormous, especially at a time when credit is critically tight.'' Kevin Colgan, Corporate Treasurer of Caterpillar: ``Our understanding of currently pending regulation in this area is that it would require a clearing function which would standardize terms like duration and amount. Any standardization of this type would prohibit us from matching exactly the terms of the underlying exposure we are attempting to hedge. This, in turn, would expose us to uncovered risk and introduce needless volatility into our financial crisis.'' Mark Grier, Vice Chairman of Prudential Financial: ``Without customized OTC derivatives, Prudential would be incapable of closely managing the risks created in selling life insurance, offering commercial loans, and proving annuities for retirement.'' John Rosenthal, Chief Hedging Officer of MetLife: ``Standardized derivatives cannot be used effectively to hedge all types of financial risk. Any increased risks would result in higher costs to offer and maintain these products. In either situation the increased costs of an inefficient derivatives market would be reflected in the pricing to our customers. To the extent the costs and/or risks associated with an inability to appropriately hedge these products became prohibitive; these products could be no longer available to customers.'' Janet Yeomans, Vice President and Treasurer of 3M: ``Not all OTC derivatives have put the financial system at risk and they should not all be treated the same. The OTC foreign exchange, commodity, and interest rate markets have operated uninterrupted throughout the economy's financial difficulties. We urge policy makers to focus on the areas of highest concern.'' At this time, I would like to submit into the record the complete letters. It is possible that I will receive additional letters in the next few days and I would also like to enter those letters in the record. While the derivatives market may seem far removed from the interests and concerns of consumers and jobs that is clearly not the case. Legislative proposals to alter the regulatory framework of over-the-counter derivatives is a very technical subject matter and the potential for legislation to have unintended consequences of legitimate transactions is considerable. We need to better understand the following questions: How do businesses use customized OTC derivatives to help stabilize prices and mitigate risk? What are the possible effects of severely restricting access to customized OTC derivatives on businesses ability to manage risk and on the prices they charge customers? What safeguards are in place to ensure that derivatives portfolios are a tool for hedging risk, rather than a source of risk? What does standardized mean, and how much of the OTC markets can and should be shifted on exchanges? ______ FOMC20080625meeting--31 29,MR. WASCHER.," Exhibit 10 reviews our assumptions about aggregate supply. As you can see from the first two rows of the table at the top, we now assume that potential output growth will hold steady at about 2� percent per year over the forecast period, about � percentage point per year higher from 2007 to 2009 than we had assumed in the April Greenbook. This upward revision is split roughly equally between structural productivity growth (lines 3 and 4) and trend hours (lines 5 and 6). The middle two panels provide the reasoning for our change. The left panel shows the difference between actual productivity growth (the black line) and a simulation from our standard model (the green line) using the pace of structural productivity growth that we had assumed in April. As you can see, labor productivity growth in recent quarters has been stronger than the model would have expected given the deceleration in economic activity. As shown in the inset box, a purely statistical model based on a Kalman filter would have responded to the recent data by raising its estimate of structural productivity growth 0.2 percentage point. Because we place less weight on data that have not yet been through an annual revision, we generally tend to revise our own estimate by less than the amount suggested by such models; moreover, the Kalman filter model does not take into account the steep rise in energy prices, which we think might subtract a bit from structural productivity growth in coming years. Nevertheless, we did think it appropriate to nudge up our productivity growth trend a little. The green line in the middle right panel shows a similar model simulation for the labor force participation rate, again using our previously estimated trend. Here, too, the incoming data have been a little higher than the model would have expected. One can think of potential explanations for this--for example, it may be that strains on household budgets associated with rising costs of food and energy have increased labor force participation among secondary earners, an influence not captured by the model. We are not ready to back away from our basic story that demographics will continue to put downward pressure on the participation rate over time, but we did slightly raise our assumed trend in response to the recent data. The key elements of the labor market forecast are shown in the bottom panels. As indicated to the left, nonfarm payroll employment (the black line) is projected to decline about 40,000 per month through the rest of this year. As the economy improves in 2009, we expect payrolls to start rising again, although at a pace below our estimate of trend employment growth (the green line) for most of the year. As shown in the inset box in the bottom right panel, we expect the unemployment rate to drop back in June from its suspiciously high May reading, which would leave the average jobless rate in the second quarter at 5.3 percent. However, with employment declines projected to continue for a while longer, we expect the unemployment rate to drift up to 5.7 percent by early next year and remain near that level through the end of 2009. Exhibit 11 presents the near-term inflation outlook. As you can see in the top left panel, the recent data on consumer prices have come in a little lower than we had expected at the time of the April Greenbook. As shown on line 3, core PCE prices rose only 0.1 percent in April, and based on the latest CPI and PPI readings, we expect an increase of 0.2 percent in May. As a result, we have marked down our estimate of core PCE inflation in the second quarter by 0.3 percentage point, to an annual rate of 2 percent. Total PCE prices (line 1) have risen at a substantially faster pace than core prices; but here, too, the current-quarter forecast is a little lower than in our previous projection, both because of the lower core inflation and because the sharp increases in oil prices have been slow to feed through to finished energy prices. Despite this recent news, we expect inflation to rise sharply over the next few months. In part, this reflects our judgment that core prices were held down in the first half by some factors that will not persist into the second half. In addition, as shown to the right, we expect increases in food and energy prices to push up the twelve-month change in the total PCE price index more than 1 percentage point over the next several months, to about 4� percent. The remaining panels of the exhibit focus on the projection for energy and food prices. As shown by the black line in the middle left panel, rising crude oil prices have pushed up retail gasoline prices sharply so far this year. Even so, margins are still relatively low, and we expect further sizable increases in pump prices in coming months. Spot prices for natural gas (the red line) have also risen noticeably, reflecting its substitutability with crude oil. Meanwhile, prices for crops, plotted in black at the right, have moved well above the levels at the time of the April Greenbook, mainly in response to the severe flooding in the Midwest. The higher prices for grains have also pushed up livestock prices (the blue line), although recent increases in supply have tempered this rise somewhat. In both cases, futures prices indicate that market participants expect these prices to flatten out at about their current levels. The bottom two panels show our forecast for overall consumer food and energy prices. Based on current futures prices, we expect energy price inflation to move yet higher next quarter before slowing to a pace close to zero in 2009. We expect food prices to show a similar--albeit less pronounced--pattern, with the fourquarter change peaking at about 5 percent this quarter and then decelerating to a pace of 2� percent next year. The upper panels of your next exhibit examine the implications of the recent increases in energy and other commodity prices for core inflation. The first thing to note is that these increases are showing through to producers' costs. As indicated in the top left panel, the producer price index for core intermediate materials (the black line) has accelerated yet again and was up more than 7 percent over the past twelve months, with especially large increases for metal products and energy-intensive materials. Likewise, the diffusion index for prices paid from the Institute for Supply Management's manufacturing survey (the red line) has climbed steadily since late last year. As Nathan noted, rising commodity prices have been an important source of the sizable increases in import prices shown to the right. In addition, higher energy prices have boosted the costs of shipping goods from manufacturers to wholesalers and retailers. As you can see in the middle left panel, the PPIs for both trucking and rail transport have accelerated sharply over the past year or so. Obviously, a key question is the extent to which these higher costs will be passed through to core consumer prices. The panel to the right provides rough estimates of the size of these pass-throughs from our suite of econometric models, with the effect of energy prices on core PCE inflation shown by the blue bars and the combined effects of import prices and other commodity prices indicated by the red bars. As you can see, these effects add more than 0.6 percentage point to our forecast of core inflation this year. With energy and import prices expected to decelerate, the contribution of these factors to core inflation steps down to � percentage point next year. In contrast to the evidence of greater cost pressures from commodity prices, we've seen no signs of acceleration in labor costs. The bottom left panel plots the three main measures of labor compensation that we follow. None of them suggests that employers have experienced a step-up in the pace of compensation growth; and given the weaker labor market in our projection, we don't think that workers will do much better over the next year and a half either. Accordingly, we expect the rise in trend unit labor costs, shown in the table to the right, to hold steady at about 2 percent per year over the projection period. In putting together our forecast, we've also had to make some decisions about how to interpret the recent data on inflation expectations--the subject of your final exhibit. As shown in the top left panel, some measures of short-run inflation expectations have jumped sharply in response to the run-up in energy and food prices this year. In particular, the Reuters-Michigan measure of one-year-ahead expectations (the blue line) rose above 5 percent in May and remained high in the preliminary June survey. Meanwhile, as shown to the right, indicators of long-run inflation expectations have ranged from roughly unchanged to higher since late April. As I already noted, the recent compensation data do not suggest that higher inflation expectations have started to push up wage increases. However, on balance, we view the data as consistent with a slight updrift in the underlying long-run inflation expectations that drive actual inflation, and we have carried this updrift into the projection period. All told, we expect core PCE inflation (line 3 of the middle left table) to step up to a 2� percent annual rate in the second half of this year, pushed up by the effects of higher input costs and the increase in inflation expectations. In 2009, core inflation is projected to step back down to 2� percent, as the effects of decelerating energy and import prices and a wider unemployment gap offset a small further updrift in expected inflation. We have taken only a small signal from the apparent deterioration in expected inflation, but we view the possibility that inflation expectations will become unmoored in response to the persistently high rate of headline inflation as a risk to our forecast. Accordingly, as indicated in the box to the right, we included in the Greenbook an alternative simulation that assumes that long-run inflation expectations move up � percentage point relative to baseline in the third quarter. Consistent with our usual practice, monetary policy in this simulation is assumed to respond according to the estimated Taylor rule. Both wages and prices are affected by these higher inflation expectations, and as you can see by the green line in the middle panel at the bottom, core inflation rises to 2.6 percent in 2009, almost � percentage point higher than baseline. Monetary policy responds in this simulation by raising the federal funds rate more than in the baseline forecast. As a result of this additional tightening, the unemployment rate declines a bit more slowly, and core inflation moderates to about 2� percent in 2012. Brian will now continue the presentation. " FOMC20061025meeting--202 200,MS. YELLEN.," Thank you, Mr. Chairman. I support keeping rates unchanged. On the wording, I guess I lean slightly toward B+ over B, but it’s not a matter that I feel strongly about, and I could certainly accept either alternative. I remain quite uncertain about how the various forces in the economy are going to play out. As I said in the economic go-round, I think that, if we maintain the current stance of policy, most likely we will get the desirable features of a soft landing with inflation coming down gradually. But I do think there are substantial risks for output growth. I guess they’re balanced around moderate growth, but I remain concerned about a downside that would include a period of sustained and significant weakness. On the inflation front, I do think that the risks remain tilted in the direction of higher inflation both because I’m uncertain just how the inflation process is working and because, while I believe inflation will come down, I don’t have confidence in the scenario underlying it. If we don’t get the play-out of the downside housing risks, I think there is some probability that growth will actually be sufficiently strong that we’ll get some upward pressure on inflation from the labor market. We’re going to learn a lot by December. A lot of data are coming out that will bear on growth, inflation pressures, the labor market, and so forth. It clearly makes sense to wait. I guess I’m slightly attracted to B+ over B because I think the language more clearly suggests an upward bias for future rate changes and that does reflect my view of the risks to inflation and the likely path of policy. At a minimum, it seems to push back a bit against the market’s view that we’re going to be unwinding rather quickly. But I take the arguments that have been made around the table for B as opposed to B+. I’m not sure that there really is much to be gained by changing the language we have in place on this, and leaving it alone may be the wiser course at the end of the day. On section 2, I think that Governor Kohn made a good argument for changing that language. Again, I could go either way. Finally, on section 3, I prefer the wording in alternative A to that in alternative B. Referring to the high level of prices of energy and other commodities, given that we’ve had a substantial decline in energy prices, really does seem a bit out of date and a bit out of touch." FOMC20060510meeting--133 131,MR. REINHART.,"2 Thank you, Mr. Chairman. Over the intermeeting period, the data came in stronger than the tone of the Committee’s deliberations in March would have led any listener to suspect. As a result, Committee communications that reflected that discussion— including the minutes, speeches by some of you, and the Chairman’s testimony—tended to pull down the expectations of future policy action, plotted in the top panel of your first exhibit, even as data releases tended to push them up. On net, the data won, and the path of policy expectations, the middle left panel, rotated up 25 to 35 basis points. The term structure of nominal Treasury yields also rotated up, implying increases in nominal forward rates, the blue bars in the middle right panel, of 25 to 55 basis points. These gains outstripped the rise in real forward rates, the green bars, resulting in significant increases in inflation compensation, the difference in the height of the bars. Inflation compensation over the next five to ten years is plotted in the bottom panel. How you interpret these movements is likely a critical element in your policy choice today. On the one hand, the recent rise in inflation compensation, the shaded yellow area, has not moved it noticeably above its range of variation in the past two years. Indeed, at 2¾ percent, forward inflation compensation is lower than at times when the Committee described inflation or inflation expectations in previous policy statements as “contained” or “well contained,” the blue shaded areas. If you think that is still the case, then you also probably believe that you have scope to be patient in policy setting. On the other hand, if you focus on the 20 basis point rise over the intermeeting period, you might conclude that there’s been a partial outbreak of inflation jitters—not a pandemic, mind you, but the first instance of trader-to-trader transmission. [Laughter] The anti-virus typically prescribed is a vigorous assertion of your willingness to tighten policy. Other evidence of possible inflation concerns is the subject covered at the top of your next exhibit. From left to right, survey measures of household inflation expectations have moved up for both near-term and longer-term horizons, and the value of the dollar has fallen sharply on foreign exchange markets. It might be that financial market participants place some weight on domestic spending retaining considerable momentum, putting pressures on resources. One such scenario was played out in the Greenbook and is summarized in the 2 The materials used by Mr. Reinhart are appended to this transcript (appendix 2). middle panels. In the “Domestic Boom” alternative scenario, the growth of spending does not moderate much—perhaps because a slowing in house-price appreciation does not materialize and firms begin to dip into their ample cash coffers to fund investment. Inflation differs little from the baseline, but that is, in part, because policy responds, raising the nominal funds rate to 6¼ percent—as in the dashed line at the right. This provides an opportunity to repeat a point made at Monday’s briefing. Such an action would be inconsistent with current market expectations in that it would place the rate at the top of the 90 percent confidence band implied by options prices (the blue span). But our understanding of the economy—as encapsulated in stochastic simulations of the FRB/US model—is sufficiently imprecise (the green range) that such an outcome shouldn’t be all that surprising. Speaking of surprises, a major objection to tightening 50 basis points at this meeting to show your anti-inflation resolve, as in alternative C of the Bluebook, is that it would catch market participants unaware. Indeed, as shown in the bottom panel, it would be the biggest surprise of the modern era of FOMC announcements, at least as measured from futures market readings just before the statement had been released. In contrast, the 25 basis point action discussed in exhibit 3 is exactly what the market is looking for. Moreover, the staff projects that the economy will hit what you might consider to be a sweet spot, with the unemployment rate (the top left panel) zeroing in on its natural rate and core PCE inflation (the top right) receding to 2 percent. That forecast is predicated on firming action today and none thereafter. Alternative B in the Bluebook was structured to accompany such an action with the message that there is some chance that you might be done today, but you might not. As can be seen in the middle left panel, energy prices have moved up sharply, which poses the classic tension of dragging down spending while imparting some lift to inflation. In that regard, the relationship between changes in energy prices and core inflation—as at the middle right—has been tenuous at best over the past twenty years, suggesting you might prefer to focus more on the consequences of the oil shock on aggregate demand than inflation. If so, you might view that source of additional restraint as a substitute for further monetary policy firming. A ¼ point hike today will bring the real federal funds rate, the solid line in the bottom panel, toward the high end of the range of estimates of its equilibrium—another reason you might view yourself as done, or at least close to done. Indeed, if you give credence to the simulations presented in the Bluebook you might view yourself as already done, which is why we included alternative A, the subject of exhibit 4. If you have an inflation goal of 2 percent and agree with the staff assessment that the equilibrium real rate is around 2¾ percent, then the current nominal funds rate of 4¾ percent probably has a lot of appeal. When we ran simulations of the version of the FRB/US model in which market participants are forward looking, holding the funds rate at 4¾, as in the top left panel, instead of tightening some and backing off a bit later, does not matter much for the paths of the unemployment rate and inflation (the bottom panels). Thus, from the perspective offered by the staff model, you can go home now and not come back until the next decade, which by the way will make the work of Governor Kohn’s subcommittee easier. [Laughter] Your last exhibit gives alternative statement language, where the items in red denote new wording relative to the March statement and those in blue represent changes relative to what you saw in the Bluebook. Some concern was expressed that alternative B did not convey sufficient concern about inflation risks, so we’ve tightened it up somewhat. As can be seen, this alternative, first, stresses that current economic growth is quite strong (row 2); second, in row 3 it now simply repeats the March language verbatim; and third, it drops the word “modest” in referring to the outlook for policy firming. One last one-word change did not get onto the table. In the second sentence of row 2, we’re proposing to go back to the March language and refer to a growth as “likely to moderate to a more sustainable pace” instead of “toward a more sustainable pace.” That concludes my prepared remarks." CHRG-109shrg30354--127 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System July 19, 2006 Mr. Chairman and Members of the Committee, I am pleased to be here again to present the Federal Reserve's Monetary Policy Report to the Congress. Over the period since our February report, the U.S. economy has continued to expand. Real gross domestic product (GDP) is estimated to have risen at an annual rate of 5.6 percent in the first quarter of 2006. The available indicators suggest that economic growth has more recently moderated from that quite strong pace, reflecting a gradual cooling of the housing market and other factors that I will discuss. With respect to the labor market, more than 850,000 jobs were added, on net, to nonfarm payrolls over the first 6 months of the year, though these gains came at a slower pace in the second quarter than in the first. Last month, the unemployment rate stood at 4.6 percent. Inflation has been higher than we had anticipated in February, partly as a result of further sharp increases in the prices of energy and other commodities. During the first 5 months of the year, overall inflation as measured by the price index for personal consumption expenditures averaged 4.3 percent at an annual rate. Over the same period, core inflation--that is, inflation excluding food and energy prices--averaged 2.6 percent at an annual rate. To address the risk that inflation pressures might remain elevated, the Federal Open Market Committee (FOMC) continued to firm the stance of monetary policy, raising the Federal funds rate another \3/4\ percentage point, to 5\1/4\ percent, in the period since our last report. Let me now review the current economic situation and the outlook in a bit more detail, beginning with developments in the real economy and then turning to the inflation situation. I will conclude with some comments on monetary policy. The U.S. economy appears to be in a period of transition. For the past 3 years or so, economic growth in the United States has been robust. This growth has reflected both the ongoing reemployment of underutilized resources, as the economy recovered from the weakness of earlier in the decade, and the expansion of the economy's underlying productive potential, as determined by such factors as productivity trends and growth of the labor force. Although the rates of resource utilization that the economy can sustain cannot be known with any precision, it is clear that, after several years of above-trend growth, slack in resource utilization has been substantially reduced. As a consequence, a sustainable, noninflationary expansion is likely to involve a modest reduction in the growth of economic activity from the rapid pace of the past 3 years to a pace more consistent with the rate of increase in the Nation's underlying productive capacity. It bears emphasizing that, because productivity growth seems likely to remain strong, the productive capacity of our economy should expand over the next few years at a rate sufficient to support solid growth in real output. As I have noted, the anticipated moderation in economic growth now seems to be under way, although the recent erratic growth pattern complicates this assessment. That moderation appears most evident in the household sector. In particular, consumer spending, which makes up more than two-thirds of aggregate spending, grew rapidly during the first quarter but decelerated during the spring. One likely source of this deceleration was higher energy prices, which have adversely affected the purchasing power of households and weighed on consumer attitudes. Outlays for residential construction, which have been at very high levels in recent years, rose further in the first quarter. More recently, however, the market for residential real estate has been cooling, as can be seen in the slowing of new and existing home sales and housing starts. Some of the recent softening in housing starts may have resulted from the unusually favorable weather during the first quarter of the year, which pulled forward construction activity, but the slowing of the housing market appears to be more broad-based than can be explained by that factor alone. Home prices, which have climbed at double-digit rates in recent years, still appear to be rising for the Nation as a whole, though significantly less rapidly than before. These developments in the housing market are not particularly surprising, as the sustained run-up in housing prices, together with some increase in mortgage rates, has reduced affordability and thus the demand for new homes. The slowing of the housing market may restrain other forms of household spending as well. With homeowners no longer experiencing increases in the equity value of their homes at the rapid pace seen in the past few years, and with the recent declines in stock prices, increases in household net worth are likely to provide less of a boost to consumer expenditures than they have in the recent past. That said, favorable fundamentals, including relatively low unemployment and rising disposable incomes, should provide support for consumer spending. Overall, household expenditures appear likely to expand at a moderate pace, providing continued impetus to the overall economic expansion. Although growth in household spending has slowed, other sectors of the economy retain considerable momentum. Business investment in new capital goods appears to have risen briskly, on net, so far this year. In particular, investment in non-residential structures, which had been weak since 2001, seems to have picked up appreciably, providing some offset to the slower growth in residential construction. Spending on equipment and software has also been strong. With a few exceptions, business inventories appear to be well-aligned with sales, which reduces the risk that a buildup of unwanted inventories might act to reduce production in the future. Business investment seems likely to continue to grow at a solid pace, supported by growth in final sales, rising backlogs of orders for capital goods, and high rates of profitability. To be sure, businesses in certain sectors have experienced financial difficulties. In the aggregate, however, firms remain in excellent financial condition, and credit conditions for businesses are favorable. Globally, output growth appears strong. Growth of the global economy will help support U.S. economic activity by continuing to stimulate demand for our exports of goods and services. One downside of the strength of the global economy, however, is that it has led to significant increases in the demand for crude oil and other primary commodities over the past few years. Together with heightened geopolitical uncertainties and the limited ability of suppliers to expand capacity in the short run, these rising demands have resulted in sharp rises in the prices at which those goods are traded internationally, which in turn has put upward pressure on costs and prices in the United States. Overall, the U.S. economy seems poised to grow in coming quarters at a pace roughly in line with the expansion of its underlying productive capacity. Such an outlook is embodied in the projections of members of the Board of Governors and the Presidents of Federal Reserve Banks that were made around the time of the FOMC meeting late last month, based on the assumption of appropriate monetary policy. In particular, the central tendency of those forecasts is for real GDP to increase about 3\1/4\ percent to 3\1/2\ percent in 2006 and 3 percent to 3\1/4\ percent in 2007. With output expanding at a pace near that of the economy's potential, the civilian unemployment rate is expected to finish both 2006 and 2007 between 4\3/4\ percent and 5 percent, close to its recent level. I turn now to the inflation situation. As I noted, inflation has been higher than we expected at the time of our last report. Much of the upward pressure on overall inflation this year has been due to increases in the prices of energy and other commodities and, in particular, to the higher prices of products derived from crude oil. Gasoline prices have increased notably as a result of the rise in petroleum prices as well as factors specific to the market for ethanol. The pickup in inflation so far this year has also been reflected in the prices of a range of nonenergy goods and services, as strengthening demand may have given firms more ability to pass energy and other costs through to consumers. In addition, increases in residential rents, as well as in the imputed rent on owner-occupied homes, have recently contributed to higher core inflation. The recent rise in inflation is of concern to the FOMC. The achievement of price stability is one of the objectives that make up the Congress's mandate to the Federal Reserve. Moreover, in the long run, price stability is critical to achieving maximum employment and moderate long-term interest rates, the other parts of the Congressional mandate. The outlook for inflation is shaped by a number of factors, not the least of which is the course of energy prices. The spot price of oil has moved up significantly further in recent weeks. Futures quotes imply that market participants expect petroleum prices to roughly stabilize in coming quarters; such an outcome would, over time, reduce one source of upward pressure on inflation. However, expectations of a leveling out of oil prices have been consistently disappointed in recent years, and as the experience of the past week suggests, possible increases in these and other commodity prices remain a risk to the inflation outlook. Although the costs of energy and other raw materials are important, labor costs are by far the largest component of business costs. Anecdotal reports suggest that the labor market is tight in some industries and occupations and that employers are having difficulty attracting certain types of skilled workers. To date, however, moderate growth in most broad measures of nominal labor compensation and the ongoing increases in labor productivity have held down the rise in unit labor costs, reducing pressure on inflation from the cost side. Employee compensation per hour is likely to rise more quickly over the next couple of years in response to the strength of the labor market. Whether faster increases in nominal compensation create additional cost pressures for firms depends in part on the extent to which they are offset by continuing productivity gains. Profit margins are currently relatively wide, and the effect of a possible acceleration in compensation on price inflation would thus also depend on the extent to which competitive pressures force firms to reduce margins rather than pass on higher costs. The public's inflation expectations are another important determinant of inflation. The Federal Reserve must guard against the emergence of an inflationary psychology that could impart greater persistence to what would otherwise be a transitory increase in inflation. After rising earlier this year, measures of longer-term inflation expectations, based on surveys and on a comparison of yields on nominal and inflation-indexed government debt, have edged down and remain contained. These developments bear watching, however. Finally, the extent to which aggregate demand is aligned with the economy's underlying productive potential also influences inflation. As I noted earlier, FOMC participants project that the growth in economic activity should moderate to a pace close to that of the growth of potential both this year and next. Should that moderation occur as anticipated, it should help to limit inflation pressures over time. The projections of the Members of the Board of Governors and the Presidents of the Federal Reserve Banks, which are based on information available at the time of the last FOMC meeting, are for a gradual decline in inflation in coming quarters. As measured by the price index for personal consumption expenditures excluding food and energy, inflation is projected to be 2\1/4\ percent to 2\1/2\ percent this year and then to edge lower, to 2 percent to 2\1/4\ percent next year. The FOMC projections, which now anticipate slightly lower growth in real output and higher core inflation than expected in our February report, mirror the somewhat more adverse circumstances facing our economy, which have resulted from the recent steep run-up in energy costs and higher-than-expected inflation more generally. But they also reflect our assessment that, with appropriate monetary policy and in the absence of significant unforeseen developments, the economy should continue to expand at a solid and sustainable pace and core inflation should decline from its recent level over the medium term. Although our baseline forecast is for moderating inflation, the Committee judges that some inflation risks remain. In particular, the high prices of energy and other commodities, in conjunction with high levels of resource utilization that may increase the pricing power of suppliers of goods and services, have the potential to sustain inflation pressures. More generally, if the pattern of elevated readings on inflation is more protracted or more intense than is currently expected, this higher level of inflation could become embedded in the public's inflation expectations and in price-setting behavior. Persistently higher inflation would erode the performance of the real economy and would be costly to reverse. The Federal Reserve must take account of these risks in making its policy decisions. In our pursuit of maximum employment and price stability, monetary policy makers operate in an environment of uncertainty. In particular, we have imperfect knowledge about the effects of our own policy actions as well as of the many other factors that will shape economic developments during the forecast period. These uncertainties bear importantly on our policy decisions because the full influence of policy actions on the economy is felt only after a considerable period of time. The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth. In formulating that outlook, we must take account of the possible future effects of previous policy actions--that is, of policy effects still ``in the pipeline.'' Finally, as I have noted, we must consider not only what appears to be the most likely outcome but also the risks to that outlook and the costs that would be incurred should any of those risks be realized. At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts demand. Thus, policy must be flexible and ready to adjust to changes in economic projections. In particular, as the Committee noted in the statement issued after its June meeting, the extent and timing of any additional firming that may be needed to address inflation risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by our analysis of the incoming information. Thank you. I would be happy to take questions. CHRG-110shrg50369--14 Mr. Bernanke," I will conclude with a quick update on the Federal Reserve's recent actions to help protect consumers in their financial dealings. The economic situation has become distinctly less favorable since the time of our July report. Strains in financial markets, which first became evident late last summer, have persisted; and pressures on bank capital and the continued poor functioning of markets for securitized credit have led to tighter credit conditions for many households and businesses. The growth of real gross domestic product held up well through the third quarter despite the financial turmoil, but it has since slowed sharply. Labor market conditions have similarly softened, as job creation has slowed and the unemployment rate--at 4.9 percent in January--has moved up somewhat. Many of the challenges now facing our economy stem from the continuing contraction of the U.S. housing market. In 2006, after a multiyear boom in residential construction and house prices, the housing market reversed course. Housing starts and sales of new homes are now less than half of their respective peaks, and house prices have flattened or declined in many areas. Changes in the availability of mortgage credit amplified the swings in the housing market. During the housing sector's expansion phase, increasingly lax lending standards, particularly in the subprime market, raised the effective demand for housing, pushing up prices and stimulating construction activity. As the housing market began to turn down, however, the slump in subprime mortgage originations, together with a more general tightening of credit conditions, has served to increase the severity of the downturn. Weaker house prices in turn have contributed to the deterioration in the performance of mortgage-related securities and reduced the availability of mortgage credit. The housing market is expected to continue to weigh on economic activity in coming quarters. Home builders, still faced with abnormally high inventories of unsold homes, are likely to cut the pace of their building activity further, which will subtract from overall growth and reduce employment in residential construction and closely related industries. Consumer spending continued to increase at a solid pace through much of the second half of 2007, despite the problems in the housing market, but it appears to have slowed significantly toward the end of the year. The jump in the price of imported energy, which eroded real incomes and wages, likely contributed to the slowdown in spending, as did the declines in household wealth associated with the weakness in house prices and equity prices. Slowing job creation is yet another potential drag on household spending, as gains in payroll employment averaged little more than 40,000 per month during the 3 months ending in January, compared with an average increase of almost 100,000 per month over the previous 3 months. However, the recently enacted fiscal stimulus package should provide some support for household spending during the second half of this year and into next year. The business sector has also displayed signs of being affected by the difficulties in the housing and credit markets. Reflecting a downshift in the growth of final demand and tighter credit conditions for some firms, available indicators suggest that investment in equipment and software will be subdued during the first half of 2008. Likewise, after growing robustly through much of 2007, nonresidential construction is likely to decelerate sharply in coming quarters as business activity slows and funding becomes harder to obtain, especially for more speculative projects. On a more encouraging note, we see few signs of any serious imbalances in business inventories aside from the overhang of unsold homes. And, as a whole, the nonfinancial business sector remains in good financial condition, with strong profits, liquid balance sheets, and corporate leverage near historical lows. In addition, the vigor of the global economy has offset some of the weakening of domestic demand. U.S. real exports of goods and services increased at an annual rate of about 11 percent in the second half of last year, boosted by continuing economic growth abroad and the lower foreign exchange value of the dollar. Strengthening exports, together with moderating imports, have in turn led to some improvement in the U.S. current account deficit, which likely narrowed in 2007--on an annual basis--for the first time since 2001. Although recent indicators point to some slowing of foreign economic growth, U.S. exports should continue to expand at a healthy pace in coming quarters, providing some impetus to domestic economic activity and employment. As I have mentioned, financial markets continue to be under considerable stress. Heightened investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates, triggered the financial turmoil. However, other factors, including a broader retrenchment in the willingness of investors to bear risk, difficulties in valuing complex or illiquid financial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for economic growth, have also roiled the financial markets in recent months. To help relieve the pressures in the market for interbank lending, the Federal Reserve--among other actions--recently introduced a term auction facility, through which prespecified amounts of discount window credit are auctioned to eligible borrowers, and we have been working with other central banks to address market strains that could hamper the achievement of our broader economic objectives. These efforts appear to have contributed to some improvement in short-term funding markets. We will continue to monitor financial developments closely. As part of its ongoing commitment to improving the accountability and public understanding of monetary policymaking, the Federal Open Market Committee--or FOMC--recently increased the frequency and expanded the content of the economic projections made by Federal Reserve Board members and Reserve Bank presidents and released to the public. The latest economic projections, which were submitted in conjunction with the FOMC meeting at the end of January and which are based on each participant's assessment of appropriate monetary policy, show that real GDP was expected to grow only sluggishly in the next few quarters and that the unemployment rate was likely to increase somewhat. In particular, the central tendency of the projections was for real GDP to grow between 1.3 percent and 2.0 percent in 2008, down from 2\1/2\ percent to 2\3/4\ percent projected in our report last July. FOMC participants' projections for the unemployment rate in the fourth quarter of 2008 have a central tendency of 5.2 percent to 5.3 percent, up from the level of about 4\3/4\ percent projected last July for the same period. The downgrade in our projections for economic activity in 2008 since our report last July reflects the effects of the financial turmoil on real activity and a housing contraction that has been more severe than previously expected. By 2010, our most recent projections show output growth picking up to rates close to or a little above its longer-term trend and the unemployment rate edging lower; the improvement reflects the effects of policy stimulus and an anticipated moderation of the contraction in housing and the strains in financial and credit markets. The incoming information since our January meeting continues to suggest sluggish economic activity in the near term. The risks to this outlook remain to the downside. The risks include the possibilities that the housing market or the labor market may deteriorate more than is currently anticipated and that credit conditions may tighten substantially further. Consumer price inflation has increased since our previous report, in substantial part because of the steep run-up in the price of oil. Last year, food prices also increased significantly, and the dollar depreciated. Reflecting these influences, the price index for personal consumption expenditures--or PCE--increased 3.4 percent over the four quarters of 2007, up from 1.9 percent in 2006. Core price inflation--that is, inflation excluding food and energy prices--also firmed toward the end of the year. The higher recent readings likely reflected some pass-through of energy costs to the prices of core consumer goods and services as well as the effect of the depreciation of the dollar on import prices. Moreover, core inflation in the first half of 2007 was damped by a number of transitory factors--notably, unusually soft prices for apparel and for financial services--which subsequently reversed. For the year as a whole, however, core PCE prices increased 2.1 percent, down slightly from 2006. The projections recently submitted by FOMC participants indicate that overall PCE inflation was expected to moderate significantly in 2008, to between 2.1 percent and 2.4 percent--the central tendency of the projections. A key assumption underlying those projections was that energy and food prices would begin to flatten out, as implied by quotes on futures markets. In addition, diminishing pressure on resources is also consistent with the projected slowing in inflation. The central tendency of the projections for core PCE inflation in 2008, at 2.0 percent to 2.2 percent, was a bit higher than in our July report, largely because of some higher-than-expected recent readings on prices. Beyond 2008, both overall and core inflation were projected to edge lower, as participants expected inflation expectations to remain reasonably well anchored and pressures on resource utilization to be muted. The inflation projections submitted by FOMC participants for 2010--which ranged from 1.5 percent to 2.0 percent for overall PCE inflation--were importantly influenced by participants' judgments about the measured rates of inflation consistent with the Federal Reserve's dual mandate and about the timeframe over which policy should aim to achieve those rates. The rate of inflation that is actually realized will, of course, depend on a variety of factors. Inflation could be lower than we anticipate if slower-than-expected global growth moderates the pressure on the prices of energy and other commodities or if rates of domestic resource utilization fall more than we currently expect. Upside risks to the inflation projection are also present, however, including the possibilities that energy and food prices do not flatten out or that the pass-through to core prices from higher commodity prices and from the weaker dollar may be greater than we anticipate. Indeed, the further increases in the prices of energy and other commodities in recent weeks, together with the latest data on consumer prices, suggest slightly greater upside risks to the projections of both overall and core inflation than we saw last month. Should high rates of overall inflation persist, the possibility also exists that inflation expectations could become less well anchored. Any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and could reduce the flexibility of the FOMC to counter shortfalls in growth in the future. Accordingly, in the months ahead, the Federal Reserve will continue to monitor closely inflation and inflation expectations. Let me turn now to the implications of these developments for monetary policy. The FOMC has responded aggressively to the weaker outlook for economic activity, having reduced its target for the Federal funds rate by 225 basis points since last summer. As the Committee noted in its most recent post-meeting statement, the intent of those actions has been to help promote moderate growth over time and to mitigate the risks to economic activity. A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability in an environment of downside risks to growth, stressed financial conditions, and inflation pressures. In particular, the FOMC will need to judge whether the policy actions taken thus far are having their intended effects. Monetary policy works with a lag. Therefore, our policy stance must be determined in light of the medium-term forecast for real activity and inflation as well as by the risks to that forecast. Although the FOMC participants' economic projections envision an improving economic picture, it is important to recognize that downside risks to growth remain. The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks. Finally, I would like to say a few words about the Federal Reserve's recent actions to protect consumers in their financial transactions. In December, following up on a commitment I made at the time of our report last July, the Board issued for public comment a comprehensive set of new regulations to prohibit unfair or deceptive practices in the mortgage market, under the authority granted us by the Home Ownership and Equity Protection Act of 1994. The proposed rules would apply to all mortgage lenders and would establish lending standards to help ensure that consumers who seek mortgage credit receive loans whose terms are clearly disclosed and that can reasonably be expected to be repaid. Accordingly, the rules would prohibit lenders from engaging in a pattern or practice of making higher-priced mortgage loans without due regard to consumers' ability to make the scheduled payments. In each case, a lender making a higher-priced loan would have to use third-party documents to verify the income relied on to make the credit decision. For higher-priced loans, the proposed rules would require the lender to establish an escrow account for the payment of property taxes and homeowners' insurance and would prevent the use of prepayment penalties in circumstances where they might trap borrowers in unaffordable loans. In addition, for all mortgage loans, our proposal addresses misleading and deceptive advertising practices, requires borrowers and brokers to agree in advance on the maximum fee that the broker may receive, bans certain practices by servicers that harm borrowers, and prohibits coercion of appraisers by lenders. We expect substantial public comment on our proposal, and we will carefully consider all information and viewpoints while moving expeditiously to adopt final rules. The effectiveness of the new regulations, however, will depend critically on strong enforcement. To that end, in conjunction with other Federal and State agencies, we are conducting compliance reviews of a range of mortgage lenders, including nondepository lenders. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations of, and improved enforcement for, all categories of mortgage lenders. The Federal Reserve continues to work with financial institutions, public officials, and community groups around the country to help homeowners avoid foreclosures. We have called on mortgage lenders and servicers to pursue prudent loan workouts and have supported the development of a streamlined, systematic approach to expedite the loan modification process. We also have been providing community groups, counseling agencies, regulators, and others with detailed analyses to help identify neighborhoods at high risk from foreclosures so that local outreach efforts to help troubled borrowers can be as focused and effective as possible. We are actively pursuing other ways to leverage the Federal Reserve's analytical resources, regional presence, and community connections to address this critical issue. In addition to our consumer protection efforts in the mortgage area, we are working toward finalizing rules under the Truth in Lending Act that will require new, more informative, and consumer-tested disclosures by credit card issuers. Separately, we are actively reviewing potentially unfair and deceptive practices by issuers of credit cards. Using the Board's authority under the Federal Trade Commission Act, we expect to issue proposed rules regarding these practices this spring. Thank you. I would be pleased to take your questions. " FOMC20080625meeting--160 158,MR. KROSZNER.," Thank you very much. Obviously, as we have all discussed, we are facing enormous challenges from the continuing strength in prices and price changes in energy and raw materials. Now, some of those are relative price changes that we don't have the tools to address directly. Recently, we have seen wheat come down as Australia has been able to replant, and it seems that things are going to come back. Corn has gone up, as we heard from a number of people around the table, because of the challenges there. We don't have the tools to address that directly, but obviously, when so many of these commodity prices and energy prices are going up, that leads to concerns about where both headline inflation and core inflation are going. So we definitely do have to be very mindful of that. I think the type of approach that we are taking in alternative B is a reasonable one. Given the challenges that we are facing right now with the fragility in the financial markets--the continuing smoldering of those embers, with still chances that they could reignite and cause us a great deal of difficulty--it seems sensible to me to be roughly where we are now in terms of policy but to be signaling that we understand that challenges are coming from various sources that could lead to inflation pressures and that we need to be ready to offset those. In terms of how accommodative monetary policy is, I think actually it would be worthwhile--and maybe at the end of this I might pose a question to Brian--to look at LIBOR� OIS spreads and how much they typically go up during recessionary periods. I know that other risk spreads typically go up, but my understanding is that those typically don't go up as much. Since so many contracts are based off the one-month and three-month LIBOR, that 75 basis points suggests that at least now we might want to take that into account in thinking about where monetary policy stands relative to other times when we would have had a funds rate at roughly this level. In terms of the language, I share Governor Warsh's view on the use or lack of use of the word ""considerable."" I think President Stern's suggestion--this is always a very dangerous and difficult game--would actually push the markets further than they are because I agree that broadly the path that they are seeing in the future is a reasonable one for them to see. This language would roughly keep it there. Taking out the acknowledgement of downside risks to growth remaining would make me concerned because (1) I certainly see those as still being there and (2) I think that would push the markets further to think that this is a signal that next time we are going to do it, and I don't think we are quite there yet. Thank you, Mr. Chairman. " CHRG-111shrg51290--67 The combination of easing credit standards and a growing economy resulted in a sharp increase in homeownership rates through 2004. As the credit quality of loans steadily grew worse over 2005 through 2007,\13\ however, the volume of unsustainable loans grew and homeownership rates dropped.\14\ (See Table 1).--------------------------------------------------------------------------- \13\ Subprime mortgage originated in 2005, 2006 and 2007 had successively worse default experiences than vintages in prior years. See Freddie Mac, Freddie Mac Update 19 (December 2008), available at www.freddiemac.com/investors/pdffiles/investor-presentation.pdf. \14\ See Jesse M. Abraham, Andrey Pavlov & Susan Wachter, Explaining the United States' Uniquely Bad Housing Market, XII Wharton Real Estate Rev. 24 (2008).--------------------------------------------------------------------------- Table 1. U.S. Homeownership Rates, by Year (U.S. Census Bureau) The explosion of nontraditional mortgage lending was timed to maintain securitization deal flows after traditional refinancings weakened in 2003. The major take-off in these products occurred in 2002, which coincided with the winding down of the huge increase in demand for mortgage securities through the refinance process. Coming out of the recession of 2001, interest rates fell and there was a massive securitization boom through refinancing that was fueled by low interest rates. The private-label securitization industry had grown in capacity and profits. But in 2003, rising interest rates ended the potential for refinancing at ever lower interest rates, leading to an increased need for another source of mortgages to maintain and grow the rate of securitization and the fees it generated. The ``solution'' was the expansion of the market through nontraditional mortgages, especially interest-only loans and option payment ARMs offering negative amortization. (See Figure 1 supra). This expansion of credit swept a larger portion of the population into the potential homeowner pool, driving up housing demand and prices, and consumer indebtedness. Indeed, consumer indebtedness grew so rapidly that between 1975 and 2007, total household debt soared from around 43 percent to nearly 100 percent of gross domestic product.\15\--------------------------------------------------------------------------- \15\ U.S. Federal Reserve Board, Bureau of Economic Analysis.--------------------------------------------------------------------------- The growth in nonprime mortgages was accomplished through market expansion of nontraditional mortgages and by qualifying more borrowing through easing of traditional lending terms. For example, while subprime mortgages were initially made as ``hard money'' loans with low loan-to-value ratios, by the height of their growth, combined loan-to-value ratios exceeded that of the far less risky prime market. (See Figure 3 supra). While the demand for riskier mortgages grew fueled by the need for product to securitize, the potential risk due to deteriorating lending standards also grew.B. Consumer Confusion If borrowers had been able to distinguish safe loans from highly risky loans, risky loans would not have crowded out the market. But numerous borrowers were not able to do so, for three distinct reasons. First, hybrid subprime ARMs, interest-only mortgages, and option payment ARMs were baffling in their complexity. Second, it was impossible to obtain binding price quotes early enough to permit meaningful comparison shopping in the nonprime market. Finally, borrowers usually did not know that mortgage brokers got higher compensation for steering them into risky loans. Hidden Risks--The arcane nature of hybrid ARMs, interest-only loans, and option payment ARMs often made informed consumer choice impossible. These products were highly complex instruments that presented an assortment of hidden risks to borrowers. Chief among those risks was payment shock--in other words, the risk that monthly payments would rise dramatically upon rate reset. These products presented greater potential payment shock than conventional ARMs, which had lower reset rates and manageable lifetime caps. Indeed, with these exotic ARMs, the only way interest rates could go was up. Many late vintage subprime hybrid ARMs had initial rate resets of 3 percentage points, resulting in increased monthly payments of 50 percent to 100 percent or more.\16\--------------------------------------------------------------------------- \16\ Statement of Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation, on Strengthening the Economy: Foreclosure Prevention and Neighborhood Preservation, before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, 538 Dirksen Senate Office Building, January 31, 2008, www.fdic.gov/news/news/speeches/chairman/spjan3108.html. --------------------------------------------------------------------------- For a borrower to grasp the potential payment shock on a hybrid, interest-only, or option payment ARM, he or she would need to understand all the moving parts of the mortgage, including the index, rate spread, initial rate cap, and lifetime rate cap. On top of that, the borrower would need to predict future interest rate movements and translate expected rate changes into changes in monthly payments. Interest-only ARMs and option payment ARMs had the added complication of potential deferred or negative amortization, which could cause the principal payments to grow. Finally, these loans were more likely to carry large prepayment penalties. To understand the effect of such a prepayment penalty, the borrower would have to use a formula to compute the penalty's size and then assess the likelihood of moving or refinancing during the penalty period.\17\ Truth-in-Lending Act disclosures did not require easy-to-understand disclosures about any of these risks.\18\--------------------------------------------------------------------------- \17\ Federal Reserve System, Truth in Lending, Part III: Final rule, official staff commentary, 73 Fed. Reg. 44522, 44524-25 (July 30, 2008); Federal Reserve System, Truth in Lending, Part II: Proposed rule; request for public comment, 73 Fed. Reg. 1672, 1674 (January 9, 2008). \18\ Patricia A. McCoy, Rethinking Disclosure in a World of Risk-Based Pricing, 44 Harv. J. Legis. 123 (2007), available at http://www.law.harvard.edu/students/orgs/jol/vol44_1/mccoy.pdf. --------------------------------------------------------------------------- Inability to Do Meaningful Comparison Shopping--The lack of binding rate quotes also hindered informed comparison-shopping in the nonprime market. Nonprime loans had many rates, not one, which varied according to the borrower's risk, the originator's compensation, the documentation level of the loan, and the naivety of the borrower. Between their complicated price structure and the wide variety of products, subprime loans were not standardized. Furthermore, it was impossible to obtain a binding price quote in the subprime market before submitting a loan application and paying a non-refundable fee. Rate locks were also a rarity in the subprime market. In too many cases, subprime lenders waited until the closing to unveil the true product and price for the loan, a practice that the Truth in Lending Act rules countenanced. These rules, promulgated by the Federal Reserve Board, helped foster rampant ``bait-and-switch'' schemes in the subprime market.\19\--------------------------------------------------------------------------- \19\ Id.; Federal Reserve System, Truth in Lending--Proposed rule; request for public comment, 73 Fed. Reg. 1672, 1675 (Jan. 9, 2008).--------------------------------------------------------------------------- As a result, deceptive advertising became a stock-in-trade of the nonprime market. Nonprime lenders and brokers did not advertise their prices to permit meaningful comparison-shopping. To the contrary, lenders treated their rate sheets--which listed their price points and pricing criteria--as proprietary secrets that were not to be disclosed to the mass consumer market. Subprime advertisements generally focused on fast approval and low initial monthly payments or interest rates, not on accurate prices. While the Federal Reserve exhorted people to comparison-shop for nonprime loans,\20\ in reality, comparison-shopping was futile. Nonprime lenders did not post prices, did not provide consumers with firm price quotes, and did not offer lock-in commitments as a general rule. Anyone who attempted to comparison-shop had to pay multiple application fees for the privilege and, even then, might not learn the actual price until the closing if the lender engaged in a bait-and-switch.--------------------------------------------------------------------------- \20\ See, e.g., Federal Reserve Board, Looking for the Best Mortgage, www.federalreserve.gov/pubs/mortgage/mortb_11.htm.--------------------------------------------------------------------------- As early as 1998, the Federal Reserve Board and the Department of Housing and Urban Development were aware that Truth in Lending Act disclosures did not come early enough in the nonprime market to allow meaningful comparison shopping. That year, the two agencies issued a report diagnosing the problem. In the report, HUD recommended changes to the Truth in Lending Act to require mortgage originators to provide binding price quotes before taking loan applications. The Federal Reserve Board dissented from the proposal, however, and it was never adopted.\21\ To this day, the Board has still not revamped Truth in Lending disclosures for closed-end mortgages.--------------------------------------------------------------------------- \21\ See Bd. of Governors of the Fed. Reserve Sys. & Dep't of Hous. & Urban Dev., Joint Report to the Congress, Concerning Reform to the Truth in Lending Act and the Real Estate Settlement Procedures Act, at 28-29, 39-42 (1998), available at www.federalreserve.gov/boarddocs/rptcongress/tila.pdf.--------------------------------------------------------------------------- Perverse Fee Incentives--Finally, many consumers were not aware that the compensation structure rewarded mortgage brokers for riskier loan products and higher interest rates. Mortgage brokers only got paid if they closed a loan. Furthermore, they were paid solely through upfront fees at closing, meaning that if a loan went bad, the losses would fall on the lender or investors, not the broker. In the most pernicious practice, lenders paid brokers thousands of dollars per loan in fees known as yield spread premiums (or YSPs) in exchange for loans saddling borrowers with steep prepayment penalties and higher interest rates than the borrowers qualified for, based on their incomes and credit scores. In sum, these three features--the ability to hide risk, thwart meaningful comparison-shopping, and reward steering--allowed lenders to entice unsuspecting borrowers into needlessly hazardous loans.C. The Crowd-Out Effect The ability to bury risky product features in fine print allowed irresponsible lenders to out-compete safe lenders. Low initial monthly payments were the most visible feature of hybrid ARMs, interest-only loans, and option payment ARMs. During the housing boom, lenders commonly touted these products based on low initial monthly payments while obscuring the back-end risks of those loans.\22\--------------------------------------------------------------------------- \22\ See, e.g., Julie Haviv & Emily Kaiser, Web lenders woo subprime borrowers despite crisis, Reuters (Apr. 22, 2007); E. Scott Reckard, Refinance pitches in sub-prime tone, Los Angeles Times, October 29, 2007.--------------------------------------------------------------------------- The ability to hide risks made it easy to out-compete lenders offered fixed-rate, fully amortizing loans. Other things being equal, the initial monthly payments on exotic ARMs were lower than on fixed-rate, amortizing loans. Furthermore, some nonprime lenders qualified borrowers solely at the low initial rate alone until the Federal Reserve Board finally banned that practice in July 2008.\23\--------------------------------------------------------------------------- \23\ In fall 2006, Federal regulators issued an interagency guidance advising option ARM lenders to qualify borrowers solely at the fully indexed rate. Nevertheless, Washington Mutual (WaMu) apparently continued to qualify applicants for option ARMs at the low, introductory rate alone until mid-2007. It was not until July 30, 2007 that WaMu finally updated its ``Bulk Seller Guide'' to require its correspondents to underwrite option ARMs and other ARMs at the fully indexed rate.--------------------------------------------------------------------------- Of course, many sophisticated customers recognized the dangers of these loans. That did not deter lenders from offering hazardous nontraditional ARMs, however. Instead, the ``one-sizefits-one'' nature of nonprime loans permitted lenders to discriminate by selling safer products to discerning customers and more lucrative, dangerous products to naive customers. Sadly, the consumers who were least well equipped in terms of experience and education to grasp arcane loan terms \24\ ended up with the most dangerous loans.--------------------------------------------------------------------------- \24\ Howard Lax, Michael Manti, Paul Raca & Peter Zorn, Subprime Lending: An Investigation of Economic Efficiency, 15 Housing Pol'y Debate 533, 552-554 (2004), http://www.fanniemaefoundation.org/programs/hpd/pdf/hpd_1503_Lax.pdf. --------------------------------------------------------------------------- In the meantime, lenders who offered safe products--such as fixed-rate prime loans--lost market share to lenders who peddled exotic ARMs with low starting payments. As conventional lenders came to realize that it didn't pay to compete on good products, those lenders expanded into the nonprime market as well.II. The Regulatory Story: Race to the Bottom Federal banking regulators added fuel to the crisis by allowing reckless loans to flourish. It is a basic tenet of banking law that banks should not extend credit without proof of ability to repay. Federal banking regulators \25\ had ample authority to enforce this tenet through safety and soundness supervision and through Federal consumer protection laws. Nevertheless, they refused to exercise their substantial powers of rulemaking, formal enforcement, and sanctions to crack down on the proliferation of poorly underwritten loans until it was too late. Their abdication allowed irresponsible loans to multiply. Furthermore, their green light to banks to invest in investment-grade subprime mortgage-backed securities and CDOs left the nation's largest banks struggling with toxic assets. These problems were a direct result of the country's fragmented system of financial regulation, which caused regulators to compete for turf.--------------------------------------------------------------------------- \25\ The four Federal banking regulators include the Federal Reserve System, which serves as the central bank and supervises State member banks; the Office of the Comptroller of the Currency, which oversees national banks; the Federal Deposit Insurance Corporation, which operates the Deposit Insurance Fund and regulates State nonmember banks; and the Office of Thrift Supervision, which supervises savings associations.---------------------------------------------------------------------------A. The Fragmented U.S. System of Mortgage Regulation In the United States, the home mortgage lending industry operates under a fragmented regulatory structure which varies according to entity.\26\ Banks and thrift institutions are regulated under Federal banking laws and a subset of those institutions--namely, national banks, Federal savings associations, and their subsidiaries--are exempt from State anti-predatory lending and credit laws by virtue of Federal preemption. In contrast, mortgage brokers and independent non-depository mortgage lenders escape Federal banking regulation but have to comply with all State laws in effect. Only State-chartered banks and thrifts in some states (a dwindling group) are subject to both sets of laws.--------------------------------------------------------------------------- \26\ This discussion is drawn from Patricia A. McCoy & Elizabeth Renuart, The Legal Infrastructure of Subprime and Nontraditional Mortgage Lending, in Borrowing to Live: Consumer and Mortgage Credit Revisited 110 (Nicolas P. Retsinas & Eric S. Belsky eds., Joint Center for Housing Studies of Harvard University & Brookings Institution Press, 2008).--------------------------------------------------------------------------- Under this dual system of regulation, depository institutions are subject to a variety of Federal examinations, including fair lending, Community Reinvestment Act, and safety and soundness examinations, but independent nondepository lenders are not. Similarly, banks and thrifts must comply with other provisions of the Community Reinvestment Act, including reporting requirements and merger review. Federally insured depository institutions must also meet minimum risk-based capital requirements and reserve requirements, unlike their independent non-depository counterparts. Some Federal laws applied to all mortgage originators. Otherwise, lenders could change their charter and form to shop for the friendliest regulatory scheme.B. Applicable Law Despite these differences in regulatory regimes, the Federal Reserve Board did have the power to prohibit reckless mortgages across the entire mortgage industry. The Board had this power by virtue of its authority to administer a Federal anti-predatory lending law known as ``HOEPA.''1. Federal Law Following deregulation of home mortgages in the early 1980's, disclosure became the most important type of Federal mortgage regulation. The Federal Truth in Lending Act (TILA),\27\ passed in 1968, mandates uniform disclosures regarding cost for home loans. Its companion law, the Federal Real Estate Settlement Procedures Act of 1974 (RESPA),\28\ requires similar standardized disclosures for settlement costs. Congress charged the Federal Reserve with administering TILA and the Department of Housing and Urban Development with administering RESPA.--------------------------------------------------------------------------- \27\ 15 U.S.C. 1601-1693r (2000). \28\ 12 U.S.C. 2601-2617 (2000).--------------------------------------------------------------------------- In 1994, Congress augmented TILA and RESPA by enacting the Home Ownership and Equity Protection Act (HOEPA).\29\ HOEPA was an early Federal anti-predatory lending law and prohibits specific abuses in the subprime mortgage market. HOEPA applies to all residential mortgage lenders and mortgage brokers, regardless of the type of entity.--------------------------------------------------------------------------- \29\ 15 U.S.C. 1601, 1602(aa), 1639(a)-(b).--------------------------------------------------------------------------- HOEPA has two important provisions. The first consists of HOEPA's high-cost loan provision,\30\ which regulates the high-cost refinance market. This provision seeks to eliminate abuses consisting of ``equity stripping.'' It is hobbled, however, by its extremely limited reach--covering only the most exorbitant subprime mortgages--and its inapplicability to home purchase loans, reverse mortgages, and open-end home equity lines of credit.\31\ Lenders learned to evade the high-cost loan provisions rather easily by slightly lowering the interest rates and fees on subprime loans below HOEPA's thresholds and by expanding into subprime purchase loans.--------------------------------------------------------------------------- \30\ 15 U.S.C. Sec. 1602(aa)(1)-(4); 12 C.F.R. 226.32(a)(1), (b)(1). \31\ 15 U.S.C. Sec. 1602(i), (w), (bb); 12 C.F.R. 226.32(a)(2) (1997); Edward M. Gramlich, Subprime Mortgages: America's Latest Boom and Bust 28 (Urban Institute Press, 2007).--------------------------------------------------------------------------- HOEPA also has a second major provision, which gives the Federal Reserve Board the authority to prohibit unfair or deceptive lending practices and refinance loans involving practices that are abusive or against the interest of the borrower.\32\ This provision is potentially broader than the high-cost loan provision, because it allows regulation of both the purchase and refinance markets, without regard to interest rates or fees. However, it was not self-activating. Instead, it depended on action by the Federal Reserve Board to implement the provision, which the Board did not take until July 2008.--------------------------------------------------------------------------- \32\ 15 U.S.C. 1639(l)(2).---------------------------------------------------------------------------2. State Law Before 2008, only the high-cost loan provision of HOEPA was in effect as a practical matter. This provision had a serious Achilles heel, consisting of its narrow coverage. Even though the Federal Reserve Board lowered the high-cost triggers of HOEPA effective in 2002, that provision still only applied to 1 percent of all subprime home loans.\33\--------------------------------------------------------------------------- \33\ Gramlich, supra note 31 (2007, p. 28).--------------------------------------------------------------------------- After 1994, it increasingly became evident that HOEPA was incapable of halting equity stripping and other sorts of subprime abuses. By the late 1990s, some cities and states were contending with rising foreclosures and some jurisdictions were contemplating regulating subprime loans on their own. Many states already had older statutes on the books regulating prepayment penalties and occasionally balloon clauses. These laws were relatively narrow, however, and did not address other types of new abuses that were surfacing in subprime loans. Consequently, in 1999, North Carolina became the first State to enact a comprehensive anti-predatory lending law.\34\ Soon, other states followed suit and passed anti-predatory lending laws of their own. These newer State laws implemented HOEPA's design but frequently expanded coverage or imposed stricter regulation on subprime loans. By year-end 2005, 29 States and the District of Columbia had enacted one of these ``mini-HOEPA'' laws. Some States also passed stricter disclosure laws or laws regulating mortgage brokers. By the end of 2005, only six States--Arizona, Delaware, Montana, North Dakota, Oregon, and South Dakota--lacked laws regulating prepayment penalties, balloon clauses, or mandatory arbitration clauses, all of which were associated with exploitative subprime loans.\35\--------------------------------------------------------------------------- \34\ N.C. Gen Stat. 24-1.1E (2000). \35\ See Raphael Bostic, Kathleen C. Engel, Patricia A. McCoy, Anthony Pennington-Cross & Susan Wachter, State and Local Anti-Predatory Lending Laws: The Effect of Legal Enforcement Mechanisms, 60 J. Econ. & Bus. 47-66 (2008), full working paper version available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1005423. --------------------------------------------------------------------------- Critics, including some Federal banking regulators, have blamed the states for igniting the credit crisis through lax regulation. Certainly, there were states that were largely unregulated and there were states where mortgage regulation was weak. Mortgage brokers were loosely regulated in too many states. Similarly, the states never agreed on an effective, uniform system of mortgage regulation. Nevertheless, this criticism of the states disregards the hard-fought efforts by a growing number of states--which eventually grew to include the majority of states--to regulate abusive subprime loans within their borders. State attorneys general and State banking commissioners spearheaded some of the most important enforcement actions against deceptive mortgage lenders.\36\--------------------------------------------------------------------------- \36\ For instance, in 2002, State authorities in 44 states struck a settlement with Household Finance Corp. for $484 million in consumer restitution and changes in its lending practices following enforcement actions to redress alleged abusive subprime loans. Iowa Attorney General, States Settle With Household Finance: Up to $484 Million for Consumers (Oct. 11, 2002), available at www.iowa.gov/government/ag/latest_news/releases/oct_2002/Household_Chicago.html. In 2006, forty-nine states and the District of Columbia reached a $325 million settlement with Ameriquest Mortgage Company over alleged predatory lending practices. See, e.g., Press Release, Iowa Dep't of Justice, Miller: Ameriquest Will Pay $325 Million and Reform its Lending Practices (Jan. 23, 2006), available at http://www.state.ia.us/government/ag/latest_news/releases/jan_2006/Ameriquest_Iowa.html. ---------------------------------------------------------------------------C. The Ability to Shop For Hospitable Laws and Regulators State-chartered banks and thrifts and their subsidiaries had to comply with the State anti-predatory lending laws. So did independent nonbank lenders and mortgage brokers. For the better part of the housing boom, however, national banks, Federal savings associations, and their mortgage lending subsidiaries did not have to comply with the State anti-predatory lending laws due to Federal preemption rulings by their Federal regulators. This became a problem because Federal regulators did not replace the preempted State laws with strong Federal underwriting rules.1. Federal Preemption The states that enacted anti-predatory lending laws did not legislate in a vacuum. In 1996, the Federal regulator for thrift institutions--the Office of Thrift Supervision or OTS--promulgated a sweeping preemption rule declaring that henceforth Federal savings associations did not have to observe State lending laws.\37\ Initially, this rule had little practical effect because any State anti-predatory lending provisions on the books then were fairly narrow.\38\--------------------------------------------------------------------------- \37\ 12 C.F.R. 559.3(h), 560.2. \38\ Bostic et al., supra note 35; Office of Thrift Supervision, Responsible Alternative Mortgage Lending: Advance notice of proposed rulemaking, 65 Fed. Reg. 17811, 17814-16 (2000).--------------------------------------------------------------------------- Following adoption of the OTS preemption rule, Federal thrift institutions and their subsidiaries were relieved from having to comply with State consumer protection laws. That was not true, however, for national banks, State banks, State thrifts, and independent nonbank mortgage lenders and brokers. The stakes rose considerably starting in 1999, when North Carolina passed the first comprehensive State anti-predatory lending law. As State mini-HOEPA laws proliferated, national banks lobbied their regulator--a Federal agency known as the Office of the Comptroller of the Currency or OCC--to clothe them with the same Federal preemption as Federal savings associations. They succeeded and, in 2004, the OCC issued its own preemption rule banning the states from enforcing their laws impinging on real estate lending by national banks and their subsidiaries.\39\ In a companion rule, the OCC denied permission to the states to enforce their own laws that were not federally preempted--state lending discrimination laws are one example--against national banks and their subsidiaries. After a protracted court battle, the controversy ended up in the U.S. Supreme Court, which upheld the OCC preemption rule.\40\--------------------------------------------------------------------------- \39\ Office of the Comptroller of the Currency, Bank Activities and Operations; Final rule, 69 Fed. Reg. 1895 (2004) (codified at 12 C.F.R. 7.4000); Office of the Comptroller of the Currency, Bank Activities and Operations; Real Estate Lending and Appraisals; Final rule, 69 Fed. Reg. 1904 (2004) (codified at 12 C.F.R. 7.4007-7.4009, 34.4). National City Corporation, the parent of National City Bank, N.A., and a major subprime lender, spearheaded the campaign for OCC preemption. Predatory lending laws neutered, Atlanta Journal Constitution, Aug. 6, 2003. \40\ Watters v. Wachovia Bank, N.A., 550 U.S. 1 (2007); Arthur E. Wilmarth, Jr., The OCC's Preemption Rules Exceed the Agency's Authority and Present a Serious Threat to the Dual Banking System, 23 Ann. Rev. Banking & Finance Law 225 (2004). The Supreme Court recently granted certiorari to review the legality of the OCC visitorial powers rule. Cuomo v. Clearing House Ass'n, L.L.C.,__U.S.__, 129 S. Ct. 987 (2009). The OCC and the OTS left some areas of State law untouched, namely, State criminal law and State law regulating contracts, torts, homestead rights, debt collection, property, taxation, and zoning. Both agencies, though, reserved the right to declare that any State laws in those areas are preempted in the future. For fuller discussion, see. McCoy & Renuart, supra note 26.--------------------------------------------------------------------------- OTS and the OCC had institutional motives to grant Federal preemption to the institutions that they regulated. Both agencies depend almost exclusively on fees from their regulated entities for their operating budgets. Both were also eager to persuade State-chartered depository institutions to convert to a Federal charter. In addition, the OCC was aware that if national banks wanted Federal preemption badly enough, they might defect to the thrift charter to get it. Thus, the OCC had reason to placate national banks to keep them in its fold. Similarly, the OTS was concerned about the steady decline in thrift institutions. Federal preemption provided an inducement to thrift institutions to retain the Federal savings association charter.2. The Ability to Shop for the Most Permissive Laws As a result of Federal preemption, State anti-predatory lending laws applied to State-chartered depository institutions and independent nonbank lenders, but not to national banks, Federal savings associations, or their mortgage lending subsidiaries. The only anti-predatory lending provisions that national banks and federally chartered thrifts had to obey were HOEPA and agency pronouncements on subprime and nontraditional mortgage loans.\41\ Of these, HOEPA had extremely narrow scope. Meanwhile, agency guidances lacked the binding effect of rules and their content was not as strict as the stronger State laws.--------------------------------------------------------------------------- \41\ Board of Governors of the Federal Reserve System et al., Interagency Guidance on Subprime Lending (March 1, 1999); OCC, Abusive Lending Practices, Advisory Letter 2000-7 (July 25, 2000); OCC et al., Expanded Guidance for Subprime Lending Programs (Jan. 31, 2001); OCC, Avoiding Predatory and Abusive Lending Practices in Brokered and Purchased Loans, Advisory Letter 2003-3 (Feb. 21, 2003); OCC, Guidelines for National Banks to Guard Against Predatory and Abusive Lending Practices, Advisory Letter 2003-2 (Feb. 21, 2003); OCC, OCC Guidelines Establishing Standards for Residential Mortgage Lending Practices, 70 Fed. Reg. 6329 (2005); Department of the Treasury et al., Interagency Guidance on Nontraditional Mortgage Product Risks; Final guidance, 71 Fed. Reg. 58609 (2006); Department of the Treasury et al., Statement on Subprime Mortgage Lending; Final guidance, 72 Fed. Reg. 37569 (2007). Of course, these lenders, like all lenders, are subject to prosecution in cases of fraud. Lenders are also subject to the Federal Trade Commission Act, which prohibits unfair and deceptive acts and practices (UDAPs). However, Federal banking regulators were slow to propose rules to define and punish UDAP violations by banking companies in the mortgage lending area.--------------------------------------------------------------------------- This dual regulatory system allowed mortgage lender to play regulators off one another by threatening to change charters. Mortgage lenders are free to operate with or without depository institution charters. Similarly, depository institutions can choose between a State and Federal charter and between a thrift charter and a commercial bank charter. Each of these choices allows a lender to change regulators. A lender could escape a strict State law by switching to a Federal bank or thrift charter or by shifting its operations to a less regulated State. Similarly, a lender could escape a strict regulator by converting its charter to one with a more accommodating regulator. Countrywide, the nation's largest mortgage lender and a major subprime presence, took advantage of this system to change its regulator. One of its subsidiaries, Countrywide Home Loans, was supervised by the Federal Reserve. This subsidiary switched and became an OTS-regulated entity as of March 2007. That same month, Countrywide Bank, N.A., converted its charter from a national bank charter under OCC supervision to a Federal thrift charter under OTS supervision. Reportedly, OTS promised Countrywide's executives to be a ``less antagonistic'' regulator if Countrywide switched charters to OTS. Six months later, the regional deputy director of the OTS West Region, where Countrywide was headquartered, was promoted to division director. Some observers considered it a reward.\42\--------------------------------------------------------------------------- \42\ Richard B. Schmitt, Regulator takes heat over IndyMac, Los Angeles Times, Oct. 6, 2008; see also Binyamin Appelbaum & Ellen Nakashima, Regulator Played Advocate Over Enforcer, Washington Post, November 23, 2008.--------------------------------------------------------------------------- The result was a system in which lenders could shop for the loosest laws and enforcement. This shopping process, in turn, put pressure on regulators at all levels--state and local--to lower their standards or relax enforcement. What ensued was a regulatory race to the bottom.III. Regulatory Failure Federal preemption would not have been such a problem if Federal banking regulators had replaced State laws with tough rules and enforcement of their own. Those regulators had ample power to stop the deterioration in mortgage underwriting standards that mushroomed into a full-blown crisis. However, they refused to intervene in disastrous lending practices until it was too late. As a result, federally regulated lenders--as well as all lenders operating in states with weak regulation--were given carte blanche to loosen their lending standards free from meaningful regulatory intervention.A. The Federal Reserve Board The Federal Reserve Board had the statutory power, starting in 1994, to curb lax lending not only for depository institutions, but for all lenders across-the-board. It declined to exercise that power in any meaningful respect, however, until after the nonprime mortgage market collapsed. In the mortgage lending area, the Fed's supervisory process has three major parts and breakdowns were apparent in two out of the three. The only part that appeared to work well was the Fed's role as the primary Federal regulator for State-chartered banks that are members of the Federal Reserve System.\43\--------------------------------------------------------------------------- \43\ In general, these are community banks on the small side. In 2007 and 2008, only one failed bank--the tiny First Georgia Community Bank in Jackson, Georgia, with only $237.5 million in assets--was regulated by the Federal Reserve System. It is not clear whether the Fed's performance is explained by the strength of its examination process, the limited role of member banks in risky lending, the fact that State banks had to comply with State anti-predatory lending laws, or all three. In the following discussion on regulatory failure by the Federal Reserve Board, the OTS, and the OCC, the data regarding failed and near-failed banks and thrifts come from Federal bank regulatory and S.E.C. statistics, disclosures, press releases, and orders; rating agency reports; press releases and other web materials by the companies mentioned; statistics compiled by the American Banker; and financial press reports.--------------------------------------------------------------------------- As the second part of its supervisory duties, the Fed regulates nonbank mortgage lenders owned by bank holding companies but not owned directly or indirectly by banks or thrifts. During the housing boom, some of the largest subprime and Alt-A lenders were regulated by the Fed, including the top- and third-ranked subprime lenders in 2006, HSBC Finance and Countrywide Financial Corporation, and Wells Fargo Financial, Inc.\44\ The Fed's supervisory record with regard to these lenders was mixed. On one notable occasion, in 2004, the Fed levied a $70 million civil money penalty against CitiFinancial Credit Company and its parent holding company, Citigroup Inc., for subprime lending abuses.\45\ Apart from that, the Fed did not take public enforcement action against the nonbank lenders that it regulated. That may be because the Federal Reserve did not routinely examine the nonbank mortgage lending subsidiaries under its supervision, which the late Federal Reserve Board Governor Edward Gramlich revealed in 2007. Only then did the Fed kick off a ``pilot project'' to examine the nonbank lenders under its jurisdiction on a routine basis for loose underwriting and compliance with Federal consumer protection laws.\46\--------------------------------------------------------------------------- \44\ Data provided by American Banker, available at www.americanbanker.com. \45\ Federal Reserve, Citigroup Inc. New York, New York and Citifinancial Credit Company Baltimore, Maryland: Order to Cease and Desist and Order of Assessment of a Civil Money Penalty Issued Upon Consent, May 27, 2004. \46\ Edward M. Gramlich, Boom and Busts, The Case of Subprime Mortgages, Speech given August 31, 2007, Jackson Hole, Wyo., at symposium titled ``Housing, Housing Finance & Monetary Policy,'' sponsored by the Federal Reserve Bank of Kansas City, pp. 8-9, available at www.kansascityfed.org/publicat/sympos/2007/pdf/2007.09.04.gramlich.pdf; Speech by Governor Randall S. Kroszner At the National Bankers Association 80th Annual convention, Durham, North Carolina, October 11, 2007.--------------------------------------------------------------------------- Finally, the Board is responsible for administering most Federal consumer credit protection laws, including HOEPA. When former Governor Edward Gramlich served on the Fed, he urged then-Chairman Alan Greenspan to exercise the Fed's power to address unfair and deceptive loans under HOEPA. Greenspan refused, preferring instead to rely on non-binding statements and guidances.\47\ This reliance on statements and guidances had two disadvantages: one, major lenders routinely dismissed the guidances as mere ``suggestions'' and, two, guidances did not apply to independent nonbank mortgage lenders.--------------------------------------------------------------------------- \47\ House of Representatives, Committee on Oversight and Government Reform, ``The Financial Crisis and the Role of Federal Regulators, Preliminary Transcript'' 35, 37-38 (Oct. 23, 2008), available at http://oversight.house.gov/documents/20081024163819.pdf. Greenspan told the House Oversight Committee in 2008: Well, let's take the issue of unfair and deceptive practices, which is a fundamental concept to the whole predatory lending issue. The staff of the Federal Reserve . . . say[ ] how do they determine as a regulatory group what is unfair and deceptive? And the problem that they were concluding . . . was the issue of maybe 10 percent or so are self-evidently unfair and deceptive, but the vast majority would require a jury trial or other means to deal with it . . . Id. at 89.--------------------------------------------------------------------------- The Federal Reserve did not relent until July 2008, when under Chairman Ben Bernanke's leadership, it finally promulgated binding HOEPA regulations banning specific types of lax and abusive loans. Even then, the regulations were mostly limited to higher-priced mortgages, which the Board confined to first-lien loans of 1.5 percentage points or more above the average prime offer rate for a comparable transaction, and 3.5 percentage points for second-lien loans. Although shoddy nontraditional mortgages below those triggers had also contributed to the credit crisis, the rule left those loans--plus prime loans--mostly untouched.\48\--------------------------------------------------------------------------- \48\ Federal Reserve System, Truth in Lending: Final rule; official staff commentary, 73 Fed. Reg. 44522, 44536 (July 30, 2008). The Board set those triggers with the intention of covering the subprime market, but not the prime market. See id. at 44536-37.--------------------------------------------------------------------------- The rules, while badly needed, were too little and too late. On October 23, 2008, in testimony before the U.S. House of Representatives Oversight Committee, Greenspan admitted that ``those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief.'' House Oversight Committee Chairman Henry Waxman asked Greenspan whether ``your ideology pushed you to make decisions that you wish you had not made?'' Greenspan replied:\49\--------------------------------------------------------------------------- \49\ House of Representatives, Committee on Oversight and Government Reform, ``The Financial Crisis and the Role of Federal Regulators, Preliminary Transcript'' 36-37 (Oct. 23, 2008), available at http://oversight.house.gov/documents/20081024163819.pdf. Mr. GREENSPAN. . . . [Y]es, I found a flaw, I don't know how significant or permanent it is, but I have been very distressed by that fact . . . Chairman WAXMAN. You found a flaw? Mr. GREENSPAN. I found a flaw in the model that defines how the world works, so to speak. Chairman WAXMAN. In other words, you found that your view of the world, your ideology, was not right, it was not working. Mr. GREENSPAN. Precisely. That's precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.\50\ \50\ Testimony of Dr. Alan Greenspan before the House of Representatives Committee of Government Oversight and Reform, October 23, 2008, available at http://oversight.house.gov/documents/20081023100438.pdf.---------------------------------------------------------------------------B. Regulatory Lapses by the OCC and OTS Federal preemption might not have devolved into a banking crisis of systemic proportions had OTS and the OCC replaced State regulation for their regulated entities with a comprehensive set of binding rules prohibiting lax underwriting of home mortgages. Generally, in lieu of binding rules, Federal banking regulators, including the OCC and OTS, issued a series of ``soft law'' advisory letters and guidelines against predatory or unfair mortgage lending practices by insured depository institutions.\51\ Federal regulators disavowed binding rules during the run-up to the subprime crisis on grounds that the guidelines were more flexible and that the agencies enforced those guidelines through bank examinations and informal enforcement actions.\52\ Informal enforcement actions were usually limited to negotiated, voluntary agreements between regulators and the entities that they supervised, which made it easy for management to drag out negotiations to soften any restrictions and to bid for more time. Furthermore, examinations and informal enforcement are highly confidential, making it easy for a lax regulator to hide its tracks.--------------------------------------------------------------------------- \51\ See note 41 supra. \52\ Office of the Comptroller of the Currency, Bank Activities and Operations; Real Estate Lending and Appraisals; Final rule, 69 Fed. Reg. 1904 (2004).---------------------------------------------------------------------------1. The Office of Thrift Supervision Although OTS was the first agency to adopt Federal preemption, it managed to fly under the radar during the subprime boom, overshadowed by its larger sister agency, the OCC. After 2003, while commentators were busy berating the OCC preemption rule, OTS allowed the largest Federal savings associations to embark on an aggressive campaign of expansion through option payment ARMs, subprime loans, and low-documentation and no-documentation loans. Autopsies of failed depository institutions in 2007 and 2008 show that five of the seven biggest failures were OTS-regulated thrifts. Two other enormous thrifts during that period--Wachovia Mortgage, FSB and Countrywide Bank, FSB--were forced to arrange hasty takeovers by large bank holding companies to avoid failing. By December 31, 2008, thrifts totaling $355 billion in assets had failed in the previous sixteen months on OTS' watch. The reasons for the collapse of these thrifts evidence fundamental regulatory lapses by OTS. Almost all of the thrifts that failed in 2007 and 2008--and all of the larger ones--succumbed to massive levels of imprudent home loans. IndyMac Bank, FSB, which became the first major thrift institution to fail during the current crisis in July 2008, manufactured its demise by becoming the nation's top originator of low-documentation and no-documentation loans. These loans, which became known as ``liar's loans,'' infected both the subprime market and credit to borrowers with higher credit scores. By 2006 and 2007, over half of IndyMac's home purchase loans were subprime loans and IndyMac Bank approved up to half of those loans based on low or no documentation. Washington Mutual Bank, popularly known as ``WaMu,'' was the nation's largest thrift institution in 2008, with over $300 billion in assets. WaMu became the biggest U.S. depository institution in history to fail on September 25, 2008, in the wake of the Lehman Brothers bankruptcy. WaMu was so large that OTS examiners were stationed there permanently onsite. Nevertheless, from 2004 through 2006, despite the daily presence of the resident OTS inspectors, risky option ARMs, second mortgages, and subprime loans constituted over half of WaMu's real estate loans each year. By June 30, 2008, over one fourth of the subprime loans that WaMu originated in 2006 and 2007 were at least thirty days past due. Eventually, it came to light that WaMu's management had pressured its loan underwriters relentlessly to approve more and more exceptions to WaMu's underwriting standards in order to increase its fee revenue from loans.\53\--------------------------------------------------------------------------- \53\ Peter S. Goodman & Gretchen Morgenson, Saying Yes, WaMu Built Empire on Shaky Loans, N.Y. Times, Dec. 28, 2008.--------------------------------------------------------------------------- Downey Savings & Loan became the third largest depository institution to fail in 2008. Like WaMu, Downey had loaded up on option ARMs and subprime loans. When OTS finally had to put it into receivership, over half of Downey's total assets consisted of option ARMs and nonperforming loans accounted for over 15 percent of the thrift's total assets. In short, the three largest depository institution failures in 2007 and 2008 resulted from high concentrations of poorly underwritten loans, including low- and no-documentation ARMs (in the case of IndyMac) and option ARMs (in the case of WaMu and Downey) that were often only underwritten to the introductory rate instead of the fully indexed rate. During the housing bubble, OTS issued no binding rules to halt the proliferation by its largest regulated thrifts of option ARMs, subprime loans, and low- and no-documentation mortgages. Instead, OTS relied on oversight through guidances. IndyMac, WaMu, and Downey apparently treated the guidances as solely advisory, however, as evidenced by the fact that all three made substantial numbers of hazardous loans in late 2006 and in 2007 in direct disregard of an interagency guidance on nontraditional mortgages issued in the fall of 2006 and subscribed to by OTS that prescribed underwriting ARMs to the fully indexed rate.\54\--------------------------------------------------------------------------- \54\ Department of the Treasury et al., Interagency Guidance on Nontraditional Mortgage Product Risks; Final guidance, 71 Fed. Reg. 58609 (2006).--------------------------------------------------------------------------- The fact that all three institutions continued to make loans in violation of the guidance suggests that OTS examinations failed to result in enforcement of the guidance. Similarly, OTS fact sheets on the failures of all three institutions show that the agency consistently declined to institute timely formal enforcement proceedings against those thrifts prohibiting the lending practices that resulted in their demise. In sum, OTS supervision of residential mortgage risks was confined to ``light touch'' regulation in the form of examinations, nonbinding guidances, and occasional informal agreements that ultimately did not work.2. The Office of the Comptroller of the Currency The OCC has asserted that national banks made only 10 percent of subprime loans in 2006. But this assertion fails to mention that national banks moved aggressively into Alt-A low-documentation and no-documentation loans during the housing boom.\55\ This mattered a lot, because the biggest national banks are considered ``too big to fail'' and pose systemic risk on a scale unmatched by independent nonbank lenders. We might not be debating the nationalization of Citibank and Bank of America today had the OCC stopped them from expanding into toxic mortgages, bonds, and SIVs.--------------------------------------------------------------------------- \55\ Testimony by John C. Dugan, Comptroller, before the Senate Committee on Banking, Housing, and Urban Affairs, March 4, 2008.--------------------------------------------------------------------------- Like OTS, ``light touch'' regulation was apparent at the OCC. Unlike OTS, the OCC did promulgate one rule, in 2004, prohibiting mortgages to borrower who could not afford to repay. However, the rule was vague in design and execution, allowing lax lending to proliferate at national banks and their mortgage lending subsidiaries through 2007. Despite the 2004 rule, through 2007, large national banks continued to make large quantities of poorly underwritten subprime loans and low- and no-documentation loans. In 2006, for example, fully 62.6 percent of the first-lien home purchase mortgages made by National City Bank, N.A., and its subsidiary, First Franklin Mortgage, were higher-priced subprime loans. Starting in the third quarter of 2007, National City Corporation reported five straight quarters of net losses, largely due to those subprime loans. Just as with WaMu, the Lehman Brothers bankruptcy ignited a silent run by depositors and pushed National City Bank to the brink of collapse. Only a shotgun marriage with PNC Financial Services Group in October 2008 saved the bank from FDIC receivership. The five largest U.S. banks in 2005 were all national banks and too big to fail. They too made heavy inroads into low- and no-documentation loans. The top-ranked Bank of America, N.A., had a thriving stated-income and no-documentation loan program which it only halted in August 2007, when the market for private-label mortgage-backed securities dried up. Bank of America securitized most of those loans, which may be why the OCC tolerated such lax underwriting practices. Similarly, in 2006, the OCC overrode public protests about a ``substantial volume'' of no-documentation loans by JPMorgan Chase Bank, N.A., the second largest bank in 2005, on grounds that the bank had adequate ``checks and balances'' in place to manage those loans. Citibank, N.A., was the third largest U.S. bank in 2005. In September 2007, the OCC approved Citibank's purchase of the disreputable subprime lender Argent Mortgage, even though subprime securitizations had slowed to a trickle. Citibank thereupon announced to the press that its new subsidiary--christened ``Citi Residential Lending''--would specialize in nonprime loans, including reduced documentation loans. But not long after, by early May 2008 after Bear Stearns narrowly escaped failure, Citibank was forced to admit defeat and dismantle Citi Residential's lending operations. The fourth largest U.S. bank in 2005, Wachovia Bank, N.A., originated low- and no-documentation loans through its two mortgage subsidiaries. Wachovia Bank originated such large quantities of these loans--termed Alt-A loans--that by the first half of 2007, Wachovia Bank was the twelfth largest Alt-A lender in the country. These loans performed so poorly that between December 31, 2006 and September 30, 2008, the bank's ratio of net write-offs on its closed-end home loans to its total outstanding loans jumped 2400 percent. Concomitantly, the bank's parent company, Wachovia Corporation, was reported its first quarterly loss in years due to rising defaults on option ARMs made by Wachovia Mortgage, FSB, and its Golden West predecessor. Public concern over Wachovia's loan losses triggered a silent run on Wachovia Bank in late September 2008, following Lehman Brothers' failure. To avoid receivership, the FDIC brokered a hasty sale of Wachovia to Wells Fargo after Wells Fargo outbid Citigroup for the privilege. Wells Fargo Bank, N.A., was in better financial shape than Wachovia, but it too made large quantities of subprime and reduced documentation loans. In 2006, over 23 percent of the bank's first-lien refinance mortgages were high-cost subprime loans. Wells Fargo Bank also securitized substantial numbers of low- and no-documentation mortgages in its Alt-A pools. In 2007, a Wells Fargo prospectus for one of those pools stated that Wells Fargo had relaxed its underwriting standards in mid-2005 and did not verify whether the mortgage brokers who had originated the weakest loans in that loan pool complied with its underwriting standards before closing. Not long after, as of July 25, 2008, 22.77 percent of the loans in that loan pool were past due or in default. As the Wells Fargo story suggests, the OCC depended on voluntary risk management by national banks, not regulation of loan terms and practices, to contain the risk of improvident loans. A speech by the then-Acting Comptroller, Julie Williams, confirmed as much. In 2005, Comptroller Williams, in a speech to risk managers at banks, coached them on how to ``manage'' the risks of no-doc loans through debt collection, higher reserves, and prompt loss recognition. Securitization was another risk management device favored by the OCC. Three years later, in 2008, the Treasury Department's Inspector General issued a report that was critical of the OCC's supervision of risky loans.\56\ Among other things, the Inspector General criticized the OCC for not instituting formal enforcement actions while lending problems were still manageable in size. In his written response to the Inspector General, the Comptroller, John Dugan, conceded that ``there were shortcomings in our execution of our supervisory process'' and ordered OCC examiners to start initiating formal enforcement actions on a timely basis.\57\--------------------------------------------------------------------------- \56\ Office of Inspector General, Department of the Treasury, ``Safety and Soundness: Material Loss Review of ANB Financial, National Association'' (OIG-09-013, Nov. 25, 2008). \57\ Id.--------------------------------------------------------------------------- The OCC's record of supervision and enforcement during the subprime boom reveals many of the same problems that culminated in regulatory failure by OTS. Like OTS, the OCC usually shunned formal enforcement actions in favor of examinations and informal enforcement. Neither of these supervisory tools obtained compliance with the OCC's 2004 rule prohibiting loans to borrowers who could not repay. Although the OCC supplemented that rule later on with more detailed guidances, some of the largest national banks and their subsidiaries apparently decided that they could ignore the guidances, judging from their lax lending in late 2006 and in 2007. The OCC's emphasis on managing credit risk through securitization, reserves, and loss recognition, instead of through product regulation, likely encouraged that laissez faire attitude by national banks.C. Judging by the Results: Loan Performance By Charter OCC and OTS regulators have argued that their agencies offer ``comprehensive'' supervision resulting in lower default rates on residential mortgages. The evidence shows otherwise. Data from the Federal Deposit Insurance Corporation show that among depository institutions, Federal thrift institutions had the worst default rate for one-to-four family residential mortgages from 2006 through 2008. (See Figure 5). Figure 5. Total Performance of Residential Mortgages by Depository Institution Lenders CHRG-110hhrg41184--15 Mr. Bernanke," Okay. In my testimony this morning, I will briefly review the economic situation and outlook, beginning with developments in real activity and inflation, and then turn to monetary policy. I will conclude with a quick update on the Federal Reserve's recent actions to help protect consumers in their financial dealings. The economic situation has become distinctly less favorable since the time of our July report. Strains in financial markets, which first became evident late last summer, have persisted, and pressures on bank capital and the continuing poor functioning of markets for securitized credit have led to tighter credit conditions for many households and businesses. The growth of real gross domestic product held up well through the third quarter despite the financial turmoil, but it has since slowed sharply. Labor market conditions have similarly softened, as job creation has slowed and the unemployment rate, at 4.9 percent in January, has moved up somewhat. Many of the challenges now facing our economy stem from the continuing contraction of the U.S. housing market. In 2006, after a multiyear boom in residential construction and house prices, the housing market reversed course. Housing starts and sales of new homes are now less than half of their respective peaks, and house prices have flattened or declined in most areas. Changes in the availability of mortgage credit amplified the swings in the housing market. During the housing sector's expansion phase, increasing lax lending standards, particularly in the subprime market, raised the effective demand for housing, pushing up prices and stimulating construction activity. As the housing market began to turn down, however, the slump in subprime mortgage originations, together with the more general tightening of credit conditions, has served to increase the severity of the downturn. Weaker house prices in turn have contributed to the deterioration in the performance of mortgage-related securities and reduced the availability of mortgage credit. The housing market is expected to continue to weigh on economic activity in coming quarters. Home builders, still faced with abnormally high inventories of unsold homes, are likely to cut the pace of their building activity further, which will subtract from overall growth and reduce employment in residential construction and in closely related industries. Consumer spending continued to increase at a solid pace through much of the second half of 2007, despite the problems in the housing market, but it appears to have slowed significantly toward the end of the year. The jump in the price of imported energy, which eroded real incomes and wages, likely contributed to the slowdown in spending, as did the declines in household wealth associated with the weakness in house prices and equity prices. Slowing job creation is yet another potential drag on household spending, as gains in payroll employment averaged little more than 40,000 per month during the 3 months ending in January, compared with an average increase of almost 100,000 per month over the previous 3 months. However, the recently enacted fiscal stimulus package should provide some support for household spending during the second half of this year and into next year. The business sector has also displayed signs of being affected by the difficulties in the housing and credit markets. Reflecting a downshift in the growth of final demand and tighter credit conditions for some firms, available indicators suggest that investment in equipment and software will be subdued during the first half of 2008. Likewise, after growing robustly through much of 2007, nonresidential construction is likely to decelerate sharply in coming quarters as business activity flows and funding becomes harder to obtain, especially for more speculative projects. On a more encouraging note, we see few signs of any serious imbalances in business inventories, aside from the overhang of unsold homes. And, as a whole, the nonfinancial business sector remains in good financial condition with strong profits, liquid balance sheets, and corporate leverage near historic lows. In addition, the vigor of the global economy has offset some of the weakening of domestic demand. U.S. real exports of goods and services increased at an annual rate of about 11 percent in the second half of last year, boosted by continuing economic growth abroad and the lower foreign exchange value of the dollar. Strengthening exports, together with moderating imports, have in turn led to some improvement in the U.S. current account deficit, which likely narrowed in 2007 on an annual basis for the first time since 2001. Although recent indicators point to some slowing of foreign growth, U.S. exports should continue to expand at a healthy pace in coming quarters, providing some impetus to domestic economic activity and employment. As I have mentioned, financial markets continue to be under considerable stress. Heightened investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates, triggered the financial turmoil. However, other factors, including a broader retrenchment in the willingness of investors to bear risk, difficulties in valuing complex or illiquid financial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for economic growth, have also roiled the financial markets in recent months. To help relieve the pressures in the market for interbank lending, the Federal Reserve, among other actions, recently introduced a term auction facility through which pre-specified amounts of discount window credit are auctioned to eligible borrowers. And we have been working with other central banks to address market strains that could hamper the achievement of our broader economic objectives. These efforts appear to have contributed to some improvement in short-term funding markets. We will continue to monitor financial developments closely. As part of its ongoing commitment to improving the accountability and public understanding of monetary policymaking, the Federal Open Market Committee, or FOMC, recently increased the frequency and expanded the content of the economic projections made by Federal Reserve Board members and Reserve Bank presidents and released to the public. The latest economic projections, which were submitted in conjunction with the FOMC meeting at the end of January, and which are based on each participant's assessment of appropriate monetary policy, show that real GDP was expected to grow only sluggishly in the next few quarters, and that the unemployment rate was seen as likely to increase somewhat. In particular, the central tendency of the projections was for real GDP to grow between 1.3 percent and 2.0 percent in 2008, down from 2.5 percent to 2.75 percent as projected in our report last July. FOMC participants' projections for the unemployment rate in the fourth quarter of 2008 have a central tendency of 5.2 percent to 5.3 percent, up from the level of about 4.75 percent projected last July for the same period. The downgrade in our projections for economic activity in 2008 since our report last July reflects the effects of the financial turmoil on real activity and a housing contraction that has been more severe than previously expected. By 2010, our most recent projections show output growth picking up to rates close to or a little above its longer-term trend, and the unemployment rate edging lower. The improvement reflects the effects of policy stimulus and an anticipated moderation of the contraction in housing and the strains in financial and credit markets. The incoming information since our January meeting continues to suggest sluggish economic activity in the near term. The risks to this outlook remain to the downside. Those risks include the possibilities that the housing market or the labor market may deteriorate more than is currently anticipated, and that credit conditions may tighten substantially further. Consumer price inflation has increased since our previous report, in substantial part because of the steep run-up in the price of oil. Last year food prices also increased significantly, and the dollar depreciated. Reflecting these influences, the price index for Personal Consumption Expenditures increased by 3.4 percent over the four quarters of 2007, up from 1.9 percent in 2006. Core price inflation, that is, inflation excluding food and energy prices, also firmed toward the end of the year. The higher recent readings likely reflected some pass-through of energy costs to the prices of consumer goods and services, as well as the effect of the depreciation of the dollar and import prices. Moreover, core inflation in the first half of 2007 was damped by a number of transitory factors; notably, unusually soft prices for apparel and for financial services, which subsequently reversed. For the year as a whole, however, core PCE prices increased by 2.1 percent, down slightly from 2006. The projections recently submitted by FOMC participants indicate that overall PCE inflation was expected to moderate significantly in 2008, to between 2.1 percent and 2.4 percent, the central tendency of the projections. A key assumption underlying those projections was that energy and food prices would begin to flatten out, as was implied by quotes on futures markets. In addition, diminishing pressure on resources is also consistent with the projected slowing in inflation. The central tendency of the projections for core PCE inflation in 2008 at 2.0 percent to 2.2 percent was a bit higher than in our July report, largely because of some higher-than-expected recent readings on prices. Beyond 2008, both overall and core inflation were projected to edge lower as participants expected inflation expectations to remain reasonably well anchored and pressures on resource utilization to be muted. The inflation projection submitted by FOMC participants for 2010, which range from 1.5 percent to 2.0 percent for overall PCE inflation, were importantly influenced by participants' judgments about the measured rates of inflation consistent with the Federal Reserve's dual mandate, and about the timeframe over which policy should aim to attain those rates. The rate of inflation that is actually realized will of course depend on a variety of factors. Inflation could be lower than we anticipate if slower-than-expected global growth moderates the pressure on the prices of energy and other commodities, or if rates of domestic resource utilization fall more than we currently expect. Upside risks to the inflation projection are also present, however, including the possibilities that energy and food prices do not flatten out, or that the pass-through to core prices from higher commodity prices and from the weaker dollar may be greater than we anticipate. Indeed, the further increases in prices of energy and other commodities in recent weeks, together with the latest data on consumer prices, suggests slightly greater upside risks to the projections of both overall and core inflation than we saw last month. Should high rates of overall inflation persist, the possibility also exists that inflation expectations could become less well anchored. Any tendency of inflation expectations to become unmoored, or for the Fed's inflation-fighting credibility to be eroded, could greatly complicate the task of sustaining price stability and could reduce the flexibility of the FOMC to counter shortfalls in growth in the future. Accordingly, in the months ahead, the Federal Reserve will continue to monitor closely inflation and inflation expectations. Let me turn now to the implications of these developments for monetary policy. The FOMC has responded aggressively to the weaker outlook for economic activity, having reduced its target for the Federal funds rate by 225 basis points since last summer. As the committee noted in its most recent post-meeting statement, the intent of those actions has been to help promote moderate growth over time and to mitigate the risk to economic activity. A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of policy is properly calibrated to foster our mandated objectives of maximum employment and price stability in an environment of downside risk to growth, stressed financial conditions, and inflation pressures. In particular, the FOMC will need to judge whether the policy actions taken thus far are having their intended effects. Monetary policy works with a lag. Therefore, our policy stance must be determined in light of the medium-term forecast of real activity and inflation as well as the risks to that forecast. Although the FOMC participants' economic projections envision an improving economic picture, it is important to recognize that downside risks to growth remain. The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks. Finally, I would like to say a few words about the Federal Reserve's recent actions to protect consumers in their financial transactions. In December, following up on a commitment I made at the time of our last report in July, the Board issued for public comment a comprehensive set of new regulations to prohibit unfair or deceptive practices in the mortgage market under the authority granted us by the Home Ownership and Equity Protection Act of 1994. The proposed rules would apply to all mortgage lenders and would establish lending standards to help ensure that consumers who seek mortgage credit receive loans whose terms are clearly disclosed and that can reasonably be expected to be repaid. Accordingly, the rules would prohibit lenders from engaging in a pattern or practice of making higher priced mortgage loans without due regard to consumers' ability to make the scheduled payments. In each case, a lender making a higher priced loan would have to use third-party documents to verify the income relied on to make the credit decision. For higher priced loans, the proposed rules would require the lender to establish an escrow account for the payment of property taxes and homeowners insurance, and would prevent the use of prepayment penalties in circumstances where they might trap borrowers in unaffordable loans. In addition, for all mortgage loans, our proposal addresses misleading and deceptive advertising practices, requires borrowers and brokers to agree in advance on the maximum fee that the broker may receive, and certain practices by servicers that harm borrowers and prohibits coercion of appraisers by lenders. We expect substantial public comment on our proposal, and we will carefully consider all information and viewpoints while moving expeditiously to adopt final rules. The effectiveness of the new regulations, however, will depend critically on strong enforcement. To that end, in conjunction with other Federal and State agencies, we are conducting compliance reviews of a range of mortgage lenders, including nondepository lenders. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations of, and improved enforcement for, all categories of mortgage lenders. The Federal Reserve continues to work with financial institutions, public officials and community groups around the country to help homeowners avoid foreclosures. We have called on mortgage lenders and servicers to pursue prudent loan workouts, and have supported the development of streamlined, systematic approaches to expedite the loan modification process. We have also been providing community groups, counseling agencies, regulators and others with detailed analyses to help identify neighborhoods at high risk for foreclosures so that local outreach efforts to help troubled borrowers can be as focused and as effective as possible. We are actively pursuing other ways to leverage the Federal Reserve's analytical resources, regional presence, and community connections to address this critical issue. In addition to our consumer protection efforts in the mortgage area, we are working towards finalizing rules under the Truth in Lending Act that will require new, more informative, and consumer-tested disclosures by credit card issuers. Separately, we are actively reviewing potentially unfair and deceptive practices by issuers of credit cards. Using the Board's authority under the Federal Trade Commission Act, we expect to issue proposed rules regarding these practices this spring. Thank you. I would be very pleased to take your questions. [The prepared statement of Chairman Bernanke can be found on page 53 of the appendix.] " FOMC20050322meeting--37 35,MR. STOCKTON.," Thank you, Mr. Chairman. By virtually all measures, the economy has been humming along at a very solid pace in recent months. We are estimating that real GDP expanded at a 4¼ percent annual rate in the fourth quarter of last year and is likely to grow at about that pace in the first quarter of this year. March 22, 2005 9 of 116 Although the pace of the expansion in real activity is much the same as that of a year ago, the character of the expansion now feels different. While I can easily imagine looking back on these words with regret [laughter], the persistent and widespread improvements that we are now witnessing certainly leave the impression that the expansion is more firmly established and less fragile with respect to adverse shocks than it was in early 2004. As you know from reading the Greenbook, we think that the recent greater momentum in real GDP will carry forward for a while. That greater momentum in activity and heightened upward pressures on inflation led us to raise the assumed path of the federal funds rate by 50 basis points beyond the very near term. As in past forecasts, tighter monetary policy, diminished impetus from rising equity values and house prices, and fading fiscal stimulus are expected to gradually put a brake on the pace of activity. In our projection, the economy reaches the end of next year with the funds rate in the neighborhood of neutral, output close to potential, and core inflation running around 1½ percent. Were it to occur, such an outcome would be very pleasant indeed. Of course, we know that our point forecast, like any point forecast, will occur with probability zero. So what should we worrying about? While my colleagues who attend our lengthy forecast meetings were not exactly thrilled by it, the removal of my arm from its sling in the past few weeks has allowed me, once again, to bring my principal value added to the forecasting process, and that is copious amounts of hand- wringing. [Laughter] In the remainder of my remarks, I=d like to focus on three difficult questions with which we had to wrestle in assembling this forecast: First, what should we make of the recent strength in capital spending and what are its implications for the outlook? Second, how should we balance some powerful crosscurrents at work on the supply side of the economy? And third, what is happening with inflation? I=ll take them each in turn, although there are some common threads that tie them together. March 22, 2005 10 of 116 So, little remains of our elegant story. Our calibrated vintage capital models failed us, and clearly finger-crossing has not proven a terribly robust forecasting technique. We even tried an approach gently suggested to us by Governor Olson at the time of our last forecast—you know, had we thought about trying common sense? [Laughter] We tried, but even that didn=t seem to work. In a conversation with our colleagues at Treasury that they asked remain confidential, they indicated having been surprised that an appreciable number of firms with taxable income have simply not taken advantage of partial expensing. Moreover, some firms have taken it for purchases of longer-lived assets, but not for shorter-lived assets. This pattern of behavior might suggest that administrative complexity may have loomed larger as a discouraging factor than we or others imagined. But the facts are likely to remain obscure for a long time, while the IRS tabulates the corporate income tax forms for recent years. For now, we=re raising the white flag of surrender and chalking it up as a defeat for models, luck, and logic. I wouldn=t drag you through this discussion if it were just a sideshow in the forecast. But the changes that we made here were of policy significance. We revised up the growth in real equipment spending by 10 percentage points in the current quarter, from a decline of 5 percent at an annual rate to an increase of 5 percent. Moreover, we had previously interpreted some of last year=s strength in capital spending as resulting from firms pulling forward outlays to take advantage of the tax break. If that was not the case, then underlying demand was likely stronger than we had previously recognized. As a consequence, we are projecting some of that additional strength to carry over into the first half of this year. After accounting for follow-on multiplier–accelerator effects, the revisions to our forecast of equipment spending boosted growth of real GDP by nearly 2 percentage point this year and by ¼ percentage point next year. These adjustments more than offset the downward revisions to our projection that were necessitated by the higher expected path of oil prices, which we estimate will trim about ¼ percentage point off the growth in real GDP in each of the next two years. The faster pace of capital spending incorporated in this projection also had implications for aggregate supply through its contribution to capital deepening. But that was just one of a number of changes we made on the supply side of our projection. As I noted earlier, we have had to contend with two strong crosscurrents in this aspect of our forecast: faster-than-expected growth of labor productivity, on the one hand, and slower-than-expected growth of the labor force, on the other. March 22, 2005 11 of 116 As you know, the surprising strength of productivity over the past few years has required us to take a stand on how much of the recent gains has reflected structural improvements that will persist going forward and how much has reflected the cautious hiring stance of businesses and their ability, at least for a time, to elicit greater effort from their workforces. In other words, we have had to parse these innovations into trend and cycle components. With positive surprises to productivity continuing, the story about caution-induced effort seemed to us to have diminishing plausibility. Both our models and our best judgment suggested raising our estimates of the structural component of productivity in recent years and correspondingly lowering the cyclical component. In addition to raising the level of structural productivity through the end of last year, we also nudged up our estimate of the growth of structural productivity going forward by about ¼ percentage point per year to about 3 percent per annum. About half of that upward revision reflected the larger contribution from capital deepening that followed from our stronger investment forecast. The other half reflects stronger projected growth of multifactor productivity. Businesses have been making substantial gains in technological and organizational efficiencies in recent years, and we anticipate more of that to continue over the next couple of years than was assumed in our January projection. While the revisions that we have made to structural productivity, all else equal, would have resulted in a noticeable upward revision to the projected growth of potential output, all else was not equal. Just as we have been surprised to the upside by productivity, we have been consistently surprised to the downside over the past year or so by the weakness in labor force participation. We had been expecting that, as the labor market began to give clearer signs of sustained improvement, more workers would be drawn back into the labor force. We still think that is likely to happen. March 22, 2005 12 of 116 On net, the upward revisions to productivity slightly exceeded the downward revisions to potential labor input, and we revised up the growth of potential output by 0.1 percentage point this year and next. These upward revisions were smaller than those we made to actual GDP, and, as a consequence, the GDP gap is a touch smaller in coming quarters than was the case in our January projection. A slightly tighter economy has added to a growing list of worries that would make any compulsive hand-wringer proud. That list would also contain higher oil prices, larger increases in non-oil import prices, a steep rise in commodity prices, a reemergence of price pressures from intermediate materials, some deterioration in near-term inflation expectations, and a disappointingly large increase in core PCE [personal consumption expenditures] prices in January. To our relief, this morning=s PPI for February did not add to this list. The increase in core finished goods—at 0.1 percent—and the increase in core intermediate materials—at 0.5 percent—were right in line with the Greenbook projection. But taken together, price developments over the intermeeting period have been troubling. The effects of higher oil prices are already being felt at the pump, and headline inflation measures will be up noticeably in February and March. Moreover, higher energy and materials prices are adding to business costs, and higher prices for imports are lessening competitive pressures on the pricing decisions of domestic producers. In response to these developments, we have raised the projected increase in core PCE prices to 1¾ percent in 2005 and 1½ percent in 2006—about ¼ percentage point higher than our previous projection in both years. Still, the basic contours of the inflation forecast remain the same. Such a modest revision might lead some to wonder if the staff should be doing a little more hand-wringing if we wish to avoid an eventual neck-wringing! But at this point, we believe that only a modest revision is warranted. As you know, for the prices of oil and other commodities, we take our cues from futures markets. And, as they have for much of the past year, those markets are suggesting that a flattening out of prices is just around the corner and that declines will occur by next year. Futures markets have not proven to be terribly reliable guides to prices over the past year, but we simply aren=t confident that we can outguess the markets in these areas. March 22, 2005 13 of 116 Moreover, the labor cost picture remains quite subdued. Growth in hourly labor compensation has basically moved sideways in recent quarters. Our projection incorporates some acceleration in wage inflation in response to higher price inflation this year and a gradual tightening of the labor market. But the faster projected growth of actual and structural labor productivity holds down the overall increase in unit labor costs. Indeed, the combination of slightly higher price inflation and lower unit labor costs resulted in an upward revision to the price markup in this projection, which already was above historical norms. In effect, greater pricing power is implicit in this forecast. As I see it, the most disquieting development on the inflation front has not been the run-up in energy and commodity prices, but has been the apparent rise in inflation compensation over the next three years—at least as best as we can judge by readings from the inflation swaps market. Should a deterioration in inflation expectations eventually come to be reflected in wage- and price-setting decisions, you would be facing a more substantial, persistent, and ultimately costly acceleration of labor costs and prices. As we showed in an alternative simulation in the Greenbook, those difficulties are amplified if monetary policy is slow to respond to heightened inflation expectations, and real interest rates are inadvertently eased. On the other hand, the most comforting development on the inflation front has been the continued exceptional performance of productivity. Although we have revised up our forecast for actual and structural productivity, we are still betting on a substantial slowdown of structural multifactor productivity. As we showed in another simulation, if that doesn’t occur, cost pressures could be considerably less than we are currently anticipating and inflation could drop to the low end of your comfort zone. Karen will continue our presentation. March 22, 2005 14 of 116 No one factor explains the run-up in prices since late January, but a major reason seems to be stronger demand in global markets—currently and prospectively, in the eyes of market participants. This stronger demand is arising from a global economy in which continued expansion at a reasonably robust pace seems likely, albeit with some variation across regions. Also, there are currently some supply risks in the usual trouble spots among oil-producing countries. But over the longer run, the issue seems to be how projected increases in demand will be met by increased supply. Of the 2.7 million barrels per day that global consumption increased during 2004, 30 percent, or 850,000 barrels per day, was accounted for by increased consumption in China. China is now the second-largest oil consumer on the globe; the United States is first. The staff continues to rely on futures markets for our projection of the spot WTI price. After the first couple of months, the futures curve slopes down and is the basis of our forecast that, by the end of 2006, that price will be somewhat below today=s price. However, we also need to forecast the U.S. oil import price, and for us the challenge is to project the spread going forward between WTI and the import price. That spread was quite variable last year, and in January of this year it jumped up again, to over $9 per barrel. We currently expect that the spread will narrow, on balance, over the forecast period, with the result that the U.S. price for imported oil will decline only slightly from current levels—noticeably less than the decrease embedded in the futures curve for WTI—by the end of next year. However, we could be surprised, and the behavior of that spread is one of the risks to the forecast. The general increase in global oil prices has been cited by many as a reason for rising inflation expectations and the move up in long-term interest rates across the major industrial countries during the intermeeting period. Ten-year sovereign rates in the major foreign industrial countries generally rose about 20 basis points since your last meeting, somewhat less than the increase in the U.S. rate. The smaller rebound in rates abroad is consistent with the perception that recent economic indicators suggest a more vigorous pace of expansion in the U.S. economy than in the other industrial economies. And foreign rates declined more sharply than did U.S. rates from the end of last June, when you began your current tightening cycle, to the turning point for rates in early February. However, it may be that the stronger price performance of bonds denominated in the major foreign currencies reflects some shift in portfolio preferences away from dollar assets toward those denominated in the other major currencies. Such an interpretation is consistent with the 1 percent net nominal depreciation of the foreign exchange value of the dollar in terms of the other major currencies over the intermeeting period and the fact that stock market indexes in the foreign industrial countries generally outperformed U.S. indexes over the same interval. March 22, 2005 15 of 116 widened nearly $90 billion from the third-quarter figure, with about $60 billion of that change accounted for by the increase in the trade deficit. Of that $60 billion, more than half represents the deterioration in the oil import bill. Relative to the figures we put in the Greenbook, net investment income surprised us in the positive direction. That surprise was entirely in net direct investment receipts, as net portfolio income came in about as expected, around $25 billion weaker than in the third quarter. Direct investment receipts were particularly strong, with the increase more than offsetting a small positive surprise in direct investment payments. The fourth- quarter increment in the current account deficit was financed by somewhat larger foreign official financial inflows and substantially larger foreign private net purchases of U.S. securities, particularly of agency bonds and corporate stocks. The rise in foreign inflows was sufficient to finance a small rise in U.S. net private acquisitions of foreign securities and an unusual but sizable increase from the third quarter of U.S. direct investment abroad. Looking forward, we expect the trade deficit to widen further both this year and next. With little change projected in the U.S. oil import price, the oil import bill should increase only slightly, and most of the deterioration in the trade balance is expected to occur within the core goods categories—that is, goods less oil, computers, and semiconductors. Accordingly, in real terms we are looking for net exports to make a small negative contribution to GDP growth in each of the two years. We expect the widening of the nominal trade deficit to be nearly matched by further reduction in the net investment income balance, as the negative change to net portfolio income substantially outweighs projected gains in net direct investment income. Accordingly, the current account deficit should widen to exceed $850 billion, or 6½ percent of GDP, by the end of next year. We also received February prices of internationally traded goods late last week. Prices for non-oil core imports increased a bit more than we were expecting. February price rises were concentrated in foods, feeds, and beverages and in non-oil industrial supplies; but for January and February combined, all categories of non-oil, core goods other than autos registered significant upward moves. These developments leave us with a projection for inflation of the core import price deflator in the first quarter of nearly 5 percent at an annual rate, higher than the January Greenbook figure and higher than our equations by themselves would suggest. We do not yet have sufficient evidence to conclude that the decline observed in past exchange rate pass-through is being reversed. With the effects of dollar depreciation in the second half of last year and the recent run-up in commodity prices likely to be felt through the end of this year, we expect core import price inflation to be about 2 percent at an annual rate during the rest of this year before slowing noticeably next year, consistent with our outlook for flat commodity prices and only modest further dollar depreciation. March 22, 2005 16 of 116" FOMC20061212meeting--69 67,MS. MINEHAN.," It’s not fair. [Laughter] Well, to the extent that this sounds like North Dakota, let me just proceed. Despite data from the housing markets that suggest that New England is suffering the real estate slowdown perhaps more than the rest of the nation—at least in terms of falling house prices—the overall regional economy appears to be doing fairly well. This is the bimodal model that a couple of people have talked about. Moderate employment growth continues. Layoffs are down, and electronic job postings, as opposed to newspaper want ads, are rising. Retailers are cautious about the fallout from the housing market, but except for those in the hardware or furniture businesses, sales were reportedly buoyed by the drop in gasoline prices. Indeed, October saw the first year-over-year decline in gas prices in the Boston area in four years. Manufacturing overall has been running ahead of last year, with aircraft, energy, and scientific equipment particularly robust. Growth in high-tech and biotech service companies remains strong; and while wage growth overall is slightly below national levels, salaries for higher-skilled staff with professional degrees are being bid up, reflecting strong demand. Consumer confidence is solid, especially regarding future conditions, and I’ve seen the same thing that President Moskow commented on—the optimism of business contacts. Business confidence as measured by local organizations has been on a steady upward trend since June, with employers significantly more positive about national economic conditions, the rising stock market, falling energy prices, and favorable interest rates. The mild fall weather, although a major problem for the early ski season, boosted tourism, which is reportedly going gangbusters—that’s a technical term—in Boston and other areas. Convention sites are booked ahead, and hotel rates are rising. The regional housing market continues on the downside. Sales of existing homes declined 20 percent from their year-earlier peaks, and inventories and time on the market continue to rise. Prices of existing homes were down in New England overall for the first six months of the year and down again from Q2 to Q3 for three of the six states, according to the OFHEO index. Moreover, new housing permits were down 13 percent, and the dollar value of construction contracts was off sharply. However, New England’s market for new construction is small, and as near as we can see, not much speculative building occurred during the boom. Thus, homebuilder finances remain in relatively reasonable shape. There will likely be write-offs for suppliers this winter and perhaps some consolidation in the local industry, but we don’t see many major local economic effects from this. On the positive side, price-level declines have the welcome effect of making regional housing stock, particularly housing in the Boston area, more affordable. Suppliers and bankers noted that they saw signs of a modest pickup in sales in September and October, and they look forward to a brighter spring season if mortgage rates stay at their current lows. Commercial real estate remains a very different world, however. In fact, comments regarding commercial real estate investment in a number of cities around New England have served to highlight the liquidity that continues to characterize debt and asset markets, driving the yields lower, keeping spreads tight, and moving prices of even unlikely assets higher. In the notes from our Beige Book contacts was a very interesting conversation with a commercial real estate firm in Hartford, Connecticut, which has long been a depressed area. The contact reported that Hartford was attracting institutional investment interest for the first time since the 1980s and that commercial real estate deals were being done with cap rates of 7 to 8 percent. Providence reported similar commercial real estate strength; and in Boston, cap rates were said to be a bit below 6 percent. Pricing action in Boston remained above replacement cost with inflows of funds for deals reportedly from Middle Eastern and Irish sources. Vacancy rates in Boston are down. Rental rates are up, and pressure to serve the growth of new biotech firms is reportedly creating hot commercial real estate markets in Cambridge and in suburban areas just west of the city. While hot commercial real estate markets in eastern Massachusetts and even Providence are not particularly new news, such interest in Hartford really is. On the one hand, investor interest in places like Hartford may be a sign of real overheating. On the other hand, if the lid stays on, areas like Hartford stand to benefit from a rise in investment and, one hopes, related job growth. Turning to the nation, the recent tone of the incoming data, especially on the manufacturing side, has been subdued, as declines in the housing market and in motor vehicle spending and production have taken their toll. But I think this tone may well result from the ebb and flow of high-frequency observations. At the time of our last meeting, incoming data seemed more positive overall, and many of the factors present then—including solid employment growth, low unemployment, healthy debt and equity markets, solid corporate profits, good foreign growth, and a less negative or even a neutral-to-positive effect of net exports—remain. Fourth-quarter GDP data may well be disappointing to the markets, but given both what the staff believes is a calculation error on the part of the BEA and the fact that so many supportive factors remain, I am hopeful about prospects for ’07 and ’08. Our forecast in Boston retains the same trajectory as the Greenbook’s—a slow fourth quarter and a growing rebound over the next couple of years as residential investment recovers combined with a gradual small uptick in unemployment and an ebb in core inflation to the low 2s. Thus, despite the sense in markets that momentum has shifted downward, I don’t think that the baseline outlook has changed much since our last meeting, and the Greenbook forecast reflects that pretty well. Similarly, although risks exist both that growth will be slower and that inflation will be faster, I believe those risks to be fairly balanced at this point, though they are certainly not minor. Of concern, however, is the cost of being wrong on the inflation side. This is certainly not the time to let down our guard on this front with labor markets fairly tight, the unemployment rate at 4½ percent, and most of the downward effect of declining energy prices behind us. We could see inflation move sideways rather than down, and that could well be an issue. Markets see us beginning to ease as soon as the late first quarter, early second. Perhaps they’re right, but I remain to be convinced by the incoming data. Thank you." FOMC20070628meeting--139 137,CHAIRMAN BERNANKE.," Thank you, and thanks to everyone. Let me try to give a quick summary, and if I misrepresent you, please let me know. Participants’ expectations for growth were varied, but most people expect to see strengthening over the remainder of this year and into 2008 and 2009. The principal source of downside risk is housing, which remains weak, perhaps in part because of problems in mortgage markets. However, significant spillovers have yet to emerge from the housing situation, and other components of demand appear to be strengthening and thereby offsetting the drag from residential construction. A number of participants referred to the strength of the global economy, which is stimulating U.S. exports but also leading to increases in costs of energy and metals. Investment has picked up from a bit of a pothole and is growing now at a moderate pace with particular strength on the commercial real estate side. Inventories are mostly aligned with sales and manufacturing seems to be strengthening overall. Consumption seems likely to grow at a steady but not exuberant level, with factors such as gasoline prices and slower house appreciation creating some drag but strong employment and incomes acting as supports. Indeed, the labor market continues to be strong, although there are some measurement issues that were noted, with unfilled demands for highly skilled workers and with some signs of wage pressures. Overall, the risks to output seem roughly balanced around the path of a gradual increase in growth. Participants did note the increase in long-term interest rates, which tended to align market policy expectations with those of the Committee. Higher long-term interest rates and some other changes in financial markets may be slightly restrictive but probably not substantially so. Some also noted risks in financial markets, including the aforementioned risks associated with the subprime sector, but also more-general concerns about structured credit products and the possible effects of a decline in liquidity. However, I would note also, as some others did, that a bit of cooling in the financial markets might not be an entirely bad thing. Recent core inflation numbers have been favorable, and most of you see continued moderation in inflation resulting from mildly restrictive policy, the ending of some temporary influences, and slower increases in shelter costs. However, a few of you have suggested that some of the recent improvement in core inflation is transitory, and they noted upside risks, including resource utilization, possible pass-through from energy and commodity costs, slower productivity growth, and the possible effect of high headline inflation on inflation expectations. High capacity utilization—and “globally,” President Fisher—is also a source of possible inflation pressure." FOMC20060920meeting--9 7,MR. KOS.,"1 Thank you, Mr. Chairman. Among market participants, September has a reputation for being difficult on portfolios, for sudden bursts of volatility that lead to risk aversion and wider spreads, and for sometimes spectacular blowups in the speculative community. The ERM crisis in 1992, Long-Term Capital Management in 1998, and the aftermath of the terrorist attacks in 2001 are three of the more notable examples. Until Monday, this year looked different. Spreads were and they continue to be narrow. Volatility has generally been low, with the notable exception of energy. Yields are benign, and equity prices, if anything, have been rising in recent weeks. 1 The materials used by Mr. Kos are appended to this transcript (appendix 1). The massive loss disclosed on Monday by a large hedge fund has had remarkably, almost suspiciously, little spillover effects thus far. But with political crises suddenly popping up in Hungary and Thailand, it may suggest that risks in some of these smaller, less-liquid market sectors such as emerging markets and commodities have risen. Overnight the Thai baht was slightly weaker, Thai banks and markets were closed, and currencies and equity markets of neighboring countries were, on balance, only marginally weaker. Meanwhile in the G3, markets have generally been calm, though recent moves suggest a more sober outlook for growth than had been priced in earlier this summer. On page 1 of your handout, the top panel graphs the three-month Eurodollar deposit rate in black and the same rate three, six, and nine months forward in red since the beginning of the year. In recent weeks, forward rates traded through the cash rate as assorted reports—especially housing and inflation data—convinced market participants that (1) the Committee would continue to hold the target funds rate steady for sometime longer and (2) the probability of an ease early next year was far more likely than a resumption of the tightening cycle. That view was seemingly shared by investors in the Treasury market. As shown in the middle panel, two-year and ten-year yields have been gently declining since the June meeting. The ten-year yield currently trades about 50 basis points below the target funds rate—the widest negative spread since March 2001. Meanwhile, various measures of the yield curve have now been mildly inverted for several weeks—perhaps also reflecting the market’s view that a slowdown is in the offing. The bottom panel graphs the straight ten-year breakeven rate and the five-year rate five years forward. Both declined modestly since the last meeting, helped by inflation readings that did not repeat this spring’s elevated numbers and also by the moderation of commodity prices in general and energy prices in particular. The view that growth may be less robust was reflected in overseas markets as well. On page 2, the top panel graphs the calendar spread for interest rate futures between the December 2007 and the December 2006 contracts for the G5 economies since January 1. In recent weeks that spread has, on balance, been declining slightly as markets have taken out tightenings that had been priced in for coming quarters. Even in Europe, where the ECB has been talking tough, market participants are reassessing what effect a U.S. slowdown would have on the ECB’s trajectory. The middle panel graphs ten-year sovereign yields for the United States, Canada, the United Kingdom, and, as a proxy for the euro area, France. Those yields rose during the first six months of the year and have retreated more recently. While there is a story for each economy, the most recent sets of data have been slightly less favorable, and forecasts for the next few quarters have been trimmed back. Meanwhile, as shown by the middle right panel, U.S. and Canadian breakevens have declined slightly. In contrast, breakeven rates in the United Kingdom and France have risen somewhat. Indeed, the ECB has repeatedly voiced concerns about rising headline inflation and the persistence of that trend. Japan is a somewhat special case. Through midyear, forecasts for Japanese growth had been rising. Deflation was ebbing, loan growth was rising, and the BoJ opportunistically exited its quantitative easing policy in March and then exited the zero interest rate policy in mid-July. However, as shown in the bottom left panel, yields could not get past 2 percent and then began to decline as data such as machinery orders disappointed investors and led them to question how fast the BoJ would raise interest rates. Then on August 24, Japan released revisions to the CPI, which showed that inflation had been lower than previously reported. Markets quickly pushed back the timing of future call rate increases despite the BoJ’s assertions that the revisions did not change its basic outlook. Japan does have a nascent inflation-linked Japanese government bond market. The bottom right panel graphs the breakeven, which has fallen from about 1 percent to about 60 basis points. As shown in the top panel of page 3, the entire JGB curve has shifted down since the last FOMC meeting. One factor that has continued to work in favor of Japan’s export sector has been the exchange rate. The yen’s nominal value has been falling against most currencies in recent weeks and hit its lowest level against the euro since the single currency’s launch. The middle panel takes a much longer perspective on the yen; it graphs the real effective exchange rate since the beginning of the floating rate era. The real effective rate has been falling steadily since 2000 and is at its lowest level in more than 20 years despite the chronic trade and current account surpluses that Japan has generated in the interim. The bottom two panels on page 3 reflect the recent volatility in commodity prices, with metal prices on the bottom left and energy prices on the bottom right. Metal prices continue to fluctuate but show some signs of having topped out for the time being. Energy prices, however, have made a round trip from where they were at the beginning of the year. The retracing of prices has fed discussions about whether the so-called speculative premium in energy prices has now been taken out. Certainly there are signs that speculators have been exiting some of these positions. Those signs are most visible for natural gas, which is something of an outlier in the bottom right. Last week’s sharp decline in prices may have been related to the liquidation of positions by the large hedge fund that was closing out positions. If the speculative money is being chased out, for natural gas but also for other products, then perhaps energy prices now better reflect underlying fundamentals. Finally, I want to come back briefly to a topic I mentioned at the last meeting related to the nascent development of an early-return fed funds market. As background, fed funds contracts do not generally dictate the timing of the return leg. So, not surprisingly, most fed funds are returned to the lender late in the day. The GSEs have been interested in developing an early-return facility to meet the principal and interest payment timetable given the new PSR (payment system risk) rules. The data are sparse, and our conclusions are tentative, but I wanted to give you a brief update. On page 4, the blue bar in the top panel graphs daily volumes of regular overnight fed funds contracts. The smaller green bar represents overnight early- return volumes. The black line shows the percentage of overall volumes represented by early returns. The time series starts on August 8, which is when data first became available to us. This series does not include term trades with early-return provisions. In general, early returns make up about 10 percent of overall volumes. The middle panel graphs the effective rate for those trades with early-return provisions in red. The blue line is the 9:00 a.m. rate. Early-return trades are transacted in midmorning and thus show a strong correlation with the 9:00 a.m. rate, generally trading about 2 basis points below regular funds. Finally, as shown in the bottom panel, early-return trades have far less volatility. The reason for the lower volatility is primarily that these trades are executed in midmorning rather than during the late afternoon rush, when the funds rate often can move with large swings. Getting back to the GSEs, they in fact have not been active users of overnight early-return fed funds. They have, however, used term fed funds of up to a month maturity with early-return provisions timed to mature on the date of their large P&I dates. For term rates, unlike for overnight trades, there is no rate concession. Mr. Chairman, there were no foreign exchange operations for the period. I will need a vote to approve domestic operations." fcic_final_report_full--184 CDOs were issued under a different regulatory framework from the one that ap- plied to many mortgage-backed securities, and were not subject even to the minimal shelf registration rules. Underwriters typically issued CDOs under the SEC’s Rule A, which allows the unregistered resale of certain securities to so-called qualified institutional buyers (QIBs); these included investors as diverse as insurance compa- nies like MetLife, pension funds like the California State Teachers’ Retirement Sys- tem, and investment banks like Goldman Sachs.  The SEC created Rule A in , making securities markets more attractive to borrowers and U.S. investment banks more competitive with their foreign counter- parts; at the time, market participants viewed U.S. disclosure requirements as more onerous than those in other countries. The new rule significantly expanded the mar- ket for these securities by declaring that distributions which complied with the rule would no longer be considered “public offerings” and therefore would not be subject to the SEC’s registration requirements. In , Congress reinforced this exemption with the National Securities Markets Improvements Act, legislation that Denise Voigt Crawford, a commissioner on the Texas Securities Board, characterized to the Com- mission “as prohibit[ing] the states from taking preventative actions in areas that we now know have been substantial contributing factors to the current crisis.”  Under this legislation, state securities regulators were preempted from overseeing private placements such as CDOs. In the absence of registration requirements, a new debt market developed quickly under Rule A. This market was liquid, since qualified investors could freely trade Rule A debt securities. But debt securities when Rule A was enacted were mostly corporate bonds, very different from the CDOs that dominated the private placement market more than a decade later.  After the crisis unfolded, investors, arguing that disclosure hadn’t been adequate, filed numerous lawsuits under federal and state securities laws. As we will see, some have already resulted in substantial settlements. REGULATORS: “MARKETS WILL ALWAYS SELF CORRECT ” Where were the regulators? Declining underwriting standards and new mortgage products had been on regulators’ radar screens in the years before the crisis, but dis- agreements among the agencies and their traditional preference for minimal interfer- ence delayed action. Supervisors had, since the s, followed a “risk-focused” approach that relied extensively on banks’ own internal risk management systems.  “As internal systems improve, the basic thrust of the examination process should shift from largely dupli- cating many activities already conducted within the bank to providing constructive feedback that the bank can use to enhance further the quality of its risk-management systems,” Chairman Greenspan had said in .  Across agencies, there was a “his- toric vision, historic approach, that a lighter hand at regulation was the appropriate way to regulate,” Eugene Ludwig, comptroller of the currency from  to , told the FCIC, referring to the Gramm-Leach-Bliley Act in .  The New York Fed, in a “lessons-learned” analysis after the crisis, pointed to the mistaken belief that “markets will always self-correct.” “A deference to the self-correcting property of markets inhib- ited supervisors from imposing prescriptive views on banks,” the report concluded.  The reliance on banks’ own risk management would extend to capital standards. Banks had complained for years that the original  Basel standards did not allow them sufficient latitude to base their capital on the riskiness of particular assets. After years of negotiations, international regulators, with strong support from the Fed, in- troduced the Basel II capital regime in June , which would allow banks to lower their capital charges if they could show they had sophisticated internal models for es- timating the riskiness of their assets. While no U.S. bank fully implemented the more sophisticated approaches that it allowed, Basel II reflected and reinforced the super- visors’ risk-focused approach. Spillenkothen said that one of the regulators’ biggest mistakes was their “acceptance of Basel II premises,” which he described as display- ing “an excessive faith in internal bank risk models, an infatuation with the specious accuracy of complex quantitative risk measurement techniques, and a willingness (at least in the early days of Basel II) to tolerate a reduction in regulatory capital in re- turn for the prospect of better risk management and greater risk-sensitivity.”  Regulators had been taking notice of the mortgage market for several years before the crisis. As early as , they recognized that mortgage products and borrowers had changed during and following the refinancing boom of the previous year, and they began work on providing guidance to banks and thrifts. But too little was done, and too late, because of interagency discord, industry pushback, and a widely held view that market participants had the situation well in hand. “Within the board, people understood that many of these loan types had gotten to an extreme,” Susan Bies, then a Fed governor and chair of the Federal Reserve Board’s subcommittees on both safety and soundness supervision and consumer protection supervision, told the FCIC. “So the main debate within the board was how tightly [should we] rein in the abuses that we were seeing. So it was more of ‘to a degree.’”  Indeed, in the same June  Federal Open Market Committee meeting de- scribed earlier, one FOMC member noted that “some of the newer, more intricate and untested credit default instruments had caused some market turmoil.” Another participant was concerned “that subprime lending was an accident waiting to hap- pen.” A third participant noted the risks in mortgage securities, the rapid growth of subprime lending, and the fact that many lenders had “inadequate information on borrowers,” adding, however, that record profits and high capital levels allayed those concerns. A fourth participant said that “we could be seeing the final gasps of house price appreciation.” The participant expressed concern about “creative financing” and was “worried that piggybacks and other non-traditional loans,” whose risk of default could be higher than suggested by the securities they backed, “could be making the books of GSEs look better than they really were.” Fed staff replied that the GSEs were not large purchasers of private label securities.  CHRG-111hhrg74855--23 Mr. Scalise," Thank you, Mr. Chairman. I am strongly in favor of pursuing policies that prevent another financial market collapse from occurring and I strongly support increasing transparency and oversight in our financial markets. However, I have serious concerns about provisions in this bill that will raise utility costs on every American family and will ship thousands more American jobs overseas. Derivatives serve many purposes including stabilizing prices and ensuring future deliveries of commodities. Market participants also use derivatives to ensure that consumers are protected from sudden price hikes and other events including natural disaster that can negatively impact costs. While I support increasing oversight and transparency to reign in the large financial institutions which contributed to the current economic crisis, we need to make sure to consider the effects on those who play by the rules. Mr. Chairman, as with cap and trade and other reckless policies, these proposals would kill American jobs and increase costs for businesses and families across this country. From the perspective of my position on this committee, I have serious concerns about the utility rate hikes that will result from provisions in this bill but it doesn't stop there. We are seeing a dangerous trend with this administration and the Democrats running Congress. Provisions in this bill will have serious negative impacts on our economy and these proposals taken with the cap and trade energy tax and the government takeover of healthcare will prohibit our small businesses, those very job creators in our country from getting our economy back on track. These reckless policies will result in billions of dollars in new taxes on American families, millions of American jobs lost and shipped overseas and the destruction of our economy. In this current economic crisis, our focus should be on creating new jobs not more reckless policy that run jobs out of our country. Again, Mr. Chairman, I am strongly in favor of pursuing policies to prevent bad players from bringing down our markets in the future and I believe that oversight and transparency are key components to that goal. The American people are asking where are the jobs and all they get from this tone-deaf Congress are more radical schemes that raise taxes on American families and run more jobs out of our country. Enough is enough. Thank you and I yield back. " FOMC20070509meeting--84 82,MR. WARSH.," Thank you, Mr. Chairman. My own views on the economy haven’t changed much since we last met and aren’t terribly at odds with the Greenbook. I’d highlight a couple of reasons for concern, a couple of areas in which the misses could be severe. I share the views expressed by many around the table, most recently by Governor Kohn, on the inflation front. I remain quite concerned about inflation prospects, and I’m keeping a wary eye on inflation expectations, particularly if there were to be acceleration in the trends on commodity prices or the foreign exchange value of the dollar. My sense is that the markets haven’t fully taken into account what that could be, and we could find the markets more preoccupied with an inflation scare than they appear to be at this moment. So I think that, during the balance of ’07, the inflation risks tend to be more significant than the growth risks, and I would expect to see sequential increases in GDP, as in the Greenbook, as we go through the next several quarters. The big point of what that is predicated on is really the continued accommodation in the credit markets and the capital markets, as several people have noted. I was thinking about my projections and, as we look to ’08 and ’09, the bigger risks there tend to be more policy oriented as we head into the next election, and they may well have some effect on the capital markets. So as I think about the second half of ’08 and the first half of ’09 and what the likely GDP implications would be, I can’t help but think that changes or perceived changes in tax policy and trade policy could be the biggest drivers to the capital markets and, as a result, have the biggest effects on the macroeconomy. So there are huge risks, as I look beyond ’07, in terms of where GDP might come out; but as a central case, the Greenbook formulation looks roughly in accord with my own. Let me spend a moment on consumption. My view is broadly consistent with what others have said earlier today. I spoke in the past week with one credit card company whose customer base is similar to the average aggregate customer base in the United States. They have about one-fifth of all credit card spending, and they reported to me their April results, which might provide us with some clues about PCE growth and credit quality. Card spending for April, from their perspective, was consistent with moderate deceleration in real consumption. They ended up in April with nominal year-over-year growth of about 4 percent in non-auto retail sales, which is a slowdown from the fourth quarter of ’06 and a slowdown from January, but it is up a bit from February and March, when they were getting quite despondent and were worrying a bit about their projections for the next three quarters. They think their April numbers look okay, quite consistent with the moderate deceleration that many folks here have talked about. They believe that they have hit the floor on that, but time will tell. What they have not been able to do, at least up to the time of my discussions with them, is to break out retail purchases outside fuel to find out whether less strength is there than the 4 percent top-line number would suggest. I suspect that would be the case. How all this fits into market expectations we’ll know over the next couple of days. This strikes me as an average, okay number that may be a touch better than market expectations, but it shouldn’t give us a whole lot of comfort if we’re trying to suggest that there is a robust recovery on consumption and PCE. Credit quality remains very strong across consumer credit and the company’s mortgage products. I would note that they don’t have much subprime in their portfolio—what is subprime has fallen to that level rather than having begun there when they issued the credit. Payment rates, use of credit lines, delinquencies, charge- offs—all are at very positive levels with little indication of more-serious weakening of consumer demand. So, again, I think the prospects outlined by the Greenbook in terms of PCE look broadly consistent with the April numbers. Let me turn now to the capital markets and the credit markets and speak about three or four observations that may be a bit more newsworthy than when we last met six weeks ago. First, I will talk a little about the dearth of defaults in corporate loans, then spend a couple of moments on private equity, building on Bill Dudley’s discussion at the outset on the correlation among asset classes, and finally spend a moment on the shakeout in the mortgage markets. The predicate for this is something that we all know, and several people have spoken about earlier today. As corporate America has become more cautious, Wall Street has become more aggressive to satisfy investors’ appetites for risk. So we’re seeing risk aversion in one category on Main Street and real risk-seeking behavior on Wall Street. Financial risk-taking remains high and may well have even increased since we last met. If you’ll look at the MOVE options index measuring one-month volatility on Treasuries, it’s the lowest it has been in about nine years, since the index came into being, and it suggests President Minehan’s point that all the forces of liquidity and froth that might be in the market are probably more present today than any of us could have imagined given the tumult in the markets in late February. At the same time, nonfinancial corporate risk-taking continues to be more subdued than objective measures would suggest it should be. There is reason to hope that the cap-ex data will come around to where many of us expected it to be already, but some determination still needs to be done on that. So we hear, and some of us even say, that these capital markets appear priced to perfection, that credit markets are as strong as ever, and that liquidity is plentiful. I would add my concern to the implausibility of that notion, which President Geithner and others spoke about. The reason for central bankers to worry is, of course, that these narrower spreads provide less of a shock absorber for unforeseen events. Let me now go through the points that I mentioned at the outset and describe their implications for the decisions we make. First is the dearth of defaults on corporate loans. Historically low year-ahead default rates were referenced in the Greenbook, and they should give us comfort, at least in theory. I share the Greenbook view that corporate defaults should increase as profits level out and leverage increases to more normal levels. But fewer defaults are even possible in this financing environment, and that makes me a little less sanguine about those data. If we think about covenant packages on corporate loans, both originated on Wall Street and originated at community banks—I think President Yellen spoke at a previous meeting about covenant-lite deals—it is incredibly hard to get defaults in the context of these loans, never mind event-of-default notices and everything else that would find its way into the indentures. As a result, we have seen a recent spate of financings with covenant packages that are increasingly issuer-friendly, without triggers that would otherwise cause defaults: no debt payment schedules, never mind even the need to make interest payments, with the ability to turn those into sort of pay-in-kind notes. All of that, it strikes me, should make us nervous if business fundamentals shift abruptly and investors are left with little opportunity to gain access to their capital or to be in a position to force companies to restructure their operations. As a result I am less sanguine about these low default data that we continue to receive from Wall Street. A second point is the state of private equity in the capital markets. What I note builds on the recent history that we’ve seen: massive fund-raisings; larger LBOs; increasing leverage; in the past twelve months, we’ve seen the so-called club deal phenomenon; the growth of equity bridges, which I and others have talked about; and when we last met, we discussed the interest many of these firms have for rushing into the capital markets by finding permanent capital. The newest development is the growth of syndication in the equity placement in these LBO markets. The same way that we have syndicated debt markets that have matured incredibly over the past six to ten years, on the equity side there are huge investments that are presently being considered and potentially being made. So one LBO sponsor might fund a certain portion of the equity check on an LBO and then line up, through an equity syndicate manager at a traditional investment bank or a commercial bank, the ability to sell down the rest of that equity through an infrastructure and distribution system that is being built. I doubt that we will see that syndication market five years from now as deep and as large as the debt markets. But I do think that it shows us that new liquidity continues to come even to the private placement 144(a) markets alongside the growth in the public capital markets. That liquidity could well improve tradability. To the extent that these syndications are new, they show us that liquidity is plentiful; but they also show us that many of these new mechanisms have not been stress-tested. The other implication of this boom in private equity is that it has raised the floor on equity prices. My sense is that there is a private equity put that may well have replaced what used to be thought of as a Federal Reserve put on the floor of equity prices, and that equity put appears to be larger than it has ever been. Thus we have seen increased total leverage through these structured products; credit markets, as I’ve mentioned, are more robust; and there is a question of stress testing, which is still to be determined. Another point on the capital markets relates to what Bill said about the correlation among asset classes. CEOs, CFOs, and chief risk officers of large financial firms have found quite troubling the greater correlation among asset classes than most of their internal models had suggested. As they looked at their dashboards in the weeks after the tumult that we saw last February, they grew increasingly uncomfortable about whether they had accurately measured what their firms’ downside risks are. Certainly it’s encouraging, as Bill showed us, that there appears to be less correlation over recent weeks. That’s a lesson being learned and relearned and tested and retested in these institutions. That they may be heeding the wakeup call is good news, but time will tell whether it will be enough to catch up before problems arise in the market. My final point concerns the consequences of a shakeout in the mortgage markets. My sense is that, after the fallout in subprime, the market is becoming more consolidated with larger, more-sophisticated lenders that can more quickly provide more markets that satisfy customers’ newest wants. The success in these markets of investment banks and hedge funds will go to those with scale, with strong distribution systems, and with control over their servicing businesses, so that they are effectively able to engineer workouts and avoid the need to foreclose. I think that over the balance of this year we will hear more news from small and medium-sized commercial banks that feel as though their market share is being taken away during this tumult, and that is something that we need to continue to observe. With that, Mr. Chairman, I’ll save the rest of my comments for the next round." CHRG-110shrg50369--143 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System February 28, 2008 Chairman Dodd, Ranking Member Shelby, and other Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. In my testimony this morning I will briefly review the economic situation and outlook, beginning with developments in real activity and inflation, then turn to monetary policy. I will conclude with a quick update on the Federal Reserve's recent actions to help protect consumers in their financial dealings. The economic situation has become distinctly less favorable since the time of our July report. Strains in financial markets, which first became evident late last summer, have persisted; and pressures on bank capital and the continued poor functioning of markets for securitized credit have led to tighter credit conditions for many households and businesses. The growth of real gross domestic product (GDP) held up well through the third quarter despite the financial turmoil, but it has since slowed sharply. Labor market conditions have similarly softened, as job creation has slowed and the unemployment rate--at 4.9 percent in January--has moved up somewhat. Many of the challenges now facing our economy stem from the continuing contraction of the U.S. housing market. In 2006, after a multiyear boom in residential construction and house prices, the housing market reversed course. Housing starts and sales of new homes are now less than half of their respective peaks, and house prices have flattened or declined in most areas. Changes in the availability of mortgage credit amplified the swings in the housing market. During the housing sector's expansion phase, increasingly lax lending standards, particularly in the subprime market, raised the effective demand for housing, pushing up prices and stimulating construction activity. As the housing market began to turn down, however, the slump in subprime mortgage originations, together with a more general tightening of credit conditions, has served to increase the severity of the downturn. Weaker house prices in turn have contributed to the deterioration in the performance of mortgage-related securities and reduced the availability of mortgage credit. The housing market is expected to continue to weigh on economic activity in coming quarters. Homebuilders, still faced with abnormally high inventories of unsold homes, are likely to cut the pace of their building activity further, which will subtract from overall growth and reduce employment in residential construction and closely related industries. Consumer spending continued to increase at a solid pace through much of the second half of 2007, despite the problems in the housing market, but it appears to have slowed significantly toward the end of the year. The jump in the price of imported energy, which eroded real incomes and wages, likely contributed to the slowdown in spending, as did the declines in household wealth associated with the weakness in house prices and equity prices. Slowing job creation is yet another potential drag on household spending, as gains in payroll employment averaged little more than 40,000 per month during the 3 months ending in January, compared with an average increase of almost 100,000 per month over the previous 3 months. However, the recently enacted fiscal stimulus package should provide some support for household spending during the second half of this year and into next year. The business sector has also displayed signs of being affected by the difficulties in the housing and credit markets. Reflecting a downshift in the growth of final demand and tighter credit conditions for some firms, available indicators suggest that investment in equipment and software will be subdued during the first half of 2008. Likewise, after growing robustly through much of 2007, nonresidential construction is likely to decelerate sharply in coming quarters as business activity slows and funding becomes harder to obtain, especially for more speculative projects. On a more encouraging note, we see few signs of any serious imbalances in business inventories aside from the overhang of unsold homes. And, as a whole, the nonfinancial business sector remains in good financial condition, with strong profits, liquid balance sheets, and corporate leverage near historical lows. In addition, the vigor of the global economy has offset some of the weakening of domestic demand. U.S. real exports of goods and services increased at an annual rate of about 11 percent in the second half of last year, boosted by continuing economic growth abroad and the lower foreign exchange value of the dollar. Strengthening exports, together with moderating imports, have in turn led to some improvement in the U.S. current account deficit, which likely narrowed in 2007 (on an annual basis) for the first time since 2001. Although recent indicators point to some slowing of foreign economic growth, U.S. exports should continue to expand at a healthy pace in coming quarters, providing some impetus to domestic economic activity and employment. As I have mentioned, financial markets continue to be under considerable stress. Heightened investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates, triggered the financial turmoil. However, other factors, including a broader retrenchment in the willingness of investors to bear risk, difficulties in valuing complex or illiquid financial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for economic growth, have also roiled the financial markets in recent months. To help relieve the pressures in the market for interbank lending, the Federal Reserve--among other actions--recently introduced a term auction facility (TAF), through which prespecified amounts of discount window credit are auctioned to eligible borrowers, and we have been working with other central banks to address market strains that could hamper the achievement of our broader economic objectives. These efforts appear to have contributed to some improvement in short-term funding markets. We will continue to monitor financial developments closely. As part of its ongoing commitment to improving the accountability and public understanding of monetary policy making, the Federal Open Market Committee (FOMC) recently increased the frequency and expanded the content of the economic projections made by Federal Reserve Board members and Reserve Bank presidents and released to the public. The latest economic projections, which were submitted in conjunction with the FOMC meeting at the end of January and which are based on each participant's assessment of appropriate monetary policy, show that real GDP was expected to grow only sluggishly in the next few quarters and that the unemployment rate was seen as likely to increase somewhat. In particular, the central tendency of the projections was for real GDP to grow between 1.3 percent and 2.0 percent in 2008, down from 2\1/2\ percent to 2\3/4\ percent projected in our report last July. FOMC participants' projections for the unemployment rate in the fourth quarter of 2008 have a central tendency of 5.2 percent to 5.3 percent, up from the level of about 4\3/4\ percent projected last July for the same period. The downgrade in our projections for economic activity in 2008 since our report last July reflects the effects of the financial turmoil on real activity and a housing contraction that has been more severe than previously expected. By 2010, our most recent projections show output growth picking up to rates close to or a little above its longer-term trend and the unemployment rate edging lower; the improvement reflects the effects of policy stimulus and an anticipated moderation of the contraction in housing and the strains in financial and credit markets. The incoming information since our January meeting continues to suggest sluggish economic activity in the near term. The risks to this outlook remain to the downside. The risks include the possibilities that the housing market or labor market may deteriorate more than is currently anticipated and that credit conditions may tighten substantially further. Consumer price inflation has increased since our previous report, in substantial part because of the steep run-up in the price of oil. Last year, food prices also increased significantly, and the dollar depreciated. Reflecting these influences, the price index for personal consumption expenditures (PCE) increased 3.4 percent over the four quarters of 2007, up from 1.9 percent in 2006. Core price inflation--that is, inflation excluding food and energy prices--also firmed toward the end of the year. The higher recent readings likely reflected some pass-through of energy costs to the prices of core consumer goods and services as well as the effect of the depreciation of the dollar on import prices. Moreover, core inflation in the first half of 2007 was damped by a number of transitory factors--notably, unusually soft prices for apparel and for financial services--which subsequently reversed. For the year as a whole, however, core PCE prices increased 2.1 percent, down slightly from 2006. The projections recently submitted by FOMC participants indicate that overall PCE inflation was expected to moderate significantly in 2008, to between 2.1 percent and 2.4 percent (the central tendency of the projections). A key assumption underlying those projections was that energy and food prices would begin to flatten out, as was implied by quotes on futures markets. In addition, diminishing pressure on resources is also consistent with the projected slowing in inflation. The central tendency of the projections for core PCE inflation in 2008, at 2.0 percent to 2.2 percent, was a bit higher than in our July report, largely because of some higher-than-expected recent readings on prices. Beyond 2008, both overall and core inflation were projected to edge lower, as participants expected inflation expectations to remain reasonably well-anchored and pressures on resource utilization to be muted. The inflation projections submitted by FOMC participants for 2010--which ranged from 1.5 percent to 2.0 percent for overall PCE inflation--were importantly influenced by participants' judgments about the measured rates of inflation consistent with the Federal Reserve's dual mandate and about the time frame over which policy should aim to attain those rates. The rate of inflation that is actually realized will of course depend on a variety of factors. Inflation could be lower than we anticipate if slower-than-expected global growth moderates the pressure on the prices of energy and other commodities or if rates of domestic resource utilization fall more than we currently expect. Upside risks to the inflation projection are also present, however, including the possibilities that energy and food prices do not flatten out or that the pass-through to core prices from higher commodity prices and from the weaker dollar may be greater than we anticipate. Indeed, the further increases in the prices of energy and other commodities in recent weeks, together with the latest data on consumer prices, suggest slightly greater upside risks to the projections of both overall and core inflation than we saw last month. Should high rates of overall inflation persist, the possibility also exists that inflation expectations could become less well anchored. Any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and could reduce the flexibility of the FOMC to counter shortfalls in growth in the future. Accordingly, in the months ahead, the Federal Reserve will continue to monitor closely inflation and inflation expectations. Let me turn now to the implications of these developments for monetary policy. The FOMC has responded aggressively to the weaker outlook for economic activity, having reduced its target for the federal funds rate by 225 basis points since last summer. As the Committee noted in its most recent post-meeting statement, the intent of those actions has been to help promote moderate growth over time and to mitigate the risks to economic activity. A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability in an environment of downside risks to growth, stressed financial conditions, and inflation pressures. In particular, the FOMC will need to judge whether the policy actions taken thus far are having their intended effects. Monetary policy works with a lag. Therefore, our policy stance must be determined in light of the medium-term forecast for real activity and inflation as well as the risks to that forecast. Although the FOMC participants' economic projections envision an improving economic picture, it is important to recognize that downside risks to growth remain. The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks. Finally, I would like to say a few words about the Federal Reserve's recent actions to protect consumers in their financial transactions. In December, following up on a commitment I made at the time of our report last July, the Board issued for public comment a comprehensive set of new regulations to prohibit unfair or deceptive practices in the mortgage market, under the authority granted us by the Home Ownership and Equity Protection Act of 1994. The proposed rules would apply to all mortgage lenders and would establish lending standards to help ensure that consumers who seek mortgage credit receive loans whose terms are clearly disclosed and that can reasonably be expected to be repaid. Accordingly, the rules would prohibit lenders from engaging in a pattern or practice of making higher-priced mortgage loans without due regard to consumers' ability to make the scheduled payments. In each case, a lender making a higher priced loan would have to use third-party documents to verify the income relied on to make the credit decision. For higher-priced loans, the proposed rules would require the lender to establish an escrow account for the payment of property taxes and homeowners' insurance and would prevent the use of prepayment penalties in circumstances where they might trap borrowers in unaffordable loans. In addition, for all mortgage loans, our proposal addresses misleading and deceptive advertising practices, requires borrowers and brokers to agree in advance on the maximum fee that the broker may receive, bans certain practices by servicers that harm borrowers, and prohibits coercion of appraisers by lenders. We expect substantial public comment on our proposal, and we will carefully consider all information and viewpoints while moving expeditiously to adopt final rules. The effectiveness of the new regulations, however, will depend critically on strong enforcement. To that end, in conjunction with other federal and state agencies, we are conducting compliance reviews of a range of mortgage lenders, including nondepository lenders. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations of, and improved enforcement for, all categories of mortgage lenders. The Federal Reserve continues to work with financial institutions, public officials, and community groups around the country to help homeowners avoid foreclosures. We have called on mortgage lenders and servicers to pursue prudent loan workouts and have supported the development of streamlined, systematic approaches to expedite the loan modification process. We also have been providing community groups, counseling agencies, regulators, and others with detailed analyses to help identify neighborhoods at high risk from foreclosures so that local outreach efforts to help troubled borrowers can be as focused and effective as possible. We are actively pursuing other ways to leverage the Federal Reserve's analytical resources, regional presence, and community connections to address this critical issue. In addition to our consumer protection efforts in the mortgage area, we are working toward finalizing rules under the Truth in Lending Act that will require new, more informative, and consumer-tested disclosures by credit card issuers. Separately, we are actively reviewing potentially unfair and deceptive practices by issuers of credit cards. Using the Board's authority under the Federal Trade Commission Act, we expect to issue proposed rules regarding these practices this spring. Thank you. I would be pleased to take your questions. FOMC20080430meeting--56 54,MR. MADIGAN.," 2 I will be referring to the package labeled ""Material for Briefing on FOMC Participants' Economic Projections."" Table 1 shows the central tendencies and ranges of your current forecasts for 2008, 2009, and 2010. Central tendencies and ranges of the projections published by the Committee last February are shown in italics. Regarding your monetary policy assumptions (not shown) about three-fourths of the participants envisage a moderately to substantially higher federal funds rate by late next year than assumed in the Greenbook, a path perhaps similar to the one incorporated in financial market quotes. Most of you conditioned your projections on a path for the federal funds rate that begins to rise either in late 2008 or sometime in 2009, in contrast to the Greenbook path, which remains flat through 2009. Many of you were less clear whether you differed from the Greenbook path 2 The materials used by Mr. Madigan are appended to this transcript (appendix 2). over the near term; but with a little reading between the lines, it seems fair to say that most of you assumed a slightly higher funds rate over the near term. As shown in the first set of rows and first column of table 1, the central tendency of your real economic growth forecasts for 2008 has been marked down nearly 1 percentage point since January. Most of you pointed to weak incoming data, tight credit conditions, falling house prices, and rising energy prices as factors that prompted you to lower your growth expectations for this year. About half of you forecast a decline in economic activity over the first half of the year (not shown), with another quarter of you seeing a flat trajectory over that period. However, only four of you used the word ""recession"" to describe the current state of the economy. None of you has a more negative first-half outlook than the Greenbook. The downward revisions to your growth forecasts are roughly equal across both halves of 2008, and so the contour remains one of a rising growth rate over the year. Members' projections for the speed of the recovery in late 2008 exhibit considerable dispersion, with some calling for a quick return to near-potential growth supported by monetary and fiscal stimulus, and others seeing a prolonged period of weakness owing partly to persisting financial headwinds. Most of you appear to expect growth to return to near its trend rate in 2009 (column 2) and to move slightly above trend in 2010 (column 3). The Greenbook forecast for real growth in 2008 is near the low end of the central tendency of FOMC members' projections, but it is at the high end in 2009 and 2010. The second set of rows indicates that you have revised up your projections for the unemployment rate throughout the forecast period. Of those of you who provided estimates of the natural rate of unemployment, most expect unemployment to remain above the natural rate in 2010 with the others seeing a return to the natural rate. As shown in the third set of rows, your projections for headline PCE inflation in 2008 have been revised up a full percentage point, largely due to the surge in the prices of energy and other commodities. Incoming information has also prompted a small upward revision to your projections of core PCE inflation this year (the fourth set of rows). The rate of decline of core inflation in 2009 is essentially unchanged from that in the January projections, presumably reflecting the offsetting effects of the higher unemployment rates in the April projections, on the one hand, and the lagged pass-through of this year's higher food and energy prices, on the other. By 2010 the prolonged period of economic slack pushes down core inflation to around the same rates that were projected in January. Although the central tendencies for headline inflation, the third set of rows, also decline markedly over the forecast period, overall inflation is projected to be about � percentage point higher next year than you anticipated in January. Nonetheless, by 2010, headline inflation is expected to be in essentially the same range of around 1� to 2 percent that you forecasted in January. Your inflation projections for 2010 are close to their values in January, but more than half of you raised your projections for the unemployment rate in 2010 significantly more than 0.1 percent. To the extent that the higher unemployment rate projections are viewed as implying an economy operating below its potential in 2010, outside analysts may infer that you expect inflation to edge down further beyond 2010. Turning to the risks to the outlook, as shown in the upper left-hand panel of exhibit 2, a large majority of you regard uncertainty about GDP growth as greater than normal. The upper right-hand panel shows that most of you perceive the risks to GDP growth as weighted to the downside. Correspondingly, the risks to unemployment, not shown, are seen as weighted to the upside. You typically attributed the downside growth risks to the potential for sharper declines in house prices and persisting financial strains. Overall, the distributions of your views on the uncertainties and skews regarding growth are little changed from January. However, as shown in the lower panels, your perceptions of the risks regarding inflation have changed noticeably since January. As shown in the lower left panel, only half as many participants now see the degree of uncertainty regarding the inflation outlook as historically normal, and twice as many see the uncertainties as larger than usual. As indicated to the right, fewer see the risks to their outlook for overall inflation as balanced, and more see the risks as skewed to the upside. Your narratives indicate that you see the upside risks to inflation as deriving from the potential for continued increases in commodity prices, further depreciation of the dollar, and an upward drift in inflation expectations. That concludes our remarks. " CHRG-111hhrg63105--154 Mr. Sprecher," Thank you, Chairman Boswell, Chairman Peterson, Ranking Member Moran. I am Jeff Sprecher. I am the Chairman and Chief Executive Officer of IntercontinentalExchange, which is known in our industry as ICE; and I am grateful for the opportunity to provide comments on the position limit rulemaking that is pending before the Commodity Futures Trading Commission. ICE has supported setting aggregate position limits across trading venues if administered in a fair and nondiscriminatory manner. In summary, ICE's position on this subject has been very clear. We believe that the CFTC should set aggregate position limits in economically equivalent markets; to avoid negatively impacting liquidity that is relied upon by commercial end-users to hedge their risk, aggregate position limits should be set at levels taking into account the volumes of both the existing futures markets and the broader over-the-counter markets; and financially and physically settled contracts should be treated differently at their expiration in a revised position limit regime. There have been exhaustive hearings by Congress and the Commission over the last several years, and they have concluded that economically equivalent contracts traded on separate exchanges operate as an aggregate market. Therefore, ICE agrees with Congress and believes that the Commission is the appropriate neutral authority to set and administer aggregate position limits for U.S. energy futures and for significant price discovery contracts. Only the Commission is in a position to view a market participant's positions across all venues and to administer aggregate position limits in an objective manner. However, we also believe that the position limit rulemaking should focus on implementing the core requirements of Dodd-Frank, and that is namely setting aggregate position limits across markets, and they should avoid the consideration of experimental rules, such as rules that would set concentration limits for each and every exchange and every swap execution facility. In setting aggregate limits, the Commission should take into account trading data from both futures markets and the broader over-the-counter swaps market. Failing to take into account accurate data from each of these markets risks setting aggregate position limits at levels that could negatively impact liquidity that is actually relied upon by the commercial users to effectively hedge their price risk. This would certainly be an unintended consequence, and it would be inconsistent with the goals of Dodd-Frank. Finally, in setting position limits in the expiration or the spot month, the Commission should treat financially and physically settled contracts differently as market participants use financial and physical contracts differently for different purposes. The Commission already recognizes there is a distinction between financial and physically settled contracts. These rules promote contract convergence and they eliminate the need for significant numbers of hedge exemptions that exist in the energy futures markets today. In conclusion, we are a strong proponent of open, competitive derivatives markets and of appropriate regulatory oversight; and, to that end, we are pleased to work with Congress to find solutions that promote the best marketplaces possible. Mr. Chairman, I would like to thank you for the opportunity to share our views with you here today. [The prepared statement of Mr. Sprecher follows:] Prepared Statement of Jeffrey C. Sprecher, Chairman and CEO, IntercontinentalExchange, Inc., Atlanta, GAIntroduction Chairman Boswell, Ranking Member Moran, I am Jeffrey C. Sprecher, Chairman and Chief Executive Officer of IntercontinentalExchange, Inc., or ``ICE.'' We are grateful for the opportunity to provide comments on the position limit rulemaking pending before the Commodity Futures Trading Commission (Commission). As background, ICE was established in 2000 as an over-the-counter (OTC) marketplace with the goal of providing transparency and a level playing field for the previously opaque, fragmented energy market. Since that time, ICE has grown significantly through organic growth fostered by product, technology and clearing innovation, and by acquisition of futures exchanges that have broadened its product offerings and risk management services. Today, ICE operates a leading global marketplace for futures and OTC derivatives across a variety of product classes, including agricultural and energy commodities, foreign exchange and equity indexes. Commercial market participants rely on our products to hedge and manage risk and investors in these markets provide necessary liquidity. ICE believes proper regulation is essential for ensuring that market participants--as well as the broader public--have confidence in the price formation process that takes place in our markets. This assurance of integrity lies at the heart of the futures exchange model. The U.S. energy futures markets, governed by the Commission's comprehensive-but-flexible regulatory structure, have permitted commercial and professional market users to hedge future price risk in an efficient and cost-effective manner.Position Limits The Dodd-Frank Wall Street Reform and Consumer Protection Act gives the Commission new authority to set aggregate position limits on both energy futures and swaps and to have those position limits apply across competing exchanges and trading venues. This authority was granted by Congress because economically equivalent contracts may vary only where they are listed for trading, or in how they are settled, and have repeatedly been shown to trade as a single market up until the final days of trading.\1\--------------------------------------------------------------------------- \1\ Excessive Speculation in the Natural Gas Markets, Staff Report, Senate Permanent Subcommittee on Investigations (June 2007), pgs. 36-38. http://hsgac.senate.gov/public/_files/REPORTExcessiveSpeculationintheNaturalGasMarket.pdf.--------------------------------------------------------------------------- ICE supports aggregate position limits across trading venues if administered by the Commission in a fair, non-discriminatory manner. In summary, ICE's position on this subject is clear: (1) Different sized position limits for different exchanges, or so- called ``concentration limits'', were considered and rejected by Congress, and should not form a part of the Commission's proposed rules because they are conceptually inconsistent with the ``single market'' theory and anti-competitively favor larger exchanges; and (2) To avoid negatively impacting liquidity that is relied upon by commercial end-users to hedge their risk, aggregate position limits should be set at levels taking into account both existing futures volumes and the broader OTC markets. The Dodd-Frank Act gives the Commission 180 days to implement the position limit provisions for energy. ICE believes that the position limit rulemaking would be easier and less costly to implement if the Commission focused its rulemaking on implementing the core requirements of Dodd-Frank, namely aggregate position limits across markets--and avoids consideration of experimental rules and such as single-exchange concentration limits that have already been rejected by Congress.Concentration Limits for Single Exchanges Were Rejected by Congress and Are Redundant and Anti-Competitive In the Commission's previous position limit rulemaking, which was withdrawn in anticipation of the passage of Dodd-Frank, the Commission proposed an aggregate position limit regime across markets, but with separate ``concentration limits'' for individual exchanges and trading venues. The concentration limit would be set at 30% of the given exchange or venue's open interest for all months, and 20% of open interest in any single month, with each percentage based on the exchange's open interest in the previous year. The Commission's rationale for the concentration limit was to prevent concentrated positions from causing abrupt price movements and distortions in a market, and to ``fragment'' the market to allow multiple traders to step in where a smaller number of traders may have existed previously. The theory rested upon the unproven assumption that large traders are crowding out smaller participants. ICE disagrees with setting exchange specific concentration limits in any new rulemaking as they ignore the premise that economically equivalent contracts operate as a single aggregate market, were expressly rejected by Congress in drafting Dodd-Frank; and may have significant anti-competitive implications.\2\ Exhaustive hearings by Congress and the Commission over the last several years have concluded that economically equivalent contracts traded on two separate exchanges operate as a single aggregate market. In testimony before this Subcommittee in September 2007, Dr. James Newsome, former Commission Chairman and then President of NYMEX, stated ``the two competing trading venues [ICE and NYMEX] are now tightly linked and highly interactive and in essence are simply two components of a broader derivatives market.'' \3\ This is because participants arbitrage between economically equivalent markets, causing prices to converge. As this Subcommittee is well aware, the one market concept was the impetus for provisions in the farm bill which mandate regulation of swaps determined to be Significant Price Discovery Contracts in an equivalent manner as futures. Thus, the idea of imposing concentration limits on an ``individual exchange'' basis is unnecessary given the aggregate limit, which will serve the same purpose.--------------------------------------------------------------------------- \2\ H.R. 4173, Section 3155. \3\ Testimony of Dr. James Newsome, Chief Executive Officer, New York Mercantile Exchange, before the Subcommittee on General Farm Commodities and Risk Management, United States House of Representatives (September 26, 2007).--------------------------------------------------------------------------- Importantly, Congress expressly rejected a concentration limit in Dodd-Frank when it dropped language in the Section 738 of the Act in the House version of the legislation \4\ requiring foreign boards of trade to set position limits based upon ``relative'' market size. In addition, having market specific concentration limits appears inconsistent with other parts of Dodd-Frank, which contemplates multiple competing Swap Execution Facilities with open access to central clearing houses where swap positions would be traded into on one SEF and out of on another SEF.\5\ It is not apparent how this could be accomplished with SEF-specific concentration limits based upon open interest at an open-access clearinghouse used by multiple platforms.--------------------------------------------------------------------------- \4\ See, supra note 1. \5\ Dodd-Frank Wall Street Reform and Consumer Protection Act, Section 723(3).--------------------------------------------------------------------------- Finally, a single exchange concentration limit is anti-competitive. The Commodity Exchange Act mandates that the Commission ``regulate the futures markets by the least anti-competitive means available.'' By design, a concentration position limit will impose smaller, or stricter, concentration limits in smaller markets. A smaller market with fewer market participants has its open interest concentrated in these market participants. Thus, applying a concentration limit for an individual exchange will inhibit competition by impeding liquidity, given that smaller markets are concentrated. This would effectively lock in the market share of existing exchanges. A nascent exchange with such restrictions would likely face insurmountable odds in establishing a market and competing with incumbents. In addition, large market participants will effectively be prevented from leaving one market for another that offers a competitive advantage due to its inability to carry a similar sized position on the second market due to the ``concentration limit.'' This would substantially curtail innovation and the choice that exists in today's markets. Slowly, over time, the dominant market will continue to gain market share, as liquidity attracts liquidity. In the end, concentration limits may create the opposite of what the Commission intends: a diverse, highly competitive market for execution of derivatives.Position Limits Across Futures and OTC Markets Should Be Set to Avoid Negatively Impacting Liquidity Available to Commercial Users of the Markets and Should Be Based Upon Data of Each Market In setting aggregate position limits across futures and OTC markets, the Commission should act only after taking into account trading data from both the futures markets and the broader OTC swaps markets. Failing to take into account accurate data from each market risks setting aggregate position limits at artificially low levels that could negatively impact the liquidity relied upon by commercial users to efficiently hedge their price risk. Dodd-Frank requires the Commission for the first time to regulate previously un-regulated OTC markets that have themselves been used by segments of the commercial market to hedge risk. Should the Commission not take into account the size of this market in setting speculative position limits in the now-combined market, liquidity could be adversely impacted with commercial end-users paying wider spreads to hedge their price risk. This would certainly be an unintended consequence and inconsistent with Dodd-Frank's broader goals.Conclusion ICE is a strong proponent of open and competitive derivatives markets, and of appropriate regulatory oversight of those markets. As an operator of global futures and OTC markets, and as a publicly-held company, we understand the essential role of trust and confidence in our markets. To that end, we are pleased to work with Congress to address the challenges presented by derivatives markets, and we will continue to work cooperatively for solutions that promote the best marketplace possible. Mr. Chairman, thank you for the opportunity to share our views with you. I am happy to answer any questions you may have. The Chairman [presiding.] We thank you. " Mr. Jones," STATEMENT OF ROBERT JONES, SENIOR VICE PRESIDENT, ABN AMRO CLEARING CHICAGO LLC; MEMBER, RISK CHRG-110hhrg44901--5 Mr. Gutierrez," Thank you, Mr. Chairman. Welcome back, Chairman Bernanke. There is a lot of debate about whether or not we are in the midst of a recession, but to most people out there, it is really a moot question as they look at their bank accounts. And we all know IndyMac went under, and everybody else is really worried. There are a lot of calls at the office, should I check my savings account, my bank account, is it insured, do they have enough money? Then there is word that there might be another 90 banks. Some people say they are small. We don't know. Nobody is ever going to really tell us. So, recession? When gasoline pops up to $4.50 in Chicago, and your real earnings haven't increased, it seems like a recession to them. Most folks say, well, I wasn't in the stock market. Most folks, because we have done so much good work at purchasing homes, have lost a lot of their net value. Their house isn't worth what it was worth last year. It seems like a recession to them. GM is on the verge of bankruptcy. Let's hope it doesn't go under. I don't want to be a pessimist, but things are not good. Tens of thousands of retirees heard from GM yesterday that it is so bad that their health care insurance is being canceled after 35 or 40 years of working at GM. It is bad. I don't know if we are in a recession, but if you came out to my district and saw the foreclosure signs, literally the foreclosure signs everywhere. They say it is really worse on the east or the west coast. I think it is worse in those neighborhoods where people were finally getting a leg under and finally moving forward. So I hope today, as we look at gas prices and food prices and what they really mean, and I know a lot of this is very familiar to you, I would like to know your thoughts on inflation in the current environment. With stagnant wages, we are not entering into a wage spiral, and inflation is running high when measured by personal consumption expenditures, and with gasoline and consumer energies even higher, inflation seems to be a real threat in the near term. I understand the markets need to grow, and that means lower interest rates, but at the same time, specifically with the sharp increases in commodity prices, inflation has had to play a larger role in Federal Reserve decisionmaking. So, Mr. Bernanke, in the past you have discussed inflation targets, and I would like to know if you think such targets might be appropriate in this environment. I am also concerned about the weak dollar. We went to the Middle East on a congressional delegation to look into sovereign wealth funds, and it was suggested by some of these sovereign wealth managers, and I guess they would know since they have so much oil and the petrodollars, they say about 25 percent of it is due to the weakening of the dollar. So I look forward--and I do want to close by saying thank you for allowing the GSEs access to the discount window. I was really happy to read and hear about the decisions you made in terms of stopping predatory lending. I specifically ask you for that as we move forward. Thank you so much, Chairman Bernanke. " FOMC20081007confcall--37 35,CHAIRMAN BERNANKE.," Thank you. Other questions? All right. If not, let me just say a few words. I will be brief. It's more than obvious that we have an extraordinary situation. It is not a single market. It's not like the 1987 stock market crash or the 1970 commercial paper crisis. Virtually all the markets--particularly the credit markets--are not functioning or are in extreme stress. It's really an extraordinary situation, and I think everyone can agree that it's creating enormous risks for the global economy. What to do about it? The exchange we just had suggests that we may have disagreements about the benefits of liquidity provision. I personally think that it has been helpful. But I think we can agree that it is obviously not a panacea because, as the Vice Chairman points out, it doesn't address the underlying capital issues. That suggests that the right solutions probably have a significant fiscal element to them. However, one feature of the last few days is how striking, how uncoordinated, and how erratic some of the fiscal approaches have been--particularly in Europe, where there has been a remarkable lack of coordination in the European Union. So the fiscal solutions are coming, but they're not there yet, and it is going to be a while. We need greater clarity on those issues. We had a meeting today on the Treasury's authority, and they are hoping in the next few weeks to begin to provide greater clarity, which will be very helpful. But I think that, if we can find some kind of bridge, it would be helpful, and that's what this meeting is about. Although the financial markets are the dramatic element of the situation, I think we can make a case for easing policy today on the macro outlook, as given by Larry and Nathan. I won't go into detail. I think it's fairly clear. You look first at inflation, and you see the remarkable decline in commodity prices, the appreciation of the dollar, and the decline in breakevens. The 10-year breakeven this morning was about 1.35. Of course, that could be a noisy indicator, but certainly it's quite low. I would say that, in terms of activity and the relation to inflation, we don't have to rely on any flat Phillips curves here. We have a global slowdown, and the implications for commodity prices are first order for our inflation forecast. It is never safe to declare inflation under complete control, and I certainly don't claim that no risks are there; but clearly the outlook for inflation is not looking nearly so threatening as it may have in the past. On the economic growth side, what is particularly worrisome to me is that, before this latest upsurge in financial stress, we had already seen deceleration in growth, including the declines, for example, in consumer spending. Everyone I know who has looked at it--outside forecasters and the Greenbook producers here at the Board--believes that the financial stress we are seeing now is going to have a significant additional effect on growth. Larry gave some estimates of unemployment above 7 percent for a couple of years. So even putting aside the extraordinary conditions in financial markets, I think the macro outlook has shifted decisively toward output risks and away from inflation risks, and on that basis, I think that a policy move is justified. I should say that this comes as a surprise to me. I very much expected that we could stay at 2 percent for a long time, and then when the economy began to recover, we could begin to normalize interest rates. But clearly things have gone off in a direction that is quite worrisome. One could legitimately ask questions about the transmission mechanism under these conditions, and I think those are good questions. But first it seems to me that we can, to some extent, offset costs of credit through our actions, even if spreads are wide. Second, to the extent that the global coordination creates some more optimism about the future of the global economy, we may see some improvements in credit spreads. We may not, but it seems to me that this is the right direction in which to go. Despite everything that's happening, I might not be bringing this to you at this point, except that we have the opportunity to move jointly with five other major central banks, and I think the coordination and cooperation is a very important element of this proposal. First of all, again, I mentioned before the lurching and the lack of coordination among fiscal authorities and other governments. I think it would be extraordinarily helpful to confidence to show that the world central banks are working closely together, have a similar view of global economic conditions, and are willing to take strong actions to address those conditions. I think that there is a multiplier effect, if you will. Our move, along with these other moves, will have a stronger effect on the global economy and on the U.S. economy than our acting alone. Moving together has other benefits. Just to note one, we can have less concern about the dollar if we're all moving together and less concern about inflation expectations given that all the banks are moving and all see the same problem. There is a tactical issue. I think the real key to this is actually the European Central Bank. They have had some difficulty coming to the realization that Europe would be under a great deal of stress and was not going to be decoupled from the United States. They made an important rhetorical step at their last meeting to open the way for a potential cut, but I think that this coordinated action gives them an opportunity to get out of the corner into which they are somewhat painted and their move will have a big impact on global expectations about policy responsiveness. So, again, I think the coordination is a very important part of this. I want to say once again that I don't think that monetary policy is going to solve this problem. I don't think liquidity policy is going to solve this problem. I think the only way out of this is fiscal and perhaps some regulatory and other related policies. But we don't have that yet. We're working toward that. We are in a very serious situation. So it seems to me that there is a case for moving now in an attempt to provide some reassurance--it may or may not do so--but in any case, to try to do what we can to make a bridge toward the broader approach to the crisis. So that's my recommendation, that we join the other central banks in a 50 basis point move before markets open tomorrow morning. If we proceed in that direction, there are, as I mentioned, two statements. Brian, do the Presidents have the joint statement? " FOMC20050503meeting--29 27,MR. STOCKTON.," Thank you, Mr. Chairman. In reviewing my remarks from the last meeting, I managed to find that at least one of my insights had survived the intermeeting period. If you will allow me, I quote: “While I can easily imagine looking back on these words with regret, the persistent and widespread improvements that we are now witnessing certainly leave the impression that the expansion is more firmly established and less fragile with respect to shocks than it was in early 2004.” Unfortunately, as I see it, the surviving insight is that I would come to regret my words. Just how much, I think remains an open question. But the past six weeks have clearly restored a greater sense of two-way risks to the outlook. Just as the great preponderance of data that became available in the early part of the year had led us to revise up our outlook for the real economy, it seems nearly every major economic release since the last meeting has been to the low side of our expectations. The litany of bad news has been long and varied. Private payrolls increased by just 100,000 in March. In the manufacturing sector, output slipped a bit that month, and our estimates for January and February were revised down. A very weak retail sales report for March held down the growth of overall consumer spending in the first quarter. With orders and shipments for capital equipment having dropped sharply in March, growth of equipment and software spending is looking a bit weaker in the first half of this year than was incorporated in the previous forecast. Moreover, the data on merchandise trade for February suggest that demand for our exports was softer than we had expected and that a greater portion of domestic demand is being met by foreign rather than domestic producers. And, reflecting the softer tone of the economic data, stock prices dropped about 4 percent below our March baseline assumptions. All in all, it has been a pretty downbeat collection of data. May 3, 2005 10 of 116 larger output gap occurs despite the fact that we trimmed our path for the funds rate by 25 basis points starting in the second half of this year. Obviously, the relevant questions at this point are: What are the explanations for the recent spate of disappointing economic reports and what are the accompanying implications for the outlook? One plausible hypothesis is that what we have experienced has largely been statistical noise that has produced a weak quarter of GDP growth but that should have little or no implication for our assessment of the strength of the economy going forward. There is evidence to support this view. Perhaps most notably, initial claims for unemployment insurance have averaged about 325,000 over the past month—a figure at the low end of the range that has prevailed as the labor market has gradually but steadily improved. And insured unemployment has also continued to drift lower. So there is not much sign of an inflection point in activity here. Moreover, despite last month=s weak retail sales report, home sales remained strong, and the reports we have received from the automakers suggest that motor vehicle sales were solid in April. These are developments that don=t seem consistent with a view that consumers are in the process of throwing in the towel. And in the business sector, anecdotal reports from our contacts have generally remained favorable both with respect to their order books and their capital spending plans. Those considerations made us comfortable discounting significantly the recent weakness in the data. But we didn’t think it was prudent to dismiss that weakness entirely, either. There simply was too much bad news. In addition, there was corroboration for some of the downbeat statistical readings from other sources. The poor performance of retail sales has coincided with a sag in measures of consumer sentiment over the past few months. Likewise, the reports from purchasing managers are consistent with the slower growth of manufacturing activity that appears to have occurred since the turn of the year. May 3, 2005 11 of 116 By our estimates, the depressing effects of the increase of oil prices since December 2003 on the growth of real GDP should be peaking in the first half of this year, so the timing is consistent with our view that energy prices may well have been an important factor in the slowdown in activity that we have experienced. But the weakness seems too extensive to stem from that cause alone. Accordingly, we have also put some weight on the possibility that the incoming data are signaling that underlying aggregate demand is not as strong as we had earlier anticipated. Of course, one interpretation of that observation is that the degree of monetary accommodation may not have been as large as we had previously gauged. Over much of the past year, despite gradual increases in the real funds rate, our estimates suggested that we could be very comfortable with the view that policy remained accommodative—a view that seemed consistent with the incoming data on the economy. We still see monetary policy as accommodative, at least from a medium-term perspective, but we recognize that we are now edging into grayer territory. The confidence intervals around estimates of the equilibrium real funds rate that we show in the Bluebook are intended to give you a sense of just how ignorant we are about its precise value, if that wasn=t already abundantly obvious to you. We certainly can=t rule out that we have overreacted to the recent news. A rebound in April spending, a few upward revisions to data from earlier months, and this recent period will barely register a ripple on the surface of a solid underlying expansion. But I would note that our reaction has not been idiosyncratic either. Market participants have also marked down their path for the federal funds rate by about as much as we have over the intermeeting period. Of course, weaker real activity has been only one of the difficulties with which we have had to contend. The news on inflation, for the most part, has also been somewhat disappointing, especially the readings on energy and import prices. In response, we have revised up prices in these two areas noticeably in the first half of the year. The incoming data on core consumer prices were only a tad above our expectation. To be sure, the 0.4 percent increase in the core CPI grabbed considerable attention. But we correctly anticipated that this increase would translate into a milder 0.2 percent increase for the market-based core PCE measure. This was higher than we had projected in the March Greenbook, but by an amount measured in basis points, not tenths. May 3, 2005 12 of 116 first half do have consequences for inflation going forward. Higher consumer price inflation, through a combination of formal and informal arrangements in labor markets and perhaps through some slippage in inflation expectations more generally, seems likely to find its way eventually into wage inflation and back into prices. That was the motivation for the upward adjustment to our projection of core consumer price inflation to 1.9 percent this year and 1.7 percent next year—0.1 percent higher than our March projection in both years. However, the contour of our inflation projection remains the same. As in past forecasts, we expect some slight easing of pressures on inflation as the pass-through of higher prices for oil, imports, and other commodities begins to wane. Of course, it remains an open question as to whether and when we will get the slowing in oil and materials costs that we are projecting. For the most part, we continue to take our cues from futures markets for these prices. Although I cannot see a clearly superior alternative, I will admit this approach has not been a surefire recipe for success over the past year. During that time, the cumulative upward revision in our forecast for core PCE prices in 2005 has been about ¾ percentage point. As we noted in yesterday=s Board briefing, we believe that this revision can largely be explained by the upward surprises that we have experienced in the prices of oil, imports, and commodities. Looking forward, an easing of those pressures remains an important element of our forecast. But it remains just that, a forecast. Moreover, we recognize that, at some point, the consequence of a series of cost shocks could look to many people an awful lot like an accelerating price level. And if that view were to cement itself, the implications for inflation expectations and the feedback into wages and prices could be a less favorable inflation outcome than shown in the Greenbook. In that regard, we continue to draw comfort from the fact that wage inflation has shown no signs of increase during the past couple of years. Hourly labor compensation from the national accounts increased 4 percent at an annual rate in the first quarter, below both our March projection and the average pace posted last year. More surprisingly, the employment cost index, released last Friday after completion of the Greenbook, showed an increase in hourly compensation of just 2½ percent at an annual rate in the first quarter—with wages rising at a subdued pace of just under 2½ percent and hourly benefits slowing to a 4¼ percent pace, the smallest rate of increase we=ve seen in quite some time. This is certainly good news and suggests that we are not yet witnessing anything that looks like a wage-price spiral. May 3, 2005 13 of 116 my professional or personal life. [Laughter] If I step back and take a more dispassionate look, while recent developments have highlighted reasons for concern, the outlook still remains quite favorable. The economy has been averaging growth at or above potential over the past year despite what has been a huge energy price shock, the removal of massive fiscal stimulus, and the withdrawal of monetary accommodation. And after a dip in the first quarter, growth is projected to return to its above-trend pace starting in the current quarter. Meanwhile, even with sharply higher oil prices, a declining dollar, rising commodity costs, and diminishing slack, core consumer prices are up only 1¾ percent over the past 12 months—a pace that remains low even by the standards of the past decade. And we are projecting core PCE inflation to remain at or below 2 percent over the projection period. By most objective metrics, it remains a bright picture. Having accumulated another 2,000 words of potential regret, I should probably turn the floor over to Karen at this point." CHRG-109hhrg23738--11 Mr. Greenspan," Mr. Chairman and members of the committee, I am pleased to be here to present the Federal Reserve's Monetary Policy Report to the Congress. I am surprised to hear it is the 35th time. In recent weeks, employment has remained on an upward trend; retail spending has posted appreciable gains; inventory levels have been modest; and business investment appears to have firmed. At the same time, low long-term interest rates have continued to provide a lift to housing activity. Although both overall and core consumer price inflation have eased of late, the prices of oil and natural gas have moved up again, on balance, since May and are likely to place some upward pressure on consumer prices, at least over the near term. Slack in labor and product markets has continued to decline. In light of these developments, the Federal Open Market Committee raised the federal funds rate at its June meeting to further reduce monetary policy accommodation. That action brought the cumulative increase in the funds rate over the past year to 2.25 percentage points. Should the prices of crude oil and natural gas flatten out after their recent runup, the forecast currently embedded in futures markets, the prospects for aggregate demand appear favorable. Household spending, buoyed by past gains in wealth, ongoing increases in employment and income, and relatively low interest rates, is likely to continue to expand. Business investment in equipment and software seems to be on a solid upward trajectory in response to supportive conditions in financial markets and the ongoing need to replace or upgrade aging high-tech and other equipment. Moreover, some recovery in non-residential construction appears in the offing, spurred partly by lower vacancy rates and rising prices for commercial properties. However, given the comparatively less buoyant growth of many foreign economies and the recent increase in the foreign exchange rate of the dollar, our external sector does not seem poised to contribute steadily to U.S. growth. A flattening out of the prices of crude oil and natural gas, were it to materialize, would also lessen upward pressure on inflation. Thus our baseline outlook for the U.S. economy is one of sustained economic growth and contained inflation pressures. In our view, realizing this outcome will require the Federal Reserve to continue to remove monetary accommodation. This generally favorable outlook, however, is attended by some significant uncertainties that warrant careful scrutiny. With regard to the outlook for inflation, future price performance will be influenced importantly by the trend in unit labor cost, or its equivalent, the ratio of hourly labor compensation to output per hour. Over most of the past several years, the behavior of unit labor costs has been quite subdued. But those costs have turned up of late, and whether the favorable trends of the past few years will be maintained is unclear. Hourly labor compensation as measured from the national income and product accounts increased sharply near the end of 2004. However, that measure appears to have been boosted significantly by temporary factors. Over the past 2 years, growth in output per hour seems to have moved off the peak that it reached in 2003. However, the cause, extent and duration of that slowdown are not yet clear. Energy prices represent a second major uncertainty in the economic outlook. A further rise could cut materially into private spending and thus damp the rate of economic expansion. Judging from the high level of far-future prices, global demand for energy apparently is expected to remain strong, and market participants are evidencing increased concerns about the potential for supply disruption in various oil-producing regions. More favorably, the current and prospective expansion of U.S. capability to import liquefied natural gas will help ease longer-term natural gas stringencies and perhaps bring natural gas prices in the United States down to world levels. The third major uncertainty in the economic outlook relates to the behavior of long-term interest rates. The yield on 10-year Treasury notes, currently near 4.25 percent, is about 50 basis points below its level of late spring 2004. This decline in long-term rates has occurred against the backdrop of generally firm U.S. economic growth, a continued boost to inflation from higher energy prices, and fiscal pressures associated with the fast-approaching retirement of the baby-boom generation. The drop in long-term rates is especially surprising given the increase in the federal funds rate over the same period. Such a pattern is clearly without precedent in our recent experience. Two distinct but overlapping developments appear to be at work: a longer-term trend decline in bond yields; and an acceleration of that trend of late. Some, but not all, of the decade-long trend decline in that forward yield can be ascribed to expectations of lower inflation, a reduced risk premium resulting from less inflation volatility, and a smaller real-term premium that seems due to a moderation of the business cycle over the past few decades. This decline in inflation expectations and risk premiums is a signal development. As I noted in my testimony before this Committee in February, the effective productive capacity of the global economy has substantially increased, in part because of the breakup of the Soviet Union and the integration of China and India into the global marketplace; and this increase in capacity in turn has doubtless contributed to expectations of lower inflation and lower inflation-risk premiums. In addition to these factors, the trend reduction worldwide in long-term rates surely reflects an excess of intended savings over intended investment. This configuration is equivalent to an excess of the supply of funds relative to the demand for investment. What is unclear is whether the excess is due to a glut of savings or a shortfall of investment. Because intended capital investment is to some extent driven by forces independent of those governing intended saving, the gap between intended saving and investment can be quite wide and variable. It is real interest rates that bring actual capital investment worldwide and its means of financing global savings into equality. We can directly observe only the actual flows, not the savings and investment tendencies. Nonetheless, as best we can judge, both high levels of intended savings and low levels of intended investment have combined to lower real long-term rates over the past decade. Since the mid 1990s, a significant increase in the share of world gross domestic product produced by economies with persistently above-average savings, predominantly the emerging economies of Asia, has put upward pressure on world savings. These pressures have been supplemented by shifts in income toward the oil-exporting countries, which more recently have built surpluses because of steep increases in oil prices. Softness in intended investment is also evident. Although corporate capital investment in the major industrial countries rose in recent years, it apparently failed to match increases in corporate cash flow. In the United States, for example, capital expenditures were below the very substantial level of corporate cash flow in 2003, the first shortfall since the severe recession of 1975. That development was likely a result of the business caution that was apparent in the wake of the stock market decline and the corporate scandals early this decade. Japanese investment exhibited prolonged restraint following the bursting of their speculative bubble in the early 1990s; and investment in emerging Asia, excluding China, fell appreciably after the Asian financial crisis in the late 1990s. Whether the excess of global intended saving over intended investment has been caused by weak investment or excessive savings--that is, by weak consumption--or, more likely, a combination of both does not much affect the intermediate-term outlook for world GDP or, for that matter, U.S. monetary policy. What have mattered in recent years are the sign and the size of the gap of intentions and the implications for interest rates, not whether the gap results from a saving glut or an investment shortfall. That said, saving and investment propensities do matter over the longer term. Higher levels of investment relative to consumption build up the capital stock and thus add to the productive potential of an economy. The economic forces driving the global saving-investment balance have been unfolding over the course of the past decade, so the steepness of the recent decline in long-term dollar yields and the associated distant forward rates suggests that something more may have been at work over the past year. Inflation premiums in forward rates 10 years ahead have apparently continued to decline, but real yields have also fallen markedly over the past year. Risktakers apparently have been encouraged, by a perceived increase in economic stability, to reach out to more distant time horizons. These actions have been accompanied by significant declines in measures of expected volatility in equity and credit markets. History cautions that long periods of relative stability often engender unrealistic expectations of its permanence and at times may lead to financial excess and economic stress. Such perceptions, many observers believe, are contributing to the boom in home prices and creating some associated risks. And certainly the exceptionally low interest rates on 10-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of home building, home turnover, and particularly in the steep climb in home prices. Whether home prices on average for the nation as a whole are overvalued relative to underlying determinants is difficult to ascertain, but there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels. Among other indicators, the significant rise in purchases of homes for investment since 2001 seems to have charged some regional markets with speculative fervor. The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices. Nevertheless, we certainly cannot rule out declines in home prices, especially in some local markets. If declines were to occur, they likely would be accompanied by some economic stress, though the macroeconomic implications need not be substantial. Historically, it has been rising real long-term interest rates that have restrained the pace of residential building and have suppressed existing home sales, high levels of which have been the major contributor to the home equity extraction that arguably has financed a noticeable share of personal-consumption expenditures and home-modernization outlays. The trend of mortgage rates or long-term interest rates more generally is likely to be influenced importantly by the worldwide evolution of intended saving and intended investment. We at the Federal Reserve will be closely monitoring the path of this global development few, if any, have previously experienced. As I indicated earlier, the capital investment climate in the United States appears to be improving following significant headwinds since late 2000, as is that in Japan. Capital investment in Europe, however, remains tepid. A broad worldwide expansion of capital investment not offset by rising worldwide propensity to save would presumably move real long-term interest rates higher. Moreover, with term premiums at historical lows, further downward pressure on long-term rates from this source is unlikely. We collectively confront many risks beyond those I have mentioned. As was tragically evidenced again by the bombings in London earlier this month, terrorism and geopolitical risk have become enduring features of the global landscape. Another prominent concern is the growing evidence of antiglobalization sentiment and protectionist initiatives, which if implemented would significantly threaten the flexibility and resilience of many economies. This situation is especially troubling for the United States, where openness and flexibility have allowed us to absorb a succession of large shocks in recent years with only minimal economic disruption. That flexibility is, in large measure, a testament to the industry and resourcefulness of our workers and businesses. But our success in this dimension has also been aided importantly by more than two and a half decades of bipartisan effort aimed at reducing unnecessary regulation and promoting the openness of our market economy. Going forward, policymakers will need to be vigilant to preserve this flexibility, which has contributed so constructively to our economic performance in recent years. In conclusion, Mr. Chairman, despite the challenges I have outlined and the many I have not, the U.S. economy has remained on a firm footing, and inflation continues to be well contained. Moreover, the prospects are favorable for a continuation of those trends. Accordingly, the Federal Open Market Committee in its June meeting reaffirmed that it believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects, as needed, to fulfill its obligation to maintain price stability. Thank you very much. I look forward to your questions. [The prepared statement of Hon. Alan Greenspan can be found on page 53 in the appendix.] " FOMC20080625meeting--77 75,MR. PLOSSER.," Thank you, Mr. Chairman. In the Third District, as anticipated, manufacturing activity, residential construction, and employment have remained weak. Nonresidential construction has now softened, although vacancy rates in Philadelphia and around the District remain relatively low. Retail sales remain sluggish. Bank lending has been restrained. The outlook among our business contacts, however, varies significantly by sector. Manufacturers expect a rebound in activity over the coming six months, and residential real estate contacts report that they believe market conditions may be near bottom, although they expect any recovery to be slow. Interestingly enough, it is the same sort of anecdotal evidence that President Lockhart referred to. Now, it is hard to know whether it is just mostly wishful thinking or whether there is something real there--although his saying it and my saying it sort of reinforces it a little. But it is the first time that I have heard such news in a very, very long time. Retailers are quite pessimistic, however, because they are expecting the increase in energy prices to limit sales, especially among lower-income customers, despite the tax rebates. Despite the soft economic conditions, the most prominent concern that we have heard from our business contacts across a variety of industries is the run-up in commodity prices and other prices. Thus far, firms have resisted passing along their rising costs to customers, to the extent that they could, but many firms tell us that they have gone as far as they can on holding the line on their own prices and plan to raise prices further in the next few months. Some firms are including general cost-increase clauses in their new contracts. Earlier we saw various sorts of fuel surcharges added onto prices, but now contracts are being written in a way that includes broad cost-adjustment increases. This is still only anecdotal evidence although it has been referred to--I think President Fisher made a couple of comments in this regard. But it may be yet another early warning sign that inflation expectations cannot remain in check indefinitely in this current environment. In June, the prices-paid index in our business outlook survey of manufacturers rose to the highest level it has been since 1980. Manufacturers and firm contacts across a wide range of industries say that they expect their input prices and the prices of their own goods to increase further over the next six months. They see no abatement of price pressures in the near term or medium term and are very pessimistic about inflation. The national economic situation is similar to what I see in my own District, and it is an uncomfortable situation for all of us. The data we have received on economic activity over the intermeeting period have come in slightly better than I expected, but the continued price increases, particularly in oil and commodities, have been a very unpleasant development. Certainly, economic conditions remain weak, and the recent positive news may prove to be transitory. From the financial side, credit spreads have fallen, bond issuance has risen, and it appears that financial market functioning has at least improved. In my view, although downside risks to growth remain, the tail risk of a very bad outcome has clearly been diminished. I expect GDP growth to come in around 1.7 percent this year--only marginally higher than my April projection--before picking back up to trend of around 2.7 percent in 2009-10. Despite the upward revisions in the Greenbook baseline, my forecast remains somewhat more optimistic for growth in 2008 and 2009 than the Greenbook. In fact, my forecast is similar to the Board staff's ""upside risk"" alternative scenario, which essentially removed the downward adjustment factors the staff added to build in more recession-like features caused by the financial turmoil and other factors not captured in their baseline model, which is what Dave was mentioning earlier. My concerns about the inflation outlook have increased since our last meeting. I am not alone. Inflation has become a predominant concern for many businesses and consumers, and you only have to read the newspapers to see that. Obviously, monetary policy cannot control the price of energy, but we do have a responsibility to act to keep broad-based inflation under control. Contributing to the increase in inflation risk is not only the surge in energy and other commodity prices; it is supported also by our own accommodative stance of monetary policy. Short-term inflation expectations and headline inflation measures are up significantly since our last meeting. So far, core inflation increases have been modest, and long-term inflation expectations remain, although volatile, within a tolerable range. But if we continue to maintain the real funds rate well below zero, despite inflation that is well above acceptable levels, can we really expect inflation expectations to remain anchored? We must remember that longer-term inflation expectations tend to lag inflation not to lead it. If we wait until these measures rise, we will be too late. Apropos of President Evans's question about wages, I have been troubled by stories in the press suggesting that we can be less concerned about inflation than we were in the 1970s because wages haven't risen and labor unions are less prominent. These stories suggest that the wage�price spiral caused the unanchoring of inflation expectations in the '70s. But I think this gets the direction of causation backwards. In my view, the story of the '70s was that the public lacked confidence in the central bank's commitment to price stability--it didn't believe the central bank would take the necessary steps to bring inflation under control. As a consequence, inflation expectations rose and wages rose. It was the higher inflation and the lack of credibility that led to higher wage demands. The key to avoiding such a situation, in my view, is maintaining the credibility that the Fed has worked so hard to achieve. The Board staff memo on optimal monetary policy in the context of higher oil prices illustrates the importance of maintaining credibility, and I want to thank the staff for their efforts in this regard. I think it was an excellent piece of work. As they clearly say, the critical factor in containing inflation through an expectations channel is the belief that policymakers will always adhere to a full-commitment rule. When the central bank is unable or unwilling to commit in a credible manner to future policy actions or to a long-run inflation goal, the result is both higher inflation and lower output. In the real world, of course, full commitment can never absolutely be achieved. But beliefs about which regime better approximates reality are informed by the actions taken by the central bank to maintain its commitment to price stability. I believe that the FOMC has done a good job with our words--including FOMC statements, minutes, and speeches--in helping to anchor longer-term expectations. I believe the Chairman's speech at the Boston Fed conference earlier this month delivered a well-articulated and important message about the importance of keeping longer-term inflation expectations anchored. But our credibility rests on more than just words. We must act in a way that is consistent with our hard-earned reputation, or our credibility could soon vanish. To underscore our words, we should take actions and take back some of the insurance we have put on in the context of elevated downside tail risks. Given recent economic developments and the improvement in financial market functioning, coupled with our accommodative stance of policy, it seems pretty clear to me that, if the economy continues to evolve as it has over the past couple of months, we should move to raise the funds rate. This is also the view of market participants, whose expectations for policy have steepened considerably over the intermeeting period. My forecast, therefore, incorporates a monetary policy path that is steeper than the one in the Greenbook. I assume that the funds rate will reach 2.75 percent by the end of 2008 and move up to 4.5 percent by the end of 2009. This steeper funds rate path is necessary, in my view, to deliver inflation that is declining back toward our goal. Regarding the suggestion by the Subcommittee on Communications on lengthening the forecast period, I think it can be a very useful device, and I support it. My preference, however, is for option 2, although I think option 1 could work just as well. I'm for option 2 partly because I, too, am less confident about forecasting whatever the dynamic adjustment process happens to be, and so just going to year 5 I think would be useful. Omitting year 4 is not omitting any information that is terribly informative, as far as I am concerned. I am a little reluctant to go to some longer-term average like five-to-ten years because I think that muddles the communication picture and may signal a weakening of our commitment about the timeframe over which we think we can really achieve some objective. So I am most comfortable with option 2, or I could be happy with option 1 as well. Thank you, Mr. Chairman. " CHRG-111hhrg53021--347 Chairman Peterson," With that, we will bring this to a close. I want to thank Chairman Frank and all the Members of both Committees for a great hearing, good questions, good dialogue. And we look forward to working with the two Committees together, along with the Administration, to make this thing work. So thank you all. Thank you, Mr. Secretary. The Committees are adjourned. [Whereupon, at 1:07 p.m., the Committees were adjourned.] [Material submitted for inclusion in the record follows:] Joint Submitted Letter by Hon. Frank D. Lucas; on Behalf of Business Roundtable; Grocery Manufacturers Association; National Association of Manufacturers; U.S. Chamber of CommerceHon. Barney Frank, Hon. Spencer Bachus,Chairman, Ranking Minority Member,Committee on Financial Services; Committee on Financial Services;Hon. Collin C. Peterson, Hon. Frank D. Lucas,Chairman, Ranking Minority Member,Committee on Agriculture, Committee on Agriculture,Washington, D.C. Washington, D.C. Dear Chairmen Frank and Peterson and Ranking Members Bachus and Lucas: Businesses from diverse sectors and sizes across the United States enter into over-the-counter (``OTC'') derivative transactions to manage risks associated with their business operations, including fluctuations in interest rates, currency exchange rates and commodity prices. A survey of publicly-available information conducted by the International Swaps and Derivatives Association found that more than 90 percent of Fortune 500 companies use OTC derivatives. It is critical to note that many of our members use them--not to speculate or augment short-term profits--but as a normal course of business. Many OTC derivatives contracts are bought and sold with standard terms and conditions; however, there are also many derivatives contracts that are customized to meet the unique needs and risk exposures of individual companies, including such basic terms as dates, rates and notional amount. When businesses employ derivatives in this manner, they are not taking speculative positions. Quite the opposite; they are seeking to reduce risks that arise from their business activities. Whether standard or custom, OTC derivatives help American businesses protect themselves from risk and improve their access to credit. We support efforts to ensure appropriate regulatory oversight of market participants and their derivatives activities, consistent with the objectives outlined by the Obama Administration in its white paper, Financial Regulatory Reform: A New Foundation. More specifically, we believe the right approach encourages central clearing for standardized contracts where appropriate, while promoting transparency of customized contracts through a reporting regime that ensures regulators have the information necessary to oversee the markets. This approach strikes the right balance: it reduces counterparty risk and enhances transparency while maintaining an OTC market and the benefits it provides to our members. However, legislation requiring that all contracts be traded on exchanges or be centrally cleared will prevent companies from using non-standard products to reduce the volatility of their financial statements and lower their cost of capital--thereby expanding, not reducing, risk to companies. Such legislation would require companies to divert cash from being used to sustain and grow their businesses to meeting collateral and margin requirements. In short, the proposal could dramatically expand the need for liquidity in the midst of a liquidity crisis. The customized terms and conditions of OTC derivatives contracts cannot reasonably be standardized for exchange trading or mandatory clearing. In fact, in order for companies to utilize hedge accounting under FAS 133, and thus reflect the offsetting nature of a hedge in their financial statements, they must prove a close and consistent correlation between the derivative and the underlying asset or liability. If a company could not do so, as likely would be the case if only standardized instruments were available, the benefits of its hedge transactions would not be shown in its financial statements, thereby increasing earnings volatility. In short, please ensure that any regulatory reform legislation that moves in the House preserves the ability of our member companies to use OTC derivatives to manage risk at prices and under terms that are reasonable and continue to make sense from a business perspective. We urge you to prevent an anti-derivatives sentiment from translating into anti-business legislation. Thank you for your consideration of our views and we look forward to working with you. Sincerely, [GRAPHIC] [TIFF OMITTED] T1123.002 Larry D. Burton, Mary C. Sophos,Executive Director, Senior Vice President and ChiefBusiness Roundtable; Government Affairs Officer, Grocery Manufacturers Association; [GRAPHIC] [TIFF OMITTED] T1123.001 Dorothy Coleman, R. Bruce Josten,Vice President, Tax and Domestic Executive Vice President, Economic Policy, Government Affairs,National Association of U.S. Chamber of Commerce. Manufacturers;cc: The Members of the U.S. House of Representatives ______ Submitted Statement by Hon. Frank D. Lucas; on Behalf of 3M Company 3M Company (``3M'') is a large U.S.-based employer and manufacturer established more than a century ago in Minnesota. Today, 3M is one of the largest and most diversified technology and manufacturing companies in the world. 3M thanks the Committees for studying the critical details related to reforms to the U.S. financial system and for considering our perspective in this important debate. In examining the concepts outlined in the recent U.S. Treasury proposal on financial system reforms, 3M respectfully urges the Committees to carefully consider the distinct differences among various derivative products and how they are used, and encourages the Committees to preserve commercial users' ability to continue using derivative products to manage various aspects of corporate risk while addressing concerns about stability of the financial system.Background on 3M In 1902, five northern Minnesota entrepreneurs created the Minnesota Mining & Manufacturing Company, now known today as 3M. 3M is one of the largest and most diversified technology companies in the world. 3M is home to such well-known brands as Scotch, Scotch-Brite, Post-it, Nexcare, Filtrete, Command, and Thinsulate. 3M designs, manufactures and sell products based on 45 technology platforms and serves its customers through six large businesses: Consumer and Office; Display and Graphics; Electro and Communications; Health Care; Industrial and Transportation; and Safety, Security and Protection Services. 3M achieved $25.3 billion of worldwide sales in 2008. Headquartered in St. Paul, Minnesota, 3M has operations in 27 U.S. states, including over 60% of 3M's worldwide manufacturing operations, employing 34,000 people. 3M's U.S. sales totaled approximately $9.2 billion in 2008. While its U.S. presence is strong, being able to compete successfully in the global marketplace is critical to 3M. 3M operates in more than 60 countries and sells products into more than 200 countries. In 2008, 64% of 3M's sales were outside the U.S., a percentage that is projected to rise to more than 70% by 2010. Ahead of their peers, 3M's founders insisted on a robust investment in R&D. Looking back, it is this early and consistent commitment to R&D that has been the main component of 3M's success. Our diverse technology platforms allow 3M scientists to share and combine technologies from one business to another, creating unique, innovative solutions for our customers. 3M conducts over 60% of its worldwide R&D activities within the U.S. Our commitment to R&D resulted in a $1.4 billion investment of 3M's capital in 2008 and a total of $6.8 billion during the past 5 years while producing high quality jobs for 3,700 researchers in the U.S. The success of these efforts is evidenced not only by 3M's revenue but also by the 561 U.S. patents awarded in 2008 alone, and over 40,000 global patents and patent applications in force. Our success is also attributable to the people of 3M. Generations of imaginative and industrious employees in all of its business sectors throughout the world have built 3M into a successful global company. Our interest in speaking with you today is to preserve our ability to continue to invest and grow, creating substantive jobs and providing high quality products to a growing base of customers.Treasury Proposal Treasury Secretary Geithner proposed the establishment of a comprehensive regulatory framework for OTC derivatives that is designed to: 1. Prevent activities in those markets from posing risk to the financial system. 2. Promote the efficiency and transparency of those markets. 3. Prevent market manipulation, fraud and other market abuses. 4. Ensure that OTC derivatives are not marketed inappropriately to unsophisticated parties.OTC Derivatives: Helping U.S. Companies Manage Risk in a Competitive Marketplace While 3M unequivocally supports these objectives, we have strong concerns about the potential impact on OTC derivatives and 3M's ability to continue to use them to protect our operations from the risk of undue currency, commodity, and interest rate volatility. Derivative products are essential risk management tools used by American companies in managing foreign exchange, commodity, interest rate and credit risks. The ability of commercial users to continue to use over-the-counter (``OTC'') derivatives consistent with the requirements of hedge accounting rules is critical for mitigating risk and limiting damage to American businesses' financial results in volatile market conditions. We urge policy makers to preserve commercial users' access to existing derivative products as you design new regulations. We share the following comments with you in the spirit of working together to address the concerns about the stability of the financial system: 1. Preventing Activities Within OTC Markets From Posing Risk To Financial System: We agree that the recent economic crisis has exposed some areas in our financial regulatory system that should be addressed. However, not all OTC derivatives have put the financial system at risk and they should not all be treated the same. The OTC foreign exchange, commodity, and interest rate markets have operated uninterrupted throughout the economy's financial difficulties. We urge policy makers to focus on the areas of highest concern, such as credit default swaps. We would like to work with policy makers to address oversight where warranted, but recommend that it be targeted and not applied to all segments and market participants. 2. Promoting Efficiency and Transparency within the OTC Markets: We understand the need for reporting and record- keeping. Publicly held companies are currently required by the SEC and FASB to make significant disclosures about their use of derivative instruments and hedging activities, including disclosures in their 10Ks and 10Qs. We would like to work with policy makers on ways to efficiently collect information and enhance transparency. Specifically, proposals have been made to establish a data repository for OTC derivatives to ensure transparency and disclosure. We understand and support this need for greater transparency and oversight and could support providing on a real-time basis the critical terms (amount, currency, counterparty, rate(s), maturity) for transactions over a specified minimum size (e.g., $250,000) for such a data repository. Proposals have also been made to establish regulatory supervision of the data, and we would look forward to working with the regulating entity to develop oversight parameters and participant practices that would meet the goals established by Congress. We oppose a mandate to move all derivatives into a clearing or exchange environment. One key characteristic of OTC derivatives for commercial users is the ability to customize the instrument to meet a company's specific risk management needs. Provisions that would require the clearing of OTC derivatives would lead to standardization, thus impeding a company's ability to comply with the requirements of Financial Accounting Standard 133 (FAS 133). The inability to precisely hedge specific risks, whether currency, interest rates or commodities within the context of FAS 133, would expose corporate financial statements to unwanted volatility and uncertainty. Results could include lower valuations for companies as well as a reluctance to undertake as many growth investments because of the need to maintain some dry powder for adverse impacts from unhedged financial risks. While we are mindful of the reduction in credit risk inherent in a clearing or exchange environment, robust margin requirements would create substantial incremental liquidity and administrative burdens for commercial users, resulting in higher financing and operational costs. Capital currently deployed in growth opportunities would need to be maintained in a clearinghouse. This could result in slower job creation, lower capital expenditures, less R&D and/or higher costs to consumers. Hedging in the OTC market is customized to fit the actual underlying business risks being hedged. The clearinghouse concept relies upon high volumes of standardized products, a characteristic that does not exist in the customized hedging environment of the OTC market. By imposing initial and variation margin requirements, clearinghouses will add significant capital requirements for end-users, adding significant costs, discouraging hedging, and diverting scarce capital that could otherwise be used in further growing American businesses. 3. Preventing Market Manipulation, Fraud, and Other Market Abuses. We support the appropriate regulatory agencies having the authority to police fraud, market manipulation and other market abuses. The CFTC is utilizing its existing statutory and regulatory authority to add significant transparency in the OTC market, receive a more complete picture of market information, and enforce position limits in related exchange-traded markets. The comment period remains open on the CFTC proposal and this work should be allowed to continue. 4. Ensuring That OTC Derivatives Are Not Marketed Inappropriately to Unsophisticated Parties. We support modifications to current law that would improve efforts to protect unsophisticated parties from entering into inappropriate derivatives transactions.``Clearing'' in the OTC Market The obvious benefits of clearing are the elimination of counterparty risk and the facilitation of ``data collection'' for executed transactions. By requiring a greater swath of derivatives to be cleared, the ``costs'' of trading (for both dealers and end-users) will rise. Increased costs will come in the form of trading fees, margin/capital requirements, and administrative burden associated with management of the margin requirements. This will likely result in: 1. an increase in market concentration among dealers, as marginal players lose profitability, and 2. a decrease in hedging among end-users, as margin requirements will pressure their capital/liquidity. The second impact will likely hasten the concentration effect mentioned above. Further, a clearing environment requires the use of standardized instruments. Standardized contracts are unusable to most end-users, as they do not permit companies to precisely hedge the risks of their business. Any ``mismatch'' between business exposure and hedge instrument could result in the end-user's loss of hedge accounting treatment (FAS 133), thus creating additional income statement volatility. We believe that clearing should only apply to some of the products. The currency, interest rate, and most of the commodity markets operated well throughout the recent financial crisis. Clearing, however, may be appropriate in other areas where authorities believe there is a high degree of systemic risk present. Likewise, clearing may be appropriate in the case of standardized instruments. Customized derivatives, however, need to be tailored to meet end-users' business risk management needs, making clearing problematic. It is also important to remember that, particularly with interest rate swaps and foreign exchange, these are global markets. According to the Bank for International Settlements Triennial Central Bank Survey (December 2007), just 15% of daily FX turnover occurred in the United States, while 24% was the corresponding figure in the interest rate (single currency) market. U.S. based companies could be put at a disadvantage versus their foreign competitors should OTC trading regulations change dramatically in the U.S. In addition, warehousing is not appropriate for all trades. For example, a large percentage of trades executed in the foreign exchange market (well over 50%) are of very short (1 week and under) duration. It would seem impractical to require warehousing for such transactions. Warehousing probably makes more sense for ``term'' transactions of longer maturity.Conclusion We thank the Committees for the opportunity to submit our comments in writing as an employer interested in preserving and enhancing the global competitiveness of American businesses and workers. 3M looks forward to working with you as the Committees crafts legislation to strengthen the U.S. financial system. ______ CHRG-111hhrg53021Oth--347 Chairman Peterson," With that, we will bring this to a close. I want to thank Chairman Frank and all the Members of both Committees for a great hearing, good questions, good dialogue. And we look forward to working with the two Committees together, along with the Administration, to make this thing work. So thank you all. Thank you, Mr. Secretary. The Committees are adjourned. [Whereupon, at 1:07 p.m., the Committees were adjourned.] [Material submitted for inclusion in the record follows:] Joint Submitted Letter by Hon. Frank D. Lucas; on Behalf of Business Roundtable; Grocery Manufacturers Association; National Association of Manufacturers; U.S. Chamber of CommerceHon. Barney Frank, Hon. Spencer Bachus,Chairman, Ranking Minority Member,Committee on Financial Services; Committee on Financial Services;Hon. Collin C. Peterson, Hon. Frank D. Lucas,Chairman, Ranking Minority Member,Committee on Agriculture, Committee on Agriculture,Washington, D.C. Washington, D.C. Dear Chairmen Frank and Peterson and Ranking Members Bachus and Lucas: Businesses from diverse sectors and sizes across the United States enter into over-the-counter (``OTC'') derivative transactions to manage risks associated with their business operations, including fluctuations in interest rates, currency exchange rates and commodity prices. A survey of publicly-available information conducted by the International Swaps and Derivatives Association found that more than 90 percent of Fortune 500 companies use OTC derivatives. It is critical to note that many of our members use them--not to speculate or augment short-term profits--but as a normal course of business. Many OTC derivatives contracts are bought and sold with standard terms and conditions; however, there are also many derivatives contracts that are customized to meet the unique needs and risk exposures of individual companies, including such basic terms as dates, rates and notional amount. When businesses employ derivatives in this manner, they are not taking speculative positions. Quite the opposite; they are seeking to reduce risks that arise from their business activities. Whether standard or custom, OTC derivatives help American businesses protect themselves from risk and improve their access to credit. We support efforts to ensure appropriate regulatory oversight of market participants and their derivatives activities, consistent with the objectives outlined by the Obama Administration in its white paper, Financial Regulatory Reform: A New Foundation. More specifically, we believe the right approach encourages central clearing for standardized contracts where appropriate, while promoting transparency of customized contracts through a reporting regime that ensures regulators have the information necessary to oversee the markets. This approach strikes the right balance: it reduces counterparty risk and enhances transparency while maintaining an OTC market and the benefits it provides to our members. However, legislation requiring that all contracts be traded on exchanges or be centrally cleared will prevent companies from using non-standard products to reduce the volatility of their financial statements and lower their cost of capital--thereby expanding, not reducing, risk to companies. Such legislation would require companies to divert cash from being used to sustain and grow their businesses to meeting collateral and margin requirements. In short, the proposal could dramatically expand the need for liquidity in the midst of a liquidity crisis. The customized terms and conditions of OTC derivatives contracts cannot reasonably be standardized for exchange trading or mandatory clearing. In fact, in order for companies to utilize hedge accounting under FAS 133, and thus reflect the offsetting nature of a hedge in their financial statements, they must prove a close and consistent correlation between the derivative and the underlying asset or liability. If a company could not do so, as likely would be the case if only standardized instruments were available, the benefits of its hedge transactions would not be shown in its financial statements, thereby increasing earnings volatility. In short, please ensure that any regulatory reform legislation that moves in the House preserves the ability of our member companies to use OTC derivatives to manage risk at prices and under terms that are reasonable and continue to make sense from a business perspective. We urge you to prevent an anti-derivatives sentiment from translating into anti-business legislation. Thank you for your consideration of our views and we look forward to working with you. Sincerely, [GRAPHIC] [TIFF OMITTED] T1123.002 Larry D. Burton, Mary C. Sophos,Executive Director, Senior Vice President and ChiefBusiness Roundtable; Government Affairs Officer, Grocery Manufacturers Association; [GRAPHIC] [TIFF OMITTED] T1123.001 Dorothy Coleman, R. Bruce Josten,Vice President, Tax and Domestic Executive Vice President, Economic Policy, Government Affairs,National Association of U.S. Chamber of Commerce. Manufacturers;cc: The Members of the U.S. House of Representatives ______ Submitted Statement by Hon. Frank D. Lucas; on Behalf of 3M Company 3M Company (``3M'') is a large U.S.-based employer and manufacturer established more than a century ago in Minnesota. Today, 3M is one of the largest and most diversified technology and manufacturing companies in the world. 3M thanks the Committees for studying the critical details related to reforms to the U.S. financial system and for considering our perspective in this important debate. In examining the concepts outlined in the recent U.S. Treasury proposal on financial system reforms, 3M respectfully urges the Committees to carefully consider the distinct differences among various derivative products and how they are used, and encourages the Committees to preserve commercial users' ability to continue using derivative products to manage various aspects of corporate risk while addressing concerns about stability of the financial system.Background on 3M In 1902, five northern Minnesota entrepreneurs created the Minnesota Mining & Manufacturing Company, now known today as 3M. 3M is one of the largest and most diversified technology companies in the world. 3M is home to such well-known brands as Scotch, Scotch-Brite, Post-it, Nexcare, Filtrete, Command, and Thinsulate. 3M designs, manufactures and sell products based on 45 technology platforms and serves its customers through six large businesses: Consumer and Office; Display and Graphics; Electro and Communications; Health Care; Industrial and Transportation; and Safety, Security and Protection Services. 3M achieved $25.3 billion of worldwide sales in 2008. Headquartered in St. Paul, Minnesota, 3M has operations in 27 U.S. states, including over 60% of 3M's worldwide manufacturing operations, employing 34,000 people. 3M's U.S. sales totaled approximately $9.2 billion in 2008. While its U.S. presence is strong, being able to compete successfully in the global marketplace is critical to 3M. 3M operates in more than 60 countries and sells products into more than 200 countries. In 2008, 64% of 3M's sales were outside the U.S., a percentage that is projected to rise to more than 70% by 2010. Ahead of their peers, 3M's founders insisted on a robust investment in R&D. Looking back, it is this early and consistent commitment to R&D that has been the main component of 3M's success. Our diverse technology platforms allow 3M scientists to share and combine technologies from one business to another, creating unique, innovative solutions for our customers. 3M conducts over 60% of its worldwide R&D activities within the U.S. Our commitment to R&D resulted in a $1.4 billion investment of 3M's capital in 2008 and a total of $6.8 billion during the past 5 years while producing high quality jobs for 3,700 researchers in the U.S. The success of these efforts is evidenced not only by 3M's revenue but also by the 561 U.S. patents awarded in 2008 alone, and over 40,000 global patents and patent applications in force. Our success is also attributable to the people of 3M. Generations of imaginative and industrious employees in all of its business sectors throughout the world have built 3M into a successful global company. Our interest in speaking with you today is to preserve our ability to continue to invest and grow, creating substantive jobs and providing high quality products to a growing base of customers.Treasury Proposal Treasury Secretary Geithner proposed the establishment of a comprehensive regulatory framework for OTC derivatives that is designed to: 1. Prevent activities in those markets from posing risk to the financial system. 2. Promote the efficiency and transparency of those markets. 3. Prevent market manipulation, fraud and other market abuses. 4. Ensure that OTC derivatives are not marketed inappropriately to unsophisticated parties.OTC Derivatives: Helping U.S. Companies Manage Risk in a Competitive Marketplace While 3M unequivocally supports these objectives, we have strong concerns about the potential impact on OTC derivatives and 3M's ability to continue to use them to protect our operations from the risk of undue currency, commodity, and interest rate volatility. Derivative products are essential risk management tools used by American companies in managing foreign exchange, commodity, interest rate and credit risks. The ability of commercial users to continue to use over-the-counter (``OTC'') derivatives consistent with the requirements of hedge accounting rules is critical for mitigating risk and limiting damage to American businesses' financial results in volatile market conditions. We urge policy makers to preserve commercial users' access to existing derivative products as you design new regulations. We share the following comments with you in the spirit of working together to address the concerns about the stability of the financial system: 1. Preventing Activities Within OTC Markets From Posing Risk To Financial System: We agree that the recent economic crisis has exposed some areas in our financial regulatory system that should be addressed. However, not all OTC derivatives have put the financial system at risk and they should not all be treated the same. The OTC foreign exchange, commodity, and interest rate markets have operated uninterrupted throughout the economy's financial difficulties. We urge policy makers to focus on the areas of highest concern, such as credit default swaps. We would like to work with policy makers to address oversight where warranted, but recommend that it be targeted and not applied to all segments and market participants. 2. Promoting Efficiency and Transparency within the OTC Markets: We understand the need for reporting and record- keeping. Publicly held companies are currently required by the SEC and FASB to make significant disclosures about their use of derivative instruments and hedging activities, including disclosures in their 10Ks and 10Qs. We would like to work with policy makers on ways to efficiently collect information and enhance transparency. Specifically, proposals have been made to establish a data repository for OTC derivatives to ensure transparency and disclosure. We understand and support this need for greater transparency and oversight and could support providing on a real-time basis the critical terms (amount, currency, counterparty, rate(s), maturity) for transactions over a specified minimum size (e.g., $250,000) for such a data repository. Proposals have also been made to establish regulatory supervision of the data, and we would look forward to working with the regulating entity to develop oversight parameters and participant practices that would meet the goals established by Congress. We oppose a mandate to move all derivatives into a clearing or exchange environment. One key characteristic of OTC derivatives for commercial users is the ability to customize the instrument to meet a company's specific risk management needs. Provisions that would require the clearing of OTC derivatives would lead to standardization, thus impeding a company's ability to comply with the requirements of Financial Accounting Standard 133 (FAS 133). The inability to precisely hedge specific risks, whether currency, interest rates or commodities within the context of FAS 133, would expose corporate financial statements to unwanted volatility and uncertainty. Results could include lower valuations for companies as well as a reluctance to undertake as many growth investments because of the need to maintain some dry powder for adverse impacts from unhedged financial risks. While we are mindful of the reduction in credit risk inherent in a clearing or exchange environment, robust margin requirements would create substantial incremental liquidity and administrative burdens for commercial users, resulting in higher financing and operational costs. Capital currently deployed in growth opportunities would need to be maintained in a clearinghouse. This could result in slower job creation, lower capital expenditures, less R&D and/or higher costs to consumers. Hedging in the OTC market is customized to fit the actual underlying business risks being hedged. The clearinghouse concept relies upon high volumes of standardized products, a characteristic that does not exist in the customized hedging environment of the OTC market. By imposing initial and variation margin requirements, clearinghouses will add significant capital requirements for end-users, adding significant costs, discouraging hedging, and diverting scarce capital that could otherwise be used in further growing American businesses. 3. Preventing Market Manipulation, Fraud, and Other Market Abuses. We support the appropriate regulatory agencies having the authority to police fraud, market manipulation and other market abuses. The CFTC is utilizing its existing statutory and regulatory authority to add significant transparency in the OTC market, receive a more complete picture of market information, and enforce position limits in related exchange-traded markets. The comment period remains open on the CFTC proposal and this work should be allowed to continue. 4. Ensuring That OTC Derivatives Are Not Marketed Inappropriately to Unsophisticated Parties. We support modifications to current law that would improve efforts to protect unsophisticated parties from entering into inappropriate derivatives transactions.``Clearing'' in the OTC Market The obvious benefits of clearing are the elimination of counterparty risk and the facilitation of ``data collection'' for executed transactions. By requiring a greater swath of derivatives to be cleared, the ``costs'' of trading (for both dealers and end-users) will rise. Increased costs will come in the form of trading fees, margin/capital requirements, and administrative burden associated with management of the margin requirements. This will likely result in: 1. an increase in market concentration among dealers, as marginal players lose profitability, and 2. a decrease in hedging among end-users, as margin requirements will pressure their capital/liquidity. The second impact will likely hasten the concentration effect mentioned above. Further, a clearing environment requires the use of standardized instruments. Standardized contracts are unusable to most end-users, as they do not permit companies to precisely hedge the risks of their business. Any ``mismatch'' between business exposure and hedge instrument could result in the end-user's loss of hedge accounting treatment (FAS 133), thus creating additional income statement volatility. We believe that clearing should only apply to some of the products. The currency, interest rate, and most of the commodity markets operated well throughout the recent financial crisis. Clearing, however, may be appropriate in other areas where authorities believe there is a high degree of systemic risk present. Likewise, clearing may be appropriate in the case of standardized instruments. Customized derivatives, however, need to be tailored to meet end-users' business risk management needs, making clearing problematic. It is also important to remember that, particularly with interest rate swaps and foreign exchange, these are global markets. According to the Bank for International Settlements Triennial Central Bank Survey (December 2007), just 15% of daily FX turnover occurred in the United States, while 24% was the corresponding figure in the interest rate (single currency) market. U.S. based companies could be put at a disadvantage versus their foreign competitors should OTC trading regulations change dramatically in the U.S. In addition, warehousing is not appropriate for all trades. For example, a large percentage of trades executed in the foreign exchange market (well over 50%) are of very short (1 week and under) duration. It would seem impractical to require warehousing for such transactions. Warehousing probably makes more sense for ``term'' transactions of longer maturity.Conclusion We thank the Committees for the opportunity to submit our comments in writing as an employer interested in preserving and enhancing the global competitiveness of American businesses and workers. 3M looks forward to working with you as the Committees crafts legislation to strengthen the U.S. financial system. ______ FOMC20081007confcall--3 1,MR. DUDLEY.," Yes. Thank you, Mr. Chairman. Despite our massive escalation on the liquidity provision front and passage of legislation granting the Treasury authority to set up a $700 billion troubled asset relief program, or TARP, market conditions continue to deteriorate. This is occurring in three broad respects. First, market participants continue to pull back in their willingness to engage with one another. This pullback is evident in elevated interbank lending rates and elevated foreign exchange swap bases and market liquidity more generally. The one-month and three-month LIBOR�OIS spreads have widened to 271 and 296 basis points, respectively. That is up more than 175 basis points in the past three weeks since the September 16 FOMC meeting. The all-in cost of dollar funding via the foreign exchange swap market, although bouncing around day to day, has actually been even higher than LIBOR, often by 100 basis points or more. In addition to the interbank market, the commercial paper market has come under stress. The breaking of the buck by the Reserve Fund led to a wholesale flight out of prime institutional money market funds. This forced the liquidation of assets, which has led to impairment of the commercial paper market. Term commercial paper rates are elevated, and the average tenor of commercial paper has shortened considerably. Second, financial conditions continue to tighten, and in recent weeks, the tightening has been substantial. Equity prices have plunged both in the United States and abroad. Corporate bond yields, especially for non-investment-grade debt, have increased substantially. Short- and long-term tax-exempt rates have climbed, and credit availability has been even further impaired. On the equity market side, for example, the S&P 500 index has fallen about 18 percent since the September 16 FOMC meeting. Although there is considerable uncertainty about the appropriate metrics and weights to use in examining the evolution of financial conditions over time, most data are consistent with the judgment that conditions have tightened significantly since the onset of the crisis, despite the 325 basis point reduction in the federal funds rate target. Compared with the previous two monetary policy easing cycles, there have been four important divergences. First, corporate bond yields have climbed. In previous cycles, the widening credit spreads were more than offset by the decline in Treasury note and bond yields, causing corporate bond yields to fall. Second, credit availability has declined greatly in this cycle. In the two previous cycles, the proportion of banks tightening credit standards actually fell through the easing cycle. That stands in sharp contrast to what has been happening in this cycle. Third, housing price declines have been far larger than in previous cycles, in real and in nominal terms. Fourth, the dollar has weakened actually much less than in the previous two easing cycles. The third aspect of the market that I think warrants noting is that the U.S. financial sector in particular remains under pressure, especially with respect to share prices and banks' ability to obtain funding, especially term funding. Today was a particularly bad day for financial shares, with double-digit declines common for many banks. The only good news was that credit default swaps actually narrowed a bit, maybe helped by the introduction of our commercial paper backstop facility or the fact that we've escalated so massively in terms of the term auction facility and the foreign exchange swaps with our foreign central bank counterparts. On the inflation side of the ledger, pressures continue to abate. Since the last FOMC meeting, both industrial and agricultural commodity price indexes have fallen about 15 percent. At the same time, the dollar has strengthened. The fall in the commodity prices and the strength in the dollar are two factors that have contributed to a fall in breakeven measures of inflation on both the spot and the five-year, five-year-forward basis. For example, the Barclays measure of five-year, five-year-forward breakeven inflation has declined more than 60 basis points since the September FOMC meeting. Today it was around 1.5 percent. The interbank, money market, and capital market dysfunction, the tightening of financial conditions, and the apparent easing in inflation risks have caused investors to conclude that the FOMC is likely to lower its federal funds rate target in the near future. Late today, the November federal funds futures contract implied an effective rate for the coming month of about 1.4 percent. That's more than 50 basis points below the current target. Interestingly, the failure of the FOMC to ease today actually led to a rise in October and November federal funds futures contracts. Market participants presumably interpreted the introduction of the commercial paper funding facility as potentially a substitute for further monetary policy accommodation at this time. Obviously, this is an extremely fragile and dangerous environment. I am struck by the feeble market response to the substantial escalations implemented over the past ten days. These include expanding standing foreign exchange swap facilities' capacity to $620 billion from $290 billion; expanding the TAF auction cycles to $900 billion from $150 billion; and proposing a major backstop for the commercial paper market. With respect to the commercial paper market backstop facility, the market reaction today was generally positive, but market participants clearly want to know more in terms of the specifics, especially when the program will be up and operational. Of course, I'm happy to take any questions. " CHRG-111hhrg54867--159 Mr. Lucas," Thank you, Mr. Chairman. And Mr. Secretary, let us come at this from a slightly different perspective but along the lines of my colleagues. You have used the phrase ``in practice'' several times, and I appreciate that tremendously because this is not just an academic exercise; there are practical consequences to everything we do. My constituents, small financial institutions and what some would define as nontraditional institutions out in the countryside are very nervous about the Consumer Protection Agency bill, and their nervousness is not I think so much about protecting the consumer. They all support that. But there is a fear out there in the countryside, and this comes before Chairman Frank's memo, there is a fear out in the countryside that the biggest institutions in this country with larger staffs, with greater budgets, with greater volumes of business will have the ability to meet these standards in a more cost-effective way than they will be, and that the ultimate net result, at least of the Consumer Financial Protection Agency, as envisioned by the Administration, will be to raise their cost disproportionately to the bigger institutions. And they are very concerned about that out there. That is an issue I think we need to address as we move through this process. And to touch on a slightly different subject and then whatever comments you might have, sir, on the derivative side of the equation, sitting on the Ag Committee, we have a little bit of involvement in those issues. I have a number of constituents and constituent industries back home in Oklahoma that use these kind of products to provide some sort of price stability for the commodities they sell over the period of time. Otherwise, they are a day-to-day--a day-to-day price, and that is a very difficult thing to do. They have expressed extreme concern to me, and I think there is some legitimacy to this, depending on how in the Administration's proposal we address these capital and margin requirements, they are concerned, and I think legitimately, that potentially they will be driven, because they still need the price stability--they have to have the product--if we dramatically increase capital margin requirements or place them in a fashion that is counterproductive, they will be driven to the biggest financial institutions because they will have to have someone who can afford to not only engage in the contract with them, but who can finance all these other options. Once again, the fear being, Secretary, that they will wind up having fewer people to do business with, and it will be a small handful of the biggest, which runs contrary to I think what we have been saying on this side of the aisle, which is ``too-big-to-fail'' is unacceptable, untenable, and yet there are real concerns out in the countryside that these pieces of legislation as proposed will drive more business to the biggest, will put the biggest at an even greater advantage over everyone else. So let's visit for a moment about the practical consequences about these issues. " FOMC20050503meeting--30 28,MS. JOHNSON.," The staff forecast for average real GDP growth abroad over the forecast period has changed little from that in the March Greenbook despite swings in global oil prices, nonfuel primary commodity prices, and exchange rates, plus a significant near-term revision to the outlook for U.S. growth. However, the only minor revisions to our projection for average foreign growth mask significant differences across countries and regions—differences that reflect the varying influences of recent developments. In order to explore further these differences, I will highlight those developments over the intermeeting period that were unexpected and offer our thoughts on their implications for the outlook abroad and our forecast of the U.S. external sector. Despite continued expansion of global activity, long-term sovereign interest rates in the major foreign industrial countries have dropped significantly on balance since the previous FOMC meeting. For example, the German 10-year rate moved down from about 3.7 percent at the time of the March meeting to reach an all-time low of 3.38 percent on April 29 and has remained near that low so far this week. Rates in Canada and the United Kingdom fell almost as much, and even Japanese rates decreased nearly 20 basis points. Although by themselves lower interest rates might be expected to raise equity prices, the major stock price indexes abroad have fallen over the period from 2 to 7 percent. May 3, 2005 14 of 116 Euro-area economic sentiment fell in April to its lowest level in a year and a half. The Tankan survey in Japan dropped noticeably in the first quarter. In contrast, recent developments in the emerging-market economies, although mixed, are positive on balance, and we have revised up slightly our outlook for average growth there for this year. This outcome reflects the fact that several of the emerging-market economies export oil and/or other primary commodities whose prices have remained high. It also reflects the unexpectedly strong first-quarter growth that was recorded in China. We now calculate that China=s GDP grew at a 14 percent annual rate last quarter, almost double our projection in March. Although we expect some moderation in Chinese output growth over the remainder of this year, its robust pace should support somewhat stronger expansion in the region than we previously projected. Exchange market developments also contained some surprises. The dollar appreciated broadly over the intermeeting period, particularly in terms of the Canadian dollar and the euro. Domestic political tensions appear to be weighing on the Canadian dollar. Although we continue to build into the Greenbook baseline slight real dollar depreciation, the higher starting point for the current quarter leaves us with a forecast path for the dollar that is above that in March throughout the forecast horizon, a change that boosts imports and restrains exports. Particular focus on the Chinese exchange rate regime and the timing of any modification to that regime emerged at the time of the G-7 meeting in mid-April and again last week when market participants reacted quickly to a short-lived anomaly in the renminbi/dollar rate. Since your March meeting, the amount of appreciation priced into NDF [non-deliverable forward] contracts for Chinese renminbi has risen at 1-month, 3-month, and 12-month horizons. U.S. Treasury officials have made public statements calling for Chinese officials to act soon, and the U.S. Congress has raised the possibility of action on its part if the Chinese do not move. The heightened public debate appears to have raised the sensitivity of markets to any indication that something might be happening. In the absence of any reliable information on when and in what way the Chinese might alter the present regime, we have not incorporated any such change into the forecast. The extent to which other Asian currencies will move against the dollar when the Chinese do act remains an additional major uncertainty. May 3, 2005 15 of 116 percentage points from the figure in the March Greenbook. We estimate that real growth of core imports, non-oil imports other than computers and semiconductors, was about 18 percent—far faster than historical relationships with U.S. activity and relative prices would suggest. No component among real imports stands out, leaving us with no special factors that would explain the rapid growth. This quarter, we look for the pace of core import growth to moderate substantially to one more consistent with historical determinants, particularly given the downward revision of projected U.S. real GDP growth to about 3½ percent. In addition, on a seasonally adjusted basis the volume of oil imports is projected to contract sharply. Accordingly, imports of goods and services are projected to grow only 1¼ percent this quarter and then to expand at annual rates of 6 to 7 percent over the forecast period. Putting these pieces together leaves us with a first-quarter negative arithmetic contribution to U.S. real GDP growth from net exports of about 1¼ percentage points, about the same as in the fourth quarter. With import growth forecast to drop sharply, the projected contribution swings positive for the current quarter. In the second half of this year and during 2006, the contribution is small but negative. The near-term fluctuations in imports should be evident in the nominal trade balance as well. By the second half of this year and during 2006, we expect the trade deficit to widen further. Net investment income is also projected to deteriorate. Given current position figures, we see that balance as finally turning negative next year. Together these forecasts imply a current account deficit of more than $900 billion in the fourth quarter of 2006. Dave and I will be happy to answer any questions." FOMC20080430meeting--125 123,MR. ENGLISH.," 3 I will be referring to the revised version of table 1, which is included in the package labeled ""Material for the FOMC Briefing on Monetary Policy Alternatives."" The revised table presents the same range of options regarding the target federal funds rate as the version discussed in the Bluebook, but we have proposed some changes to the statement language for alternatives B and C. New language introduced in the draft distributed on Monday is shown in blue, with language reintroduced from the March 18 statement shown in black and underlined. An additional adjustment made since Monday is shown in purple. [Laughter] We have about used up the color palette in Word. I will discuss these changes as I go along. Your policy decision at this meeting would seem to depend on three judgments: Where do you think you are; where do you want to be; and what path do you want to follow to get there? The staff's assessment of where you are--at least in terms of the stance of monetary policy--is summarized in the r* chart that was included in the Bluebook. That chart showed that the current real federal funds rate is about 50 basis points above the Greenbook-consistent measure of r*, suggesting that the rapid easing of policy this year has left the real funds rate fairly close to the level required to bring the economy back to its potential over the medium term. The low level of the 3 The materials used by Mr. English are appended to this transcript (appendix 3). equilibrium funds rate reflects the staff's judgment that the housing correction and financial market stresses--with their associated effects on consumer and business confidence--have been sufficient to shift the economy into a recession regime in which spending by both households and businesses is likely to be weak. As for where you want to be, the Greenbook projection assumes that the real funds rate is moved down to its equilibrium level--that is, the federal funds rate is trimmed 50 basis points further--and then remains unchanged over the rest of the projection period. Finally, as for the path you want to follow to get there, the staff projection assumes that you move the federal funds rate to the staff's estimate of the rate's equilibrium level relatively quickly by trimming the fed funds target 25 basis points at this meeting and another 25 basis points at the June meeting. However, there is no overshoot below the equilibrium level in order to provide insurance against a further unexpected slide in spending. If you agree with the staff that about 50 basis points of additional easing is needed to bring the real federal funds rate into alignment with its equilibrium level and you are at least moderately confident of that assessment, then you might be inclined to ease policy by 50 basis points at this meeting and issue a statement suggesting fairly balanced risks to the outlook, as in alternative A. A relatively large adjustment to policy at this meeting would be particularly attractive if the Committee wanted a somewhat faster recovery in output or was concerned about downside risks to growth and wished to move the funds rate back to its equilibrium value quickly in order to help head them off. Members might also select a larger rate cut if they were willing to live with somewhat higher inflation over time, as in the optimal control simulation in the Bluebook with an inflation goal of 2 percent. The rationale language proposed for alternative A sticks fairly closely to the language used in March, making modest adjustments that are intended to avoid leaving the impression that the weakness in economic activity or the concerns about inflation had worsened appreciably over the intermeeting period. The assessment-ofrisk language would continue to indicate that the easier stance of policy should ""foster moderate growth over time and . . . mitigate the risks to economic activity,"" but it would move toward balance by dropping the explicit reference to downside risks. As in March, it would end by promising timely action to ""promote sustainable economic growth and price stability."" Investors would be surprised by the adoption of alternative A. Market participants generally expect a 25 basis point rate cut at this meeting and put very low odds on a 50 basis point cut. However, the effect of the relatively large easing would be damped somewhat by the shift to a more balanced risk assessment. The result would likely be lower short- and intermediate-term interest rates, a rise in equity prices, and a softening of the dollar. If the Committee viewed the target federal funds rate as probably close to the level that would appropriately balance the risks to its dual objectives but saw considerable uncertainty regarding that level, then it might be inclined to reduce the funds rate another 25 basis points at this meeting and suggest a more gradual pace of policy easing, or even a pause, after this meeting, as in alternative B. Policy has been eased very rapidly, and it is difficult at this point to assess the extent to which that easing has been transmitted to households and firms and so to spending. That assessment is complicated by the ongoing turbulence in financial markets as well as the usual difficulty in extracting signals from noisy data on economic activity. Against this backdrop, the Committee may be inclined to take a relatively small policy step at this meeting and then move to a more incremental policy approach under which policy will be guided by incoming information on economic and financial developments. Moreover, with some measures of long-term inflation expectations having moved higher in recent months, members may be concerned that a larger policy move at this meeting would encourage the view that the Committee is more willing to tolerate inflation than had been thought. By taking a smaller policy step at this meeting and suggesting reduced odds of additional near-term policy action, the Committee could limit the extent to which investors extrapolate the recent large policy moves and so build into asset prices more easing than is warranted. Such a brake on expectations may be seen as particularly useful since the incoming data on employment and economic activity are likely to be pretty soft in the near term, and the data releases could well spur expectations of further rate cuts even though the Committee anticipated the weakness when setting policy. Communication on this point will presumably be enhanced by the release of the ""Summary of Economic Projections"" in three weeks, which should clarify the Committee's views on the appropriate path for policy and the expected trajectory for economic growth over coming quarters. In the Bluebook, the rationale portion of the statement associated with alternative B was identical to that under alternative A. However, in the revised version of table 1, the first sentence on inflation has been changed to acknowledge the recent improvement in readings on core inflation but point to the continued run-up in energy and other commodity prices. Rather than simply noting the Committee's judgment that a further easing move is appropriate, as in alternative A, the assessment-of-risk paragraph begins by stating that ""[t]he substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity."" The explicit, time-dependent pause that was suggested in the Bluebook formulation for this alternative has been replaced by wording that is intended to suggest that policy will be more data-dependent, with the final sentence now reading, ""The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability."" The addition of the phrase on monitoring developments coupled with the deletion of the indication in the March statement that the Committee will act ""in a timely manner"" will likely be read by investors as suggesting a slowing in the pace of easing and possibly a pause after this meeting if the economy develops as the Committee anticipates. Investors appear to expect that the Committee will trim the federal funds rate 25 basis points at this meeting and then leave the federal funds target at 2 percent for some time. The 25 basis point policy easing and the associated statement under alternative B would seem to be about in line with these expectations, implying little response in financial markets. If the Committee thinks that the substantial easing of policy already put in place, along with the coming fiscal stimulus, is likely to foster outcomes that appropriately balance its inflation and growth objectives, then it may want to stay its hand at this meeting and issue a statement suggesting that policy is likely to change gradually going forward and could even be on hold for a time, as in alternative C. The Committee may expect the ongoing weakness in spending to be relatively mild and brief. The real federal funds rate is already very low, and the incoming data may not be seen as sufficiently weak to confirm the staff's view that the economy has shifted to a recessionary footing and therefore that spending is likely to come in weaker than one would otherwise expect. With financial markets most recently improving, on balance, and investors apparently less concerned about tail events, the Committee may see smaller downside risks to the outlook for growth. At the same time, members may think that the inflation outlook remains worrisome. Prices of oil and some other commodities touched new highs over the intermeeting period, and members may anticipate that firms will be able to pass a larger share of the increase in these costs through to their customers than the staff anticipates. Longer-term inflation expectations may have increased in recent months, and the Committee might be concerned that failing to push back, at least modestly, against that rise could allow for a more significant increase in expectations that could be very costly to reverse. Moreover, some members may worry that additional policy easing could trigger declines in the foreign exchange value of the dollar and increases in commodity prices that would give a further boost to inflationary pressures. Taken together, these arguments might suggest that, if a further easing step were taken at this meeting, it might have to be reversed fairly soon--an outcome that some members may wish to avoid. The discussion of economic activity in the statement under alternative C is identical to that under the other two alternatives. The inflation paragraph is similar to that under alternative A, but it does not list the reasons for the anticipated moderation in inflation. The exclusion of this list is intended to suggest less confidence in the judgment that inflation will moderate as expected. Some members may also be uncomfortable repeating the reference to ""a projected leveling-out of energy and other commodity prices"" when those prices have surprised to the upside yet again. The assessment-of-risk portion of the statement starts by pointing to downside risks, but then proceeds as in alternative B. The reference to downside risks might counter to some degree the suggestion of a possible pause in the easing process, but the lack of policy action combined with this statement language would presumably limit expectations for easing at coming meetings. Market participants put only about one-quarter odds on unchanged policy at this meeting, and so the combination of unchanged policy and a statement suggesting that the Committee could remain on hold for a time would surprise investors, even with the retention of downside risks to growth. Short- and intermediate-term rates would rise, stock prices would likely fall, and the dollar could rally. Effects on longer-term rates, and also on inflation compensation, would depend on whether investors interpreted the statement as indicating that the Committee desired a lower level of inflation than had been thought. The unexpectedly firm policy decision could boost pressures in short-term funding markets, either immediately, as a result of higher funding costs for leveraged firms and a weaker outlook for the real economy, or over time, in the event that economic data came in weaker than anticipated and the FOMC was seen as less likely to ease policy in response. That concludes my prepared remarks. " CHRG-110hhrg44901--24 The Chairman," The gentleman from Texas, who may not be quite so lucky in getting the answer that he wants. Dr. Paul. Thank you, Mr. Chairman. I want to address the subject of the inflation being actually a tax. Today, most of us who go home and talk to our constituents hear a major complaint, and that is the rising cost of living, especially the cost of gasoline, medical care, food, and education. Most economists from all fields, whether they are monetarists or Keynesians, they generally recognize that inflation is a monetary phenomenon. But it is interesting that once we get rising prices, very few people talk about the real source and the cause of the inflation, and they go to saying, well, it's the oil companies. They charge too much. That is inflation. Labor makes too much money, and it is a labor problem. Others just say, well, it's just pure speculation, if we didn't have the speculators, we wouldn't have the inflation. Yet, most people conclude not that we have too much money, but that we don't have enough. If we only had more money, we could pay all these bills, which I think is absolutely the wrong conclusion. What we need is more value in the money. In terms of gold and other commodities, prices aren't really going up. Sometimes they actually even go down. In terms of paper money worldwide, whether the euro or the dollar, the prices are going up. But I maintain really that inflation is a tax. If the Federal Reserve and you as Chairman have this authority to increase the money supply arbitrarily, you are probably the biggest taxer in the country. You are a bigger taxer than the Congress, because they are talking now about a bailout package of $300 billion, and we will have to raise the national debt to accommodate to take care of the housing crisis. But you as the Federal Reserve Chairman and the Federal Reserve Board and the system create hundreds of billions of dollars without even the appropriations process. Then this money gets circulated, and some people benefit--the people who get to use it first benefit, and the people who get to use it last suffer the consequence of the higher prices. So every time people go and complain about these higher prices, they should say to themselves, I am paying a tax. Because whether you are monetizing debt or whatever or catching up for buying up securities, we have had a free ride for all these years. We have been able to export our inflation. We have the Chinese buying up our securities. We haven't had to monetize it. But now it is coming home, and you have to buy these things to prop them up. So I maintain that inflation, as the increase in the supply of money for various reasons is a tax, it is an unfair tax, it is a regressive tax, it hurts the poor, it hurts the retired people more because labor never goes up and keeps up with inflation. We never keep up with the need for retired individuals to keep up with the cost of living. So I would like you to comment on this. Is this completely off base, or is there something really to this? Every time we see the cost of living going up, we indirectly are paying a tax. " FOMC20060629meeting--98 96,MS. MINEHAN.," New England’s economy remains in relatively good shape, though not particularly vibrant or reflective of great strength going forward. Employment growth has been positive but slow in comparison to the nation. New England usually has a lower unemployment rate than the nation does, but for the first time in a decade or so the region’s unemployment rate has converged, mostly because the national rate dropped, but the region has flattened out over the past several months. Local measures of year-over-year inflation are about on track with the nation as well, though growth of local fuel and utility costs is considerably higher. Many business people talk about their efforts to limit their energy costs by upgrading capital equipment and facilities to be more energy efficient and by looking into alternative sources of energy. They also report mild success in passing along increased costs to consumers. Perhaps reflecting this, the rising price of gasoline, or even the consistently rainy weather over the past couple of months, consumer confidence has sagged a good deal. But not all the news is gloomy. Business sentiment, as suggested by surveys and our meetings with our Small Business Advisory Group, remains positive overall as businesses report solid growth and positive hiring plans. Many continue to note how hard it is to find the skilled labor they need. Class A office vacancies have declined in both downtown and suburban markets, and rents are rising a bit. State tax collections, in particular sales and personal income taxes, are exceeding budgets in every state except Rhode Island, which appears to be experiencing an extended, though as yet unexplained, soft spot. In general, I sense a good deal of optimism among my business contacts about their own firms but uncertainty as well when they look at the evolution of both the regional and the national economies. Indeed, both the coincident regional index done by the Philadelphia Fed and the leading index for Massachusetts that’s done by the University of Massachusetts indicate that the regional economy is likely to grow only at a modest pace over the next year or so, buoyed by a resurgence in worldwide demand for high-tech and biotech products but weighed down by subdued consumer spending in the midst of high energy costs and declines in local housing markets. I just want to reflect a bit on regional residential real estate markets. Here various data sources—and there are lots of them—suggest that regional markets have slowed, with sales falling in April and to a lesser degree in May, and unsold inventories continuing to rise, with the number of months’ supply growing from about 8.7 in May of last year to more than 11 in May of this year. However, prices, depending on whether you look at median sales or repeat sales, either have fallen only slightly or have risen at about half the pace they had been rising. Most analysts see this as a soft landing or a period of stabilization after several years of strong price appreciation. Thus, while the local media and many pundits, national as well as local, wring their hands over the potential for major real estate problems, at least up to now the market correction in New England appears to be proceeding in a fairly benign way. Turning to the national scene, incoming data have served to reinforce a sense of risk on both sides of the Greenbook forecast. As I noted earlier, that forecast is not markedly different from our own, so when I talk about risk it will be the risk to our own forecast as well. To some degree, both slower growth and higher inflation were expected in the forecasts that we’ve made over the past six months or so, but recent data may be exceeding those expectations. On the growth side, residential construction has slowed a bit more rapidly than we thought. Consumer confidence has fallen off. Weaker equity markets, higher gas prices, and somewhat lower housing prices have likely affected consumer spending, and recent data on job growth have been slower. But there continue to be a good number of supports to growth. Household wealth remains high. Growth abroad remains solid. Financial conditions outside equity markets are accommodative. Businesses remain highly profitable and cash rich as reflected in the mini-boom in investment in nonresidential structures, and productivity growth remains strong. Indeed, if one averages Q1 and Q2 expected growth, it’s a bit above our earlier forecast, though clearly one needs to be mindful of the fact that the first half started with a bang and its recent momentum has been considerably cooler. Does this recent cooling portend a faster and steeper slowdown for the rest of ’06 than reflected in the current Greenbook forecast or our own? Or could there be enough underlying strength to take us back to the growth scenario of our earlier projections? In particular, I wonder a bit about the slow rate of job growth that is embedded in the Greenbook forecast for 2007. I don’t know what the possibility is of some surprise on the upside to the Greenbook’s current ’06 and, particularly, ’07 projections, but I think there may well be some. The incoming data have been more disquieting on the price front. I’m not a person who believes that a given level of inflation is bad in and of itself, within reason of course. I think it’s important to assess the level of inflation against everything else going on in the economy. So at times a level of 2 percent and change might be fine; at other times it might bear watching. And as far as I know, it’s been hard to prove that specific low levels of inflation—let’s say, below 3 percent—are bad in and of themselves. But I do believe that a rapid increase or decrease in the rate of inflation growth can portend debilitating change in the economy. Such increases or decreases need to be monitored carefully and figure importantly in the policy discussion. Thus, I have viewed the six- and three-month changes in core CPI and PCE with some alarm as the rate of change has been faster than I am comfortable with and certainly faster than our forecast expected. Looking at the first half of this year, and using the Greenbook forecast for Q2, we see that core inflation is nearly 50 basis points higher than what we, in Boston at least, had expected. Our analysis suggests that most of the reason for this surge in inflation over the past couple of years has been higher energy costs. Barring untoward geopolitical events, that should mean that inflation growth will moderate. But given the small to nonexistent output gap we see currently reflected in the low unemployment rate, there is more than a minor risk that resource pressures could begin to play a role in inflationary growth. The Greenbook forecast suggests that slower growth will provide a moderating influence on inflation. That’s our best bet as well, but prudent risk management might suggest some hedging of that bet. Thank you." CHRG-111hhrg63105--2 The Chairman," The hearing of the Subcommittee on General Farm Commodities and Risk Management to review implementation of provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act relating to position limits will come to order. I would like to thank everybody for joining us today as we review where we are at on the implementation provisions of the Dodd-Frank regulatory reform law relating to position limits. This hearing is very timely, as just recently the CEO of Sanderson Farms said it was delaying forward purchase of feed until the CFTC had issued position limit rules, and that he doesn't like to buy grain when ``index funds own 25-30 percent of the crop.'' So I wouldn't say that is why we are here today. I would like to review where we are at on this. I see that Chairman Peterson has joined us and I would like to take a moment, if I could, and divert from the hearing and recognize the outstanding work and dedication of Chairman Collin Peterson for leading this Committee through some of the most challenging times that the agriculture community has faced since the farm crisis of the 1980s. Specifically, he has championed the bringing of oversight and transparency to the derivatives market to protect end-users. And if everyone will indulge me, I would like to take a moment and thank Chairman Peterson. Thank you, Collin Peterson. We have Members who will be leaving us for different reasons, and we are going to give them a sad farewell as we work through this process today. And I am sure I will have an opportunity to recognize Mr. Moran, as he is going on to his new endeavors, and all the rest to their new endeavors. I might just at this moment add that my very special assistant, Alexis Taylor, from east Iowa, is going to be leaving our office and going over to the Senate. She is going to be the legislative assistant for Senator Baucus. So we congratulate her on her, I guess we could say, promotion. She will be very involved there for the next farm bill and that is good. We wish her well. Congress required the establishment of enforcement of position limits to ensure that no single entity holds too much power over the marketplace. Position limits are essential to the function of effective and efficient markets, and to inject confidence in the markets by providing reliable and transparent price signals. Some will argue that the very existence of position limits operates contrary to the principles underlying a free market; however, limits ensure that speculative positions are not in control of a contract, enhance a market, and make price signals a more accurate representation of the true market price. There is a strong need to ensure that the market is not being manipulated by a few players, and we are closely watching the pace of rulemaking on the Dodd-Frank Wall Street Reform and Consumer Protection Act, especially the rule relating to position limits. I think that all of us on the Subcommittee would agree that the Commission must take the time to get this right. However the Commission also must move quickly to ensure the individuals that use the markets for bona fide hedging purposes have the confidence that these markets are fair markets. Confidence by hedgers in these markets is critical, to say nothing of the importance of the confidence by the Congress in the Commission's ability to implement all the regulations required by the Act. Back in March, this Subcommittee held a hearing on rulemaking pertaining to the implementation of Commodity Exchange Act provisions contained in the 2008 Farm Bill. At the time, the rule on provision limits was pending for several energy contracts. That rule was withdrawn after the Dodd-Frank Act made further changes. I understand this issue is on tap for discussion at tomorrow's Commission meeting. So I hope that our hearing today will provide some valuable input into the forum along with a chance to review what the Commission's plans are on this topic. I am looking forward to hearing today from Chairman Gensler who has used his leadership on the Commission to be a powerful advocate for limits, and to ensure the Commission is on a speedy though challenging path towards full implementation of the law. I am also pleased to welcome Commissioner Chilton to the Committee. Mr. Chilton has expressed concerns about the pace of the regulatory process, and we look forward to discussing these concerns in more detail. Additional reactions from the witnesses on the second panel on the pace of the rulemaking and the content of regulations on position limits will be important to assessing the needs to move this issue along in the Commission's priority list. Before I turn to my good friend and future Senator from Kansas, Jerry Moran, for an opening statement, Jerry, I just want to thank you for the knowledge and support in working together. You have been a good colleague on this, and I appreciate the service you have given to us here on the House Agriculture Committee and we look forward to having a friend over there in the Senate. We wish you Godspeed in your work over there and much success. [The prepared statement of Mr. Boswell follows:] Prepared Statement of Hon. Leonard L. Boswell, a Representative in Congress from Iowa I would like to thank everyone for joining us here today as we review the state of the implementation provisions of the Dodd-Frank regulatory reform law relating to position limits. This hearing is very timely as just yesterday, the CEO of Sanderson Farms said it was delaying forward purchases of feed until the CFTC had issued position limit rules and that he doesn't like to buy grain when ``index funds own 25-30% of the crop.'' I would especially like to thank our witnesses. The Committee looks forward to hearing your valuable insight. I would like to take a moment and divert from the hearing and recognize the outstanding work and dedication of Chairman Colin Peterson for leading the Agriculture Committee through some of the most challenging times the agriculture community has faced since the farm crisis of the 1980's. Specifically he has championed bringing oversight and transparency to the derivatives markets to protect end-users. If everyone would indulge me to please take a moment and thank Chairman Peterson. Thank you for that indulgence. Congress required the establishment and enforcement of position limits to ensure that no single entity holds too much power over the marketplace. Position limits are essential to the function of effective and efficient markets and to inject confidence in the markets by providing reliable and transparent price signals. Some argue that the very existence of position limits operates contrary to the principles underlying a free market. However, limits that ensure that speculative positions are not in control of a contract enhance the market and make price signals a more accurate representation of the true market price. There is a strong need to ensure that a market is not being manipulated by a few players, and I am closely watching the pace of rulemaking on the Dodd-Frank Wall Street Reform and Consumer Protection Act, especially the rules relating to position limits. I think that all of us on this Subcommittee would agree that the Commission must take the time to get this right. However, the Commission also must move quickly to ensure that individuals that use these markets for bona fide hedging purposes have the confidence that these markets are fair markets. Confidence by hedgers in these markets is critical, to say nothing of the importance of the confidence by the Congress in the Commission's ability to implement all of the regulations required by the Act. Back in March, this Subcommittee held a hearing on rulemaking pertaining to the implementation of Commodity Exchange Act provisions contained in the 2008 Farm Bill. At the time a rule on position limits was pending for several energy contracts. That rule was withdrawn after the Dodd-Frank Act made further changes. I understand that this issue is on tap for discussion at tomorrow's Commission meeting, so I hope that our hearing today will provide valuable input into that forum along with a chance to preview what the Commission's plans are on this topic. I am looking forward to hearing today from Chairman Gensler, who has used his leadership of the Commission to be a powerful advocate for limits and to ensure that the Commission is on a speedy, though challenging, path toward full implementation of the law. I am also pleased to welcome Commissioner Chilton to the Subcommittee. Mr. Chilton has expressed concerns about the pace of the regulatory process, and I look forward to discussing these concerns in more detail. Additionally, reactions from the witnesses on the second panel on the pace of the rulemaking and the content of the regulations on position limits will be important to assessing the need to move this issue along in the Commission's priority list. Before I turn to my good friend and future Senator from Kansas, Jerry Moran for an opening statement I would like to thank him for his knowledge and constant support of agriculture in the House. " FOMC20061025meeting--57 55,MR. BARRON.," Thank you, Mr. Chairman. Data releases and reports we have gathered over the intermeeting period do not indicate much change since the Committee last met, so far as the Sixth District is concerned. Overall growth has been moderate, with the index of District economic activity showing a year-over-year increase of about 2.7 percent, and reports of activity varied considerably among sectors of the District economy. Retail sales have been mixed, and the outlook for tourism is reasonably optimistic. Auto sales remain sluggish, and the housing market—even beyond Florida, where both prices and sales have declined significantly— continues to show additional signs of some slowing. On the positive side, construction is shifting somewhat from residential to commercial. However, the lack of availability and the high cost of home and business insurance in Florida and along the Gulf Coast is a serious concern for our region. Manufacturing activity appears stable. Prices of some commodities are reported lower. Although gasoline prices are lower, fuel surcharges remain in place. As in the national economy, the slowdown in housing and moderation in overall activity have shown little signs of spilling over into the labor market. Employment gains through September softened somewhat. However, all states in the District, except Georgia, added jobs, and together accounted for 20,000 of the nation’s 51,000 jobs added during the month. The overall unemployment rate in the District, accordingly, moved down to 3.9 percent. Shortages of skilled labor continue to be reported in some areas, and overall labor quality, as Tom Hoenig noted, continues to be a problem, both of which I interpret as indicating a relatively firm labor market. We had a meeting this past week of our Advisory Council on Small Business, Agriculture, and Labor. Nearly to a person, participants reported things were good—not great but good—and the common problem was finding qualified workers willing to work. Most council members were willing to hire if they found the right people, but at the same time, they would forgo expanding their businesses if it meant hiring individuals who were less than qualified. One member from the construction sector noted that an individual walking around a job site with a piece of pipe, without doing anything else, would fully meet the requirements for continued employment—that is, they were carrying something, and they were moving. [Laughter] Concerning the national economy, opinions differ as to how much of a slowdown we will see this quarter and how long it will last. Most professional forecasters, as well as our own in-house models, suggest that growth will slow in the third quarter and then gradually accelerate thereafter. On the positive side, the labor market is very healthy. Corporate earnings continue to be healthy, business investment is supportive, and equity markets not only are at record highs but show no signs of letting up. At the same time, our headline inflation has come down, in the most part because of the decline in energy prices. Core inflation, especially in the service price component, continues to drift upward. Further, it’s not clear that the energy price increases have played a major role in explaining the increase in core inflation, so it may be problematic to assume that the recent decline will provide a significant downward impetus to core inflation, at least in the near term. Federal funds futures prices, the TIPS spread, and inflation expectations seem to be saying that the Fed’s credibility remains intact and are consistent with the belief that the Committee will get policy right, rather than signaling that slower growth is ahead in the foreseeable future. Thank you." FinancialCrisisReport--475 To understand Goldman’s securitization activities, this section provides general background about its CDO and RMBS business and how Goldman changed its securitization activities when the mortgage market began to deteriorate in late 2006. (i) Goldman ’s Securitization Business The Goldman Mortgage Department originated CDOs through two different desks within the Department. Approximately half of Goldman’s CDOs were originated by its CDO Origination Desk, which assembled the assets, structured the CDOs, and worked with the Goldman sales force to market the resulting securities to a broad range of investors. The CDO Origination Desk was headed by Peter Ostrem from 2006 until May 2007, after which all remaining Goldman-originated CDOs were transferred to the Structured Product Group (SPG) Trading Desk and were overseen by David Lehman. Goldman’s other CDOs, which were part of a series issued under the name of Abacus, were originated by the Correlation Trading Desk, which was a sub-desk of the SPG Trading Desk. The Correlation Trading Desk specialized in arranging customized trades for investors and used the Abacus series of CDOs as one of its investment alternatives. The Correlation Trading Desk was headed by Jonathan Egol. The CDO Origination and Correlation Trading Desks were located on the same floor as the other SPG Trading Desks. RMBS securitizations were handled by the Residential Whole Loan Trading Desk, headed by Kevin Gasvoda. Sub-desks within the Residential Whole Loan Trading area oversaw the purchase of residential loan pools, constructed the RMBS securitizations, and worked with the Goldman sales force to sell the resulting securities to investors. After a desk originated a CDO or RMBS securitization and sold the Goldman-originated securities for the first time, all secondary trading of the securities was handled by the Structured Products Group’s Asset-Backed Security (ABS) Desk. In mid-2007, Goldman shut down its CDO Origination Desk and directed the ABS Desk to sell all remaining Goldman-originated CDO securities, in addition to conducting the secondary trading it normally handled. Daniel Sparks, as head of the Mortgage Department, oversaw all of Goldman’s CDO and RMBS origination activities. Mr. Sparks reported at times to Jonathan Sobel, the prior department head, and Richard Ruzika, then head of Commodities Trading. He also worked with Justin Gmelich, a managing director asked to help him run the Department on a short term basis. Mr. Sparks also had frequent contact with more senior Goldman executives, including Thomas Montag, then global co-head of Securities Trading, and Donald Mullen, then head of Credit Trading. On occasion, he also received directives from Chief Financial Officer David Viniar and Co-Presidents Gary Cohn and Jon Winkelried. (ii) Goldman ’s Negative Market View FOMC20081029meeting--232 230,MR. STERN.," Thank you, Mr. Chairman. I'll start with a few comments about the District economy, which will sound pretty familiar by now. The preponderance of the anecdotes from business contacts that I've talked with since our last meeting have been distinctly negative. It's not just a slowing of activity or some deterioration but a sharp contraction in activity, particularly with regard to discretionary spending or discretionary projects, beginning in the middle of September. The one exception to that is commercial construction, where there are enough things under way that business remains pretty good. But the backlogs are dropping, and so weakness certainly is anticipated next year. I thought another possible exception to the negative tone was the housing market in the Twin Cities--not that the housing market in the Twin Cities is in and of itself so important but that it might be representative of some middle-of-the-road markets across the country. Clearly, it's not indicative of what's going on in Florida, California, or places like those because sales volumes in the Twin Cities had been up distinctly. Some of that is no doubt due to short sales and foreclosures; nevertheless, there were some other signs that were favorable. The affordability index has really improved a lot. It is back to levels of 2002-03, which Realtors call very comfortable. The ratio of housing prices to rent has moved back to the levels of 2002-03, and that's also encouraging. I already mentioned the higher sales volumes. Unfortunately, when you get beyond those statistics and look at other things, it's too early to declare stability in the housing market or anything resembling underlying improvement. Part of the problem is something that we've talked about before. The inventory of unsold, unoccupied properties remains very substantial--by historical experience way above anything resembling normal. Second, even though the price-to-rent ratio has come down, it's still elevated relative to the longer-term historical experience. So it looks to me as though, even in that market, there are some further price declines to come and it's going to take some more time to get through all of this-- probably well into next year. As far as the national economy is concerned, I, too, have marked down my outlook for real growth for the balance of this year, for all of next year, and into early 2010 as well. This reflects to some extent the nature of the incoming data but also the intensification of the financial problems and associated headwinds, the impact of the negative wealth effect, and so on. When I looked at my June forecast, back then the forecast obviously looked better, although there were a number of what I called ""identifiable negatives."" They have proven, for worse rather than for better, to be relevant. I already talked about some of them. In addition, we still have the problem in housing with excess inventories. We have steady declines in employment, which obviously have negative implications for consumer spending, and the credit headwinds as well. So now I have the economy contracting through the middle of next year, modest growth resuming thereafter, and robust growth beginning with the second quarter of 2010--quite some distance off. On the inflation outlook, I have for some time been thinking that inflation would begin to slow this quarter. With the decline in commodity prices, the evolution of the economic outlook, and so forth, my confidence in that forecast has increased, and I do expect inflation to diminish over the forecast period. So I think I'll conclude with that. " FOMC20080130meeting--2 0,CHAIRMAN BERNANKE.," Good afternoon, everybody. Today is the last meeting for our friend and colleague, Bill Poole. Bill has been here for 81 meetings, 80 as a Reserve Bank president and one as an adviser to the Federal Reserve Bank of Boston. I thought I would read to you the transcript from March 31, 1998, when Bill first joined the table. ""Chairman Greenspan. I especially want to welcome back an old colleague, Bill Poole. I didn't realize the last time he sat in this room was 25 years ago. Mr. Poole. I was sitting back there along the wall. Chairman Greenspan. It has taken you 25 years to move from there to here? [Laughter] Mr. Poole. Baby steps."" [Laughter] We'll have a chance to honor Bill at our farewell luncheon on March 18, at our next meeting, but let's take this opportunity to thank you for 10 years of service and collegiality. " FOMC20070321meeting--120 118,CHAIRMAN BERNANKE.," Thank you. Thank you very much for the comments. I’m going to offer, as I always do, a brief summary and invite any comments and corrections, and then I’d like to add a few comments of my own. Most participants today agree that growth looks as though it’s going to be slower, but there is some diversity of opinion about how persistent the slowdown would be. Many people have marked down growth expectations for the remainder of the year, and there was a general sense that the uncertainty about growth prospects and downside risk have increased. However, some people saw the current slowdown as only a soft patch that would be reversed soon. Housing remains weak, and some participants noted the risk that problems in mortgage and credit markets and increased foreclosure rates might contribute to further weakness. However, others felt that the housing situation has not changed materially since the last meeting. The slowdown in capital investment drew more concern, in part because it has proved difficult to explain. An inventory correction continues, but automobile inventories have been brought into line. Some factors that will support growth include a booming global economy and stronger government spending at both the federal and the state and local levels. The labor market continues to be tight, with some noting increases in wages. Developments in the labor, housing, and credit markets will be important in determining the future course of consumption. Several participants pointed to potential financial risks, including possible knock-on effects of the subprime mortgage problems and the possibility of the drying up of currently abundant liquidity and financial markets. Corporate earnings are also likely to slow. If these risks materialize, they could add to downside pressures on output. However, some thought that financial conditions will remain supportive. Some, but not all, think that inflation will continue to moderate, albeit very slowly. There is general disappointment with recent inflation readings, and some were skeptical that any meaningful progress against inflation is being made. In particular, resource utilization pressures, particularly tight labor markets, pose a longer-term inflation threat. Import prices and slower productivity growth also add to inflation risk. The views of most participants were that upside inflation risks still outweigh downside risks to output, that uncertainty has increased, and that the tails of the distribution have become fatter. Are there comments? If not, let me just add a few thoughts. It’s very difficult to speak last—all the good ideas have already been presented. So I’ll say just a few things. I think the growth outlook is slightly worse. The housing market is, of course, central to near-term developments. The central scenario that housing will stabilize sometime during the middle of the year remains intact, but there have been a few negative innovations. We’ve noted the subprime issues and the possibility of foreclosures, reduced confidence, and tightened credit terms, and I’ve also noted that reports from builders about the spring selling season have not been particularly upbeat, in general. At the same time, we continue to see rough stability in sales, starts, and permits. The effects of the decline in subprime lending may have already been mostly seen, since that has slowed from last fall. Mortgage rates, of course, remain quite low, and the labor market is a key determinant of housing demand and of mortgage delinquencies, particularly cross- sectionally. Across the country, there’s a very close correlation between foreclosure rates and state unemployment rates. So long as the labor market remains strong, I would think that the general health of the housing market would be improving. The housing market, I think, will follow the same scenario, but there are a few negative innovations. There was a lot of discussion about capital investments, and I share the puzzlement about why that’s happening. Like Governor Mishkin, I am concerned that it might signal something about productivity. Another possibility in the current environment goes back to my Ph.D. thesis on the effects of uncertainty on investment, which found that greater uncertainty can make people delay their commitments. In our last meeting, we discussed the possible upside risk to consumption. I think that risk is much diminished now. Our retail sales have been quite flat, and the strong growth of consumption in the first quarter is almost entirely due to the December blip, which will carry through to the quarterly arithmetic. But consumption is very likely to slow. Gas prices are another reason that consumption is likely to slow. The labor market, again, remains strong. I agree with the Greenbook that there is some likelihood of softening going forward. In particular, I think Governor Kohn mentioned that the slowing productivity growth we’re seeing could be consistent with some labor hoarding in this late stage of the cycle. Again, I’ve marked down my growth expectations only a bit, but if we were handicapping recessions, I’m afraid that risk has probably gone up a bit. I would cite at least three reasons. First, there seems to be a pretty good chance that potential output growth is lower than in the past; and almost by definition, if growth is lower, then the chance of negative quarters is greater. Second, the Greenbook has a 60 basis point increase in unemployment occurring stably over the next two years. If that happens, it will be the first time it has ever happened. [Laughter] Generally speaking, increases in unemployment tend either not to occur or to be bigger than 60 basis points. Finally, we’ve discussed the financial market sensitivities, which are having an effect, so that changes in the outlook could have pretty substantial feedback effects onto the economy through the stock market, other financial markets, and credit markets. So I think, as President Fisher does, that the tail in that direction is unfortunately somewhat fatter. Likewise with inflation, the news was disappointing. We knew that there would be—and we have seen—month-to-month volatility. It is difficult, as President Pianalto noted, to make a firm conclusion based on the recent data about whether or not inflation is moderating. I would just note that rents and owners’ equivalent rent are still pretty important here. They have not yet slowed much, which may have to do with the nature of the uncertainties about the housing market. That possibility will be helpful going forward. At an earlier meeting I indicated that medical costs were a risk; and they have, indeed, proved to be a risk. Speaking about inflation makes me reflect on the difficulties of measuring aggregate supply in general. As we think about the economy going forward, we face two countervailing possibilities. One, which I and several others have already mentioned, is that potential output growth may well be lower than many outsiders and maybe even the Greenbook think. Obviously that will make it difficult to get economic slack and will make this situation much more challenging. At the same time, the lack of wage acceleration at least raises the possibility that the NAIRU might be somewhat lower than 5 percent, which would be helpful in the other direction. With respect to inflation, again, as I said, I’m disappointed by the recent numbers. I don’t get a sense from business people or from surveys and so on that the general public’s worry about inflation has increased very much, except insofar as they perceive that inflation is constraining the Fed from acting. So, again, I don’t think we’ve seen an adverse breakout by any means, but obviously we’re going to have to remain very vigilant and make sure that we maintain our credibility on the inflation front. As the last item, I would like Vincent to distribute table 1. We made a couple of changes in the description of the economy. He can make a few comments, and then everyone will have an opportunity to look at it overnight, and we can discuss the communication issues tomorrow." FOMC20080625meeting--86 84,MR. EVANS.," Thank you, Mr. Chairman. Most of my contacts continued to report sluggish domestic demand, and they are not currently seeing any improvement in activity. In addition, their comments often focused on the substantially higher costs that they are facing for a wide range of nonlabor inputs. With regard to business activity, much of what we heard about the District and the national economy was a rehashing of preexisting developments. At our last meeting, we felt that there was substantial risk of a further softening in second-quarter growth, so the absence of new news is a positive development. With regard to specific sectors, exporters I have talked with continue to thrive, and steel producers are doing quite well. But any business associated with housing markets is very weak, and the motor vehicle outlook continues to worsen. All Detroit Three CEOs are expecting light vehicle sales to be less than 15 million units in 2008. The Seventh District has experienced substantial flooding in recent weeks, particularly in Iowa. We have been in contact with state officials and numerous businesses. The corn and soybean crops have experienced significant losses, though the range of estimates is wide. Higher estimates for lost corn output in Iowa are about 10 percent. That substantial loss would represent a national crop loss of just about 2 percent. In addition, although there have been transportation disruptions, especially on the Mississippi, our contacts expect these to be short-lived. So overall, our sense is that the economic damage seems to be relatively contained, especially in comparison with the floods in 1993, which hit a much wider geographic area and affected activity for a longer period of time. Turning to the national picture, the incoming data regarding growth generally have been positive. Indeed, the string of upward quarterly forecast revisions continues. In particular, I have been impressed by how much second-quarter GDP growth forecasts have moved up. This is not to say that we are out of the woods. Clearly, the continued difficulties in the housing and credit markets as well as the unrelenting increases in energy prices pose important downside risks to activity. Our Chicago Fed national activity index continues to be in territory I would characterize as a recession--the three-month moving average is minus 1.08 this past month. Still, the risk of the adverse feedback loop that concerned us so much clearly seems less likely today. Importantly, the financial situation seems better. Though conditions are still far from normal, institutions have had time to cope with bad portfolios, much as President Bullard mentioned. They have made significant progress in raising capital and have increased provisions against losses. I think our lending facilities have helped financial institutions gain time to facilitate the adjustment process. It seems well beyond our abilities, however, to engineer a return to ""normal financial conditions,"" given the extent of financial losses and overbuilding in housing. With regard to our economic projections, we expect growth this quarter to be similar to the Greenbook; but unlike the Greenbook, we are looking for the momentum to carry forward to a better second half of the year. Beyond this year, we think growth will run near potential. This is based on a fed funds rate path close to that in the futures markets. We are assuming a fed funds rate of 2� percent by the fourth quarter and 3� percent by the end of 2009. Turning to inflation, a number of factors present a concern for inflation expectations and our ability to bring inflation down. As I mentioned, my contacts spent a good deal of time talking about materials cost pressures, and many around the table have talked about those as well. Many manufacturers were citing large increases in energy and most commodity prices, and everyone was passing along some portion of these cost increases. I have one anecdote on this: In retail, Crate&Barrel reported on recent buyers' trips to Asia, saying that prices for items purchased there would be 15 to 20 percent higher for next year. Finally, wage pressures have been subdued thus far. Still, econometric analysis by my staff reminded me that wage inflation tends to follow price inflation not the other way around. So by the time we see wage pressures, either we are not behind the curve now, or it is ""Katie, bar the door!"" It is probably one or the other. [Laughter] Indeed, I am concerned that large and persistent changes in costs and in relative prices of high-profile items, such as energy, could change the inflationary mindset of businesses and households. The resulting increase in inflation expectations would pose a difficult challenge for monetary policy. Maybe it will end up being okay; maybe surveys will be right. But it is a big risk, and that risk is a bit large for my comfort. Looking ahead, we all see the substantial upside risk to price stability posed by the passthrough of higher costs and any possible increase in inflation expectations. While I hope I am wrong, I feel that we may need to accept a somewhat longer period of resource slack than we would like in order to address these risks and put inflation more firmly on a downward trajectory. Under our projection for GDP growth, the economy does not close the modest resource gaps we project will be in place at the end of 2008 until beyond the forecast horizon. Along with a flattening in energy and other commodity prices, such gaps should be sufficient to contain inflation expectations and bring overall PCE inflation near 2 percent in 2009 and 2010. That is our expectation. But my base case does not have inflation moving below 2 percent until after 2010, and that is even with more aggressive policy tightening than the Greenbook path. Now, turning to the long-term projections, I think that our forecasts for 2010--or at least the way that I think about it--do suffer from some difficulties. We would like to mention in the write-up that, at the end of the period, the range is between 1� percent and 2 percent, and we can infer policymakers' preferences from that. That is one interpretation. Given the inflationary pressures, that is harder and harder for many people to come up with. I think in some cases it requires a monetary policy response that is beyond what most people would expect that we could actually do. So I don't try to force my inflation forecast into my preferred range if it is too hard. Based upon monetary policy, it is more medium term. So I do tend to favor a longer period. I am somewhat indifferent between the first and the second options. I don't really see a lot of difference, but something that has a five-year forecast I think is useful. Whether or not it has the fourth year and whether or not it is core PCE or total are less important issues. One argument for this is an interesting body of research, which I have been exposed to only at conferences--and Jim probably knows it better than most--on learning and whether individuals in the economy can learn these rules without a variety of information. Some of the better papers that I have seen on that remind us that you need more pieces of information than just what the target is, whether it be 1� percent or 2 percent. You need some type of contour when people are learning with simplistic learning rules, like least squares learning. So I think a bit more contour on the forecast would be helpful. In my mind, that pushes you toward the five years of forecasting as opposed to a steady state or a five-to-ten-year forecast. I think that's an important element. On the trial run, I think we could do it sooner than that, but I know a lot of staff resources are involved. So I favor sooner rather than later. Thank you. " CHRG-111hhrg52406--31 Mr. Galvin," Thank you, Chairman Frank, Ranking Member Bachus, and members of the committee. I want to thank you for this opportunity to testify on these important issues of consumer and investor protection. As Secretary of the Commonwealth, as has been noted, I am the chief securities regulator. The Congress is now considering an array of initiatives to improve consumer and investor protection. These include proposals in the White House, a White Paper on financial regulatory reform, as well as bills proposing the creation of the Consumer Financial Protection Agency. I commend and support the President's plan to strengthen and rationalize financial regulation, to provide greater protection against systemic risk in the financial markets, and to create a Federal agency to protect consumers in credit transactions. I support the proposal to strengthen the U.S. Securities and Exchange Commission that will enable the SEC, along with the States, to oversee the securities markets and to protect consumers. I also applaud other elements of the White House plan that would directly improve investor protection such as making securities brokers fiduciaries. True consumer protection requires that financial firms be fiduciaries for their consumers whether they are licensed investment advisors or brokers. We need to act now on the issue of mandatory arbitration. The documented problems in that area should be an indication that this should be optional for investors rather than mandatory. Too many investors have faced a stacked deck in arbitration. Most especially hedge fund registration, whereas that both hedge fund managers and the funds themselves should register with the SEC. Hedge funds are often low visibility but high impact participants in the financial markets. Hedge funds have also been the source of abusive trading in the commodities and securities markets, including trades that have distorted the oil and food markets. Wild speculation in these basic commodities during the past year has robbed millions of Americans of billions of dollars at the gas pump and the supermarket. I urge Congress to protect our now fragile economy from further damage. We support the creation of a Consumer Financial Protection Agency to enhance the protection of consumers when they enter into credit savings and payment transactions. Sadly, this hearing on the creation of this agency is necessary because existing regulatory agencies dropped the ball. While some proposals have slipped through the cracks--some problems have slipped through the cracks of existing rules too often regulators fail to maintain their independence in the industries they regulate and they fail to use their powers to promulgate and enforce rules to protect the public. Massachusetts and other States have a distinguished record of protecting retail investors and consumers. As financial regulation is redesigned, I urge you to preserve and enhance the abilities of the States and State regulators to protect investors and consumers. There is an acute need for this protection. Retail investors and savers have been forced into the risk market to meet their basic financial goals. Investors and consumers are particularly harmed when the States have been preempted from protecting their interests. These include the preemption of State usury laws, predatory mortgage lending laws, and security law preemption. The National Securities Markets Improvement Act of 1996 preempted State authority in key areas where the States protected investors. NSMIA removed the State's ability to require enhanced disclosure in mutual funds. NSMIA created a regulatory blind spot for hedge funds selling securities pursuant to the Rule 506 exemption. And NSMIA prevented a State enforcement action against large investment advisors even when the violation involved unfair or deceptive practice. Massachusetts and other States have taken the lead in bringing enforcement actions and recovering funds for investors. These include auction rate securities, illegal market timing of mutual funds, and false security analyst reports and pyramid and Ponzi schemes. The States are close to the investing public and have time and time again demonstrated that they can act quickly and effectively to help investors. The States have added value but precisely because they are independent of other agencies and self-regulatory organizations. States have been another set of eyes watching the market. States have also served as a backstop, protecting the interest of investors in important cases when other regulators have not taken action. We urge the Congress not to make the States subject to the authority of the Financial Services Oversight Council or the Federal Reserve. Similarly we urge the States not be made subject to the Consumer Financial Protection Agency. The independence of the States means that they are less likely to yield to pressure from regulated entities and they are much less likely to be captured by the firms and the industries that they regulate. In this regard, I must emphasize the record that States have of cooperating with the SEC and FINRA and this record will continue. The States will cooperate and coordinate with the Consumer Financial Protection Agency that is proposed. However, it is crucial the States not be under the CFPA's authority. The States' independence is vital and it is the key to our record of success. To be effective, the States need the tools we need to regulate effectively. We need to restore States' authority over nonpublic offerings, particularly hedge funds, which are particularly sold pursuant to the exemption under Rule 506. We need to permit the States to police larger federally registered investment advisors for unethical and dishonest practices. The rights for investors to sue for violations of State and Federal securities laws is also a powerful tool that should be reconsidered. I urge the Congress to review the impacts of the private security litigation reforms. We need to strengthen, not weaken, investor remedies. Thank you, Mr. Chairman. [The prepared statement of Secretary Galvin can be found on page 81 of the appendix.] " FOMC20080430meeting--55 53,MR. STOCKTON.," Before explaining how the global developments that Nathan just described intersect with our domestic inflation forecast, I should briefly review some of the incoming information on prices. For the most part, the recent consumer price data have been running below our expectations. At the time of the March Greenbook, we were estimating that core PCE prices had increased at an annual rate of 2� percent in both the fourth quarter of last year and the first quarter of this year. We now are projecting increases of 2� percent and 2 percent in the fourth and first quarters, respectively. Although we are estimating that core PCE prices rose 0.2 percent in March--just a couple of basis points below our previous forecast--there were noticeable downward revisions to the data stretching back to late last year, principally for medical services and nonmarket prices. Just as we had discounted some of the earlier elevated increases in core PCE prices, we are now inclined to discount the recent more favorable readings. The small increases in medical service prices are not likely to persist. Moreover, some of the recent slowdown is attributable to nonmarket prices, which we view as both noisy and mean-reverting. Still, we don't think all of the good news on core PCE prices of late should be written off; and all else being equal, we would have taken down our forecast for the year as a whole in response to the incoming data. But, of course, all else was not equal. As Nathan has noted, there has been another sizable increase in crude oil prices; the prices of non-oil imports have increased more rapidly than we had expected; and more broadly, both imported and domestically produced materials prices have risen sharply thus far this year. In reaction, we have marked up our forecast for core PCE inflation for the remainder of the year, and that upward revision basically offsets the effects of the recent good news. For now, inflation this year looks likely to repeat the pattern of the past four years. Since 2004, headline PCE prices have risen at about 3 percent per year, and core prices have been up at a rate of about 2� percent. Due to a further steep rise in energy prices, large gains in import prices, and another above-trend increase in food prices, we are projecting headline PCE prices to rise 3� percent this year and core prices to increase 2� percent--similar to the averages over the preceding four years. Moreover, our forecast for 2009 bears a striking resemblance to the out-year forecasts that we have continued to make over the past four years. By now, in answer to the question of why inflation is expected to slow in the forecast, most of you could easily recite the staff's catechism of disinflation. Based on readings from the futures markets, we expect consumer energy prices to flatten out next year and food prices to slow to a rate close to core inflation. With the dollar not expected to fall as much as it has over the past year and other commodity prices expected to move sideways, import prices are projected to slow. Those more favorable developments in combination with a noticeable increase in projected slack cause headline inflation in 2009 to slow to 1� percent and core PCE inflation to edge back to 2 percent. Both of those figures are 0.1 percentage point higher than our March forecasts, reflecting the indirect effects of higher prices for energy and other imports. As we have noted many times, a key element in our projection is the assumption that oil and non-oil commodity prices will flatten out as suggested by the futures markets. To put it mildly, that has not been a winning forecast strategy in recent years, but I'm not sure that we have a superior one to offer you. Obviously, there are some big upside and downside risks to our forecast of domestic inflation. Nathan has already covered some of those related to prices for oil and other imports, so let me say a few words about the outlook for retail food prices. Our outlook for food prices remains relatively sanguine, but there would appear to be more pronounced risks to the upside than the downside. Although most of the value of what's in your morning cereal bowl is advertising, packaging, and transportation, some corn and wheat are in there also, [laughter] and those prices have been rising rapidly. Futures markets are predicting a leveling-out in crop prices, and that expectation is built into our forecast. But worldwide stocks of grains remain tight, and any serious shortfall in production could result in sharply higher prices. In that regard, while the growing season here is just getting under way, corn production is off to a slow start because unusually wet conditions have hampered plantings. Elsewhere, increasing supplies of livestock products and poultry have been a moderating influence on retail food prices in recent months. Again, while futures markets suggest relatively subdued prices going forward, there are a few worrying signs. Although cattle on feedlots have remained near record levels, new placements have fallen off of late, reportedly because of the higher cost of feed. In addition, the portion of feedlot placements composed of females was high last fall and through the winter, which points to a reduction in the size of the breeding herd this year and thus suggests some potential supply risks ahead. In recognition of the upside risks posed by both food and energy prices, we included in the Greenbook an alternative simulation in which oil prices climb to $150 per barrel next year and food prices continue to run at the elevated pace of the past three years. In this scenario, we also assume that another year of elevated headline inflation results in a further erosion of inflation expectations of about � percentage point. Under these conditions, headline PCE price inflation posts another year north of 3 percent, and core inflation moves a bit higher to 2� percent this year and next. It strikes me that this type of persistent upward creep to inflation, which would be difficult to positively identify in real time, is a more likely risk than a sudden upward surge in price inflation. There are, however, some downside risks to the inflation outlook as well. As you know, we upped our price forecast a bit in the last round because we saw the incoming readings on inflation expectations as suggesting that there had been some modest upward movement over the preceding few months. Some of that increase may have resulted from your aggressive easing of policy early this year. But going forward, the situation may be turned around. If our forecast over the next few quarters is in the right ballpark, and on our assumption that the easing of policy is coming to an end, you will be standing pat on policy even as payroll employment falls throughout the remainder of the year, the unemployment rate trends higher, and headline inflation begins to back down. It doesn't seem a stretch to me that in that environment, inflation expectations could come down somewhat, a development not embodied in the baseline forecast. More broadly, one place that inflation expectations might be expected to manifest themselves in a way that would be most damaging to inflation would be in labor compensation. Despite the elevated headline inflation of the past four years, there is little evidence of any noticeable step-up in wage inflation. If that was the case when the unemployment rate was 4� percent, it seems less likely that larger nominal wage gains will be secured when the unemployment rate rises to 5� percent. Indeed, increases in hourly labor compensation have been running well below our models for some time, pointing to some additional downside risks to our inflation outlook. For now, we see substantial risks to the inflation outlook, but those risks still seem twosided to us. Brian will complete our presentation. " CHRG-111hhrg53021Oth--16 Chairman Peterson," I thank the gentleman and I thank the Members for their attendance and the Chairman, and the Ranking Members for their statements. The Chairman requests that other Members submit their opening statements for the record. [The prepared statement of Mrs. Bachmann follows:] Prepared Statement of Hon. Michele Bachmann, a Representative in Congress from Minnesota Thank you, Mr. Chairman. And, what a pleasure it is to have a fellow Minnesotan co-chairing this hearing today. Thank you, Mr. Peterson, as well. And, thank you, Secretary Geithner, for being here today and I look forward to the discussion. Many U.S. companies responsibly utilize over-the-counter derivatives on a daily basis to manage their risks and limit damage to their balance sheets. These end-users are America's job-creators and Congress should be careful not to over-reach and infringe on their ability to hedge risks responsibly. Our Subcommittee on Capitol Markets held a helpful hearing on this issue in June. Chairman Kanjorski invited end-users such as 3M, a global company headquartered in Minnesota, to testify so that we could hear their perspective on this important issue. We heard the sincere concern of end-users and manufacturers about losing their ability to use customized over-the-counter derivatives to hedge against foreign exchange, interest rate, and commodity price risks. I agree with Chairman Kanjorski's sentiment from that hearing that we should try to find the right balance as we move forward on this issue. While we want to improve oversight and transparency of the derivatives market, as Chairman Kanjorski stated, ``subjecting all contracts to mandatory exchange trading may cast too wide a net.'' (Financial Times, 6/10/09) The proposal submitted by the President, the legislation reported out of the Agriculture Committee in February (H.R. 977), and the Waxman-Markey cap-and-tax bill (H.R. 2454) all cast very wide nets and do not seem to make any attempt to differentiate between varying types of derivatives products. They ignore the concerns we've heard from American businesses about why mandatory clearing for all these financial products could hamper their ability to properly hedge risks. Particularly in the current economic climate, I question the prudence of impairing their ability to manage genuine operating risks. The end result would likely be unnecessarily sidelining precious capital--capital that we need in the marketplace to create jobs and help the economy recover. We should be looking for ways to improve our current patchwork of financial regulation and move toward a more effective and efficient system that legitimately improves safety and soundness. Thank you, Mr. Chairman, and I yield back the balance of my time. " CHRG-111hhrg53021--16 Chairman Peterson," I thank the gentleman and I thank the Members for their attendance and the Chairman, and the Ranking Members for their statements. The Chairman requests that other Members submit their opening statements for the record. [The prepared statement of Mrs. Bachmann follows:] Prepared Statement of Hon. Michele Bachmann, a Representative in Congress from Minnesota Thank you, Mr. Chairman. And, what a pleasure it is to have a fellow Minnesotan co-chairing this hearing today. Thank you, Mr. Peterson, as well. And, thank you, Secretary Geithner, for being here today and I look forward to the discussion. Many U.S. companies responsibly utilize over-the-counter derivatives on a daily basis to manage their risks and limit damage to their balance sheets. These end-users are America's job-creators and Congress should be careful not to over-reach and infringe on their ability to hedge risks responsibly. Our Subcommittee on Capitol Markets held a helpful hearing on this issue in June. Chairman Kanjorski invited end-users such as 3M, a global company headquartered in Minnesota, to testify so that we could hear their perspective on this important issue. We heard the sincere concern of end-users and manufacturers about losing their ability to use customized over-the-counter derivatives to hedge against foreign exchange, interest rate, and commodity price risks. I agree with Chairman Kanjorski's sentiment from that hearing that we should try to find the right balance as we move forward on this issue. While we want to improve oversight and transparency of the derivatives market, as Chairman Kanjorski stated, ``subjecting all contracts to mandatory exchange trading may cast too wide a net.'' (Financial Times, 6/10/09) The proposal submitted by the President, the legislation reported out of the Agriculture Committee in February (H.R. 977), and the Waxman-Markey cap-and-tax bill (H.R. 2454) all cast very wide nets and do not seem to make any attempt to differentiate between varying types of derivatives products. They ignore the concerns we've heard from American businesses about why mandatory clearing for all these financial products could hamper their ability to properly hedge risks. Particularly in the current economic climate, I question the prudence of impairing their ability to manage genuine operating risks. The end result would likely be unnecessarily sidelining precious capital--capital that we need in the marketplace to create jobs and help the economy recover. We should be looking for ways to improve our current patchwork of financial regulation and move toward a more effective and efficient system that legitimately improves safety and soundness. Thank you, Mr. Chairman, and I yield back the balance of my time. " CHRG-111hhrg74855--14 Mr. Dingell," Thank you, Mr. Chairman, and I very much appreciate your kind remarks. I will commend you for holding this hearing which I view as very important. If H.R. 3795, the Over-The-Counter Derivatives Act of 2009 is acted upon without significant input from the Committee on Energy and Commerce, much of the work that has been done by this committee over the years going back to before I was in this body to back when Sam Rayburn was Speaker, will be undone, and FERC will probably lose significant authority to protect electric and natural gas markets against fraud and manipulation, and worse then that, consumers will be denied protection of a consumer protection agency in favor of an agency that has a long tradition of failure in protecting consumers. So thank you for doing this hearing today, Mr. Chairman. Most recently in the Energy Policy Act of 2005, as you mentioned, the Congress acting on the suggestions of this committee gave broad authorities to FERC to protect against fraud and market manipulation to ensure price transparency in the electricity and natural gas markets. That has worked well and I look forward to hearing from Chairman Wellinghoff of FERC on the various oversight mechanisms that FERC has in place to ensure proper functioning of various markets. Collaterally, we will look forward to hearing our other witness tell us why it is that he can do better. If H.R. 3795 were enacted into law without further amendment, there is a serious potential that many of the instruments used and organized in regional electric markets and currently regulated by FERC would either be displaced by the Commodities Futures Trading Commission or confusing overlaps and conflicts would be created. In the past, such conflicts have led to FTC and a hedge fund jointly litigating to strip FERC of its consumer protection authorities. This would not seem to be beneficial then to consumers and it has been a matter of bipartisan concern as today's record will show. In fact, one of our witnesses today will testify that consumers would see a rate increase of 5 to 15 percent if these activities are forced into exchanges. Following the energy bubble price in natural gas and electricity markets during 2008, FERC economists found that this was caused in significant part by excessive speculation in futures and derivatives markets for natural gas. We will want to hear from the chairman of CFTC what they did about those matters at that time. Likewise, it was FERC that discovered a sharp spike in speculative activity in natural gas futures that led to the prosecution of the hedge fund, Amaranth Advisors. FERC's admission is simple, assist consumers in obtaining reliable and efficient energy services at a reasonable cost through appropriate regulatory and market mechanisms. However, when one considers the complexity of such task, it is critically important that the agency with years of experience and understanding of energy markets and a fine staff expertise required to carry out such a task, should be allowed to continue its successful work. We will also want to inquire as to why we have need of new intrusion into these matters by an agency without any prior expertise in these matters. I thank you, Mr. Chairman. " FOMC20080130meeting--210 208,CHAIRMAN BERNANKE.," However, there appears to be a law of nature that the turnaround in the housing market is always six months from the present date. We simply don't have any evidence whatsoever that the housing market is bottoming out. We have guesses and estimates about how far prices will fall and how far demand and construction will fall. The key issue is prices, and we are far from seeing the worst case scenario that you could imagine in prices. So long as we don't see any stabilization in the housing market or stabilization in house prices, then I don't think we can say that the downside risks to the economy or to the credit system have been contained. Until that point, I think we need to be very, very alert to those risks. Everyone has talked about inflation, as should be the case. I am also concerned. The pickup in core inflation is disappointing. There are some mitigating factors, such as the role of nonmarket prices, which tend not to be serially correlated. We haven't discussed owners' equivalent rent in this meeting for the first time in a while, but we know that it can behave in rather odd ways during periods of housing slowdowns. The hope is that energy and food prices will moderate; in fact, if oil prices do rise by less than the two-thirds increase of last year, it would obviously be helpful. Nominal wages don't seem to be reflecting high inflation expectations at this point. So I think there are some reasons for optimism; but as many people pointed out, there are upward pressures, including the point that President Fisher made that the lagged effects of the previous increases in energy, food, and other commodity prices have probably not been fully realized in core inflation. Furthermore, as we'll talk about more tomorrow, to the extent that we decide at this meeting to take out some insurance against downside risks, then implicit in that insurance premium might be a greater risk of inflation six months or a year from now. So we have to take that into account as we think about policy and about our communications, as President Plosser and others have pointed out. In particular, as Governor Mishkin and others have noted, we need to think about a policy strategy that will involve not only providing adequate insurance against what I consider to be serious downside risks but also a policy strategy that involves removing the accommodation in a timely way when those risks have moderated sufficiently. So my reading of the situation is that it's exceptionally fluid and that the financial risks, in particular--as we saw, for example, after the October meeting--can be very hard to predict. There are a lot of interactions between the financial markets and the real economy that are potentially destabilizing, and so we are going to have to be proactive in trying to stabilize the situation, recognizing that we have a confluence of circumstances that is extraordinarily difficult and that no policy approach will deliver the optimal outcome in the short term. We're just going to have to try to choose a path that will give us the best that we can get, given the circumstances that we're facing. All right. Any further comments or questions? We will reconvene tomorrow at nine o'clock. There is a reception and dinner, optional, available in the Martin Building. Thank you. [Meeting recessed] January 30, 2008--Morning Session " FinancialCrisisReport--19 Over the last ten years, some U.S. financial institutions have not only grown larger and more complex, but have also engaged in higher risk activities. The last decade has witnessed an explosion of so-called “innovative” financial products with embedded risks that are difficult to analyze and predict, including collateralized debt obligations, credit default swaps, exchange traded funds, commodity and swap indices, and more. Financial engineering produced these financial instruments which typically had little or no performance record to use for risk management purposes. Some U.S. financial institutions became major participants in the development of these financial products, designing, selling, and trading them in U.S. and global markets. In addition, most major U.S. financial institutions began devoting increasing resources to so-called “proprietary trading,” in which the firm’s personnel used the firm’s capital to gain investment returns for the firm itself rather than for its clients. Traditionally, U.S. banks, broker- dealers, and investment banks had offered investment advice and services to their clients, and did well when their clients did well. Over the last ten years, however, some firms began referring to their clients, not as customers, but as counterparties. In addition, some firms at times developed and used financial products in transactions in which the firm did well only when its clients, or counterparties, lost money. Some U.S. banks also sponsored affiliated hedge funds, provided them with billions of dollars in client and bank funds, and allowed the hedge funds to make high risk investments on the bank’s behalf, seeking greater returns. By 2005, as U.S. financial institutions reached unprecedented size and made increasing use of complex, high risk financial products, government oversight and regulation was increasingly incoherent and misguided. B. High Risk Mortgage Lending The U.S. mortgage market reflected many of the trends affecting the U.S. financial system as a whole. Prior to the early 1970s, families wishing to buy a home typically went to a local bank or mortgage company, applied for a loan and, after providing detailed financial information and a down payment, qualified for a 30-year fixed rate mortgage. The local bank or mortgage company then typically kept that mortgage until the homeowner paid it off, earning its profit from the interest rates and fees paid by the borrower. Lenders were required to keep a certain amount of capital for each loan they issued, which effectively limited the number of loans one bank could have on its books. To increase their capital, some lenders began selling the loans on their books to other financial institutions that wanted to service the loans over time, and then used the profits to make new loans to prospective borrowers. Lenders began to make money, not from holding onto the loans they originated and collecting mortgage payments over the years, but from the relatively short term fees associated with originating and selling the loans. (8/28/2009). Those banks plus Citigroup also issued one out of every two mortgages and two out of every three credit cards. Id. FOMC20070918meeting--112 110,CHAIRMAN BERNANKE., Thank you. Let’s put President Poole between us and the coffee break. President Poole. [Laughter] Sorry. FOMC20080916meeting--149 147,MS. CUMMING.," Thank you, Mr. Chairman. In our forecast, we do show a downgrade in real activity in the near term since the August meeting. Downside risks to the economy we see as still very considerable, and I would probably say that they really have increased quite a bit. I'll say a few more words about that. I'll also talk about the inflation front. We have long thought that inflation in the medium term will moderate, and we've been taking some comfort from recent developments that have been cited already. On the weaker economic outlook, we see the intensification of adverse growth coming from many things mentioned already: the unemployment rate increase and the likelihood that consumer spending is going to be negative. I would put great stress also on indications that world demand is slowing abruptly, as Nathan mentioned. I think that all three of these things are occurring in an environment in which we have massive correction, adjustment, structural change in autos, housing, and financial intermediation. That adjustment is really interconnected--one has effects on the others. As part of this--particularly in the financial sector, I would say--in our senior loan officer survey we've seen indications that, even as rates in, say, the mortgage markets start to ease a bit, nonprice terms may still be tightening. President Pianalto talked about other areas in which borrowers are facing much tougher terms. As financial institutions feel their capital is constrained--and there's plenty of evidence that balance sheets are constrained across much of the financial sector--those kinds of nonprice rationing measures probably will become more evident. Second, as we discussed earlier, we've seen that credit losses, which thus far have been largely confined to the financial sector and increasingly their shareholders, run some risk of spilling over to other kinds of investors, who to date really have not felt that impact, such as money market fund investors, as mentioned earlier. In addition, the three big corrections that we have seen in autos, housing, and financial intermediation are not limited to the United States. In particular, as you know, several G-10 countries are facing very difficult situations in their housing markets, not much different from us; and the financial intermediation adjustment is truly a global correction. On the inflation side, as I mentioned, we have acknowledged that we've seen elevated rates of inflation. But the recent developments--as we've seen in inflation expectations discussed earlier, in energy and other commodity prices, the unit labor cost developments that President Yellen discussed, and the year-over-year changes in import prices--are all pointing in the direction of some moderation of inflation and moderation of inflation expectations. In particular, we have looked at inflation expectations as measured by financial markets and feel that the decline that we see in those expectations cannot be explained simply by the drop in energy prices and technical factors but look larger than that. We would attribute that to indications, again, that global demand is slowing. Coming into this meeting today, we favor alternative B. I would associate myself with the comments of President Stern and President Evans, that if we were, in fact, going to make a move today, it would be better to make a large move of 50 basis points. Thank you, Mr. Chairman. " CHRG-111shrg49488--16 Mr. Clark," Thank you, Mr. Chairman and Ranking Member Collins, for inviting me, and thank you to the other Members. I am obviously not here as a regulatory expert, but we have a wonderful panel.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Clark appears in the Appendix on page 326.--------------------------------------------------------------------------- I am going to speak much more as a CEO who operates under the regulatory regimes. We are a little unusual in the sense that we operate on both sides of the border in Canada and the United States. We have over 1,000 branches in the United States from Maine to Florida, and we are a bank in the United States that is continuing to lend, and lend aggressively. So we have double-digit lending growth, and we are one of the few AAA-rated banks left in the world. We exited the structured products area in 2005, the source of most of the problems. I thought I would comment on a couple of things, and one was the actual management of the crisis from the beginning of August 2007 until now, and I think what certainly distinguished the Canadian system, which may not be duplicable in larger countries, is that the six banks plus the Bank of Canada, the Office of the Superintendent of Financial Institutions (OSFI), and the Department of Finance essentially worked almost continuously together and have a shared objective. There was a very strong feeling among us that if any one of our banks ran into trouble, we would all run into trouble. So there was no attempt by one bank to, in a sense, game the system, and there was also fairly quickly a view that we should try to have a private sector solution to this problem, not a public sector solution; and to the extent we involved the public sector, it should be a profitable involvement on behalf of the taxpayers, not a subsidy, and we were able to successfully do that. In terms of the structure of the industry, I think it is well known that there are some important differences. All the major dealers are owned by the Canadian banks, and we did, in fact, absorb $18 billion (CAD) of write-offs by these dealers. TD Bank did not have any significant write-offs, but $18 billion (CAD) is a significant amount in the size of Canada, but they were able to absorb that because they were tied to large entities with very stable retail earnings. Second, the mortgage market is completely different in Canada. It is concentrated in the top banks, and we originate mortgages to hold them. And so we have resisted attempts--frankly, political attempts--to have us loosen standards because we are going to bear the risks of those loosened standards. So you did not get the development in Canada of what you did in the United States. Third, in terms of the capital requirements, our capital requirements have always been above world standards, with a particular emphasis on common equity. But it has also been reinforced by the insistence of our regulation that we have our own self-assessment of how much capital we need, and that in all cases, it caused Canadian banks to hold more than regulatory minimums, not at regulatory minimums. I think the other difference would be that our regime's binding constraint is risk-weighted assets, and that is a key feature why we hold our mortgages rather than sell them. Where you have total asset tests, you, in fact, encourage banks to sell low-risk assets, and where we have a total asset test is not the binding constraint. In terms of the nature of the regulatory regime, it is a principles regime, not a rule-based regime--it is rather light in terms of the actual number of people employed in the regulatory regime. There is a high focus on ensuring that management and the board know and understand the risks that the institution is taking and that, in fact, they are building the infrastructure to monitor and manage that risk. The way I put it internally in my organization is I am actually on the side of the regulator, not on the side of the bank. We have the same interest in ensuring that the bank does not run into trouble, and do you have less of this conflict situation because I see the regulator as helping me manage the bank. I think another important element that Canada moved to in terms of compensation some time ago was to have low cash bonuses. So in my case, 70 percent of my pay would be in the form of equity which I hold. I am required to hold my economic interests in the bank for 2 years after I retire, so I cannot cut and run. And all my executives, whether in the wholesale side of the bank or the retail side of the bank, are paid on the whole bank's performance, including its ability to deliver great customer satisfaction. We also have separation of the chairman from the CEO, and all board and committee meetings have meetings without management present to ensure that independence. Clearly, the issue, I think, you are addressing is the issue of systemic risk, and I think it is the toughest issue to deal with here. I think I would have to be in the camp to say all the systemic risk issues were well known and well talked about. It is not as if there was this mystery out there that the U.S. mortgage system was, in fact, going way up the risk curve and doing what most bankers would have regarded as crazy lending. It is not as if there was not meeting after meeting among bankers around the world about the risks that are inherent in structured products. And I would say the under-saving feature of the U.S. economy was a well-known fact. And so I think you do have to sit back and say, well, if these risks were well known, why were there no, in a sense, forces against that? I can comment on our own experience. As I indicated, we did actually exit these products. We exited them because they were hard to understand. They embedded tail risk and added a lot of complexity to the organization. We also refused to, in fact, distribute the asset-backed paper program that blew up in Canada on the basis that if I would not sell it to my mother-in-law, I should not sell it to my clients. But the real issue is that in doing that, that was a very unpopular thing to do. It was unpopular within my bank. It was unpopular among my investors. It is very hard to run against these tides, and so I think when you are talking about systemic risk, you have to recognize that there is this odd confluence of political, economic, and profit force actually always propelling it. It is like a lot of the literature, what creates boom. You have the same thing behind any forces of systemic risk. So what is my conclusion as a practicer in the field? Well, I do not think there is one answer because, as I have said, banks have failed under most regulatory regimes. But I do think a strong regulator is important, and you certainly should not allow regulatory shopping. I think that is obviously a very bad thing. And while rules are important, I actually think principles do matter. It was clear throughout the industry that people were in the process of using regulatory capital arbitrage, and if you sat there from a principle point of view, I think you might have stopped it. Leadership matters enormously. I think boards should be held accountable to ensure that they actually have a CEO with the right value system. His job is to preserve the institution. And I think it is clear to say while all regulatory regimes may have known about systemic risk, they did not focus on systemic risk. And I think we are lacking mechanisms where, if you did come upon a view that existed, how would you, in fact, coordinate action to bring it to an end? I do think going forward, though, there is also a risk that we could overreact, and one of the things I would plead is that many elements of the regulatory reforms could drive institutions to take more risk rather than less risk. And I think you have to be careful in your rules to make sure that low-risk strategies, such as the TD Bank one, are not, in fact, negatively impacted by some of the rule changes. Thank you very much. " FOMC20050202meeting--131 129,MS. YELLEN.," Thank you, Mr. Chairman. The Twelfth District economy continues to expand, posting growth in line with that of the nation. Consumer spending remains strong, led by gains in travel, services, retail goods, and especially housing. Businesses have also been spending, February 1-2, 2005 86 of 177 The weaker dollar continues to benefit District exporters who report booming demand for their products. Although international trade volumes remain high, increased hiring and around-the­ clock work schedules have cleared out the backlog of ships at our ports. Some bottlenecks remain in the ground transportation networks as a result of storms, mudslides, and infrastructure problems but these, too, are waning. Turning to the national economy, recent economic data have been encouraging, raising my confidence that the expansion has found a secure footing. The December employment report was by no means spectacular, but it strengthened the impression that the labor market has firmly established a pattern of moderate improvement. In terms of the outlook for the real economy, I’m generally in agreement with the Greenbook. But I think it’s important to emphasize that this forecast, which calls for growth only moderately above potential with a very gradual diminution of the remaining labor market slack, depends on a very gradual pace of monetary tightening. The Greenbook incorporates only three more 25 basis point increases in the funds rate this year. Moreover, even with this modest tightening, I consider the Greenbook optimistic in expecting longer-term interest rates to remain at their present levels. In my judgment, the risk with respect to longer-term yields is asymmetric. Should longer-term yields increase, growth could fall well short of the Greenbook projection, as shown in an alternative simulation. Turning to inflation, the data received since our December meeting, particularly the CPI and the ECI, have been favorable. The forecast for a rise of about 1½ percent in the core PCE price index in 2005 strikes me as very reasonable. We’re all aware of the sources of risk in this outlook, including the future paths of the dollar and oil prices, the currently high markup of prices over unit labor costs, trend productivity growth, and, of course, the degree of slack left in the economy. In December I argued that the risks to inflation from productivity developments were reasonably well balanced. I hold roughly the same view on the risks emanating from labor market February 1-2, 2005 87 of 177 A considerable body of research—most conducted within the Federal Reserve System—has examined the possibility that the last recession and recovery were characterized by unusually large structural shifts, resulting in an exceptional degree of mismatch in the labor market. If an unusually small fraction of the currently unemployed are qualified for existing or emerging job vacancies, the true degree of slack in the labor market is overstated by measured unemployment. In effect, the NAIRU has risen. This possibility motivates one of the alternative simulations in the Greenbook. At the AEA [American Economic Association] meetings in Philadelphia last month, I chaired a session in which four teams of Fed economists subjected this structural-shifts hypothesis to close scrutiny. I emerged from this session a skeptic. I see this recent research as casting considerable doubt on the hypothesis that the jobless recovery was a period of pronounced economic restructuring. In fact, the consensus of the session was that sectoral reallocation has probably been running at roughly normal levels for our dynamic economy. The finding of unusually large sectoral shifts is based on the behavior of several nontraditional measures of restructuring. In contrast, such traditional measures as the dispersion in industry employment growth rates revealed the last recession and jobless recovery that followed to be a period of low, not high, sectoral reallocation. The problem with traditional measures is that they may confound cyclical with sectoral changes. The alternative restructuring measures, however, turn out not to be robust to minor changes in the time period studied and the methodology used. One sign that mismatch is not unusually high, at least during the recovery period, comes from data on job creation and job destruction. In 2003, for example, total job reallocation—defined as the sum of job creation and destruction—stood at its lowest level in the last decade for which data are available. Another sign that mismatch is not especially high comes from the Beveridge curve relating unemployment and job vacancies. A shifting out of the Beveridge curve, signaling higher levels of vacancies coexisting with any given level of unemployment, would provide evidence of increased mismatch. Using a new measure of job vacancies that adjusts for well-known biases in February 1-2, 2005 88 of 177 If skill mismatch had intensified, we might also expect to see diverging unemployment rates and compensation paths for workers of different skills. However, analysis by our staff shows that since the onset of the recession, the unemployment paths of less- and more-educated workers have been similar, and the change in compensation growth for lower-skilled occupations has been at least as rapid as for occupations requiring higher skills. These findings align with reports from our contacts who tell us that for the most part they’re able to hire workers at all skill levels. Even in markets where workers are harder to find, our contacts report little difference in hiring difficulty or compensation growth by skill. With respect to the introduction of labor-saving technologies, our sense is that such innovations are affecting the entire skill distribution. For example, reports from two of our contacts, a lawyer and a farmer, illustrate this point. We were told that the law firm had replaced skilled legal workers with software designed to search for criminal evidence in e-mail files. The farm introduced machinery that reduced the number of field workers needed to harvest row crops from 400 to 40. So, my bottom line is that I do not think the evidence supports the case that NAIRU has increased due to an unusual degree of mismatch in the job market. Turning finally to policy, I think it makes sense to remove a bit more accommodation at this meeting, but I do think we’re reaching a point where relatively soon we will need to begin to slow this process down." CHRG-111shrg54589--124 PREPARED STATEMENT OF GARY GENSLER Chairman, Commodity Futures Trading Commission June 22, 2009 Good morning Chairman Reed, Ranking Member Bunning, and Members of the Committee. I am here today testifying on behalf of the Commission. The topic of today's hearing, how to best modernize oversight of the over-the-counter derivatives markets, is of utmost importance during this crucial time for our economy. As President Obama laid out last week, we must urgently enact broad reforms in our financial regulatory structure in order to rebuild and restore confidence in our overall financial system. Such reforms must comprehensively regulate both derivative dealers and the markets in which derivatives trade. I look forward to working with the Congress to ensure that the OTC derivatives markets are transparent and free from fraud, manipulation and other abuses. This effort will require close coordination between the SEC and the CFTC to ensure the most appropriate regulation. I'm fortunate to have as a partner in this effort, SEC Chair Mary Schapiro. She brings invaluable expertise in both the security and commodity futures area, which gives me great confidence that we will be able to provide the Congress with a sound recommendation for comprehensive oversight of the OTC derivatives market. We also will work collaboratively on recommendations on how to best harmonize regulatory efforts between agencies as requested by President Obama.Comprehensive Regulatory Framework A comprehensive regulatory framework governing OTC derivative dealers and OTC derivative markets should apply to all dealers and all derivatives, no matter what type of derivative is traded or marketed. It should include interest rate swaps, currency swaps, commodity swaps, credit default swaps, and equity swaps. Further, it should apply to the dealers and derivatives no matter what type of swaps or other derivatives may be invented in the future. This framework should apply regardless of whether the derivatives are standardized or customized. A new regulatory framework for OTC derivatives markets should be designed to achieve four key objectives: Lower systemic risks; Promote the transparency and efficiency of markets; Promote market integrity by preventing fraud, manipulation, and other market abuses, and by setting position limits; and Protect the public from improper marketing practices. To best achieve these objectives, two complementary regulatory regimes must be implemented: one focused on the dealers that make the markets in derivatives and one focused on the markets themselves--including regulated exchanges, electronic trading systems and clearinghouses. Only with these two complementary regimes will we ensure that Federal regulators have full authority to bring transparency to the OTC derivatives world and to prevent fraud, manipulation, and other types of market abuses. These two regimes should apply no matter which type of firm, method of trading or type of derivative or swap is involved.Regulating Derivatives Dealers I believe that institutions that deal in derivatives must be explicitly regulated. In addition, regulations should cover any other firms whose activities in these markets can create large exposures to counterparties. The current financial crisis has taught us that the derivatives trading activities of a single firm can threaten the entire financial system and that all such firms should be subject to robust Federal regulation. The AIG subsidiary that dealt in derivatives--AIG Financial Products--for example, was not subject to any effective regulation. The derivatives dealers affiliated with Lehman Brothers, Bear Stearns, and other investment banks were not subject to mandatory regulation either. By fully regulating the institutions that trade or hold themselves out to the public as derivative dealers we can oversee and regulate the entire derivatives market. I believe that the our laws should be amended to provide for the registration and regulation of all derivative dealers. The full, mandatory regulation of all derivatives dealers would represent a dramatic change from the current system in which some dealers can operate with limited or no effective oversight. Specifically, all derivative dealers should be subject to capital requirements, initial margining requirements, business conduct rules and reporting and record keeping requirements. Standards that already apply to some dealers, such as banking entities, should be strengthened and made consistent, regardless of the legal entity where the trading takes place. Capital and Margin Requirements. The Congress should explicitly require regulators to promulgate capital requirements for all derivatives dealers. Imposing prudent and conservative capital requirements, and initial margin requirements, on all transactions by these dealers will help prevent the types of systemic risks that AIG created. No longer would derivatives dealers or counterparties be able to amass large or highly leveraged risks outside the oversight and prudential safeguards of regulators. Business Conduct and Transparency Requirements. Business conduct standards should include measures to both protect the integrity of the market and lower the risk (both counterparty and operating) from OTC derivatives transactions. To promote market integrity, the business conduct standards should include prohibitions on fraud, manipulation and other abusive practices. For OTC derivatives that come under CFTC jurisdiction, these standards should require adherence to position limits when they perform or affect a significant price discovery function with respect to regulated markets. Business conduct standards should ensure the timely and accurate confirmation, processing, netting, documentation, and valuation of all transactions. These standards for ``back office'' functions will help reduce risks by ensuring derivative dealers, their trading counterparties and regulators have complete, accurate and current knowledge of their outstanding risks. Derivatives dealers also should be subject to record keeping and reporting requirements for all of their OTC derivatives positions and transactions. These requirements should include retaining a complete audit trail and mandated reporting of any trades that are not centrally cleared to a regulated trade repository. Trade repositories complement central clearing by providing a location where trades that are not centrally cleared can be recorded in a manner that allows the positions, transactions, and risks associated with those trades to be reported to regulators. To provide transparency of the entire OTC derivatives market, this information should be available to all relevant Federal financial regulators. Additionally, there should be clear authority for regulating and setting standards for trade repositories and clearinghouses to ensure that the information recorded meets regulatory needs and that the repositories have strong business conduct practices. The application of these business conduct standards and the transparency requirements will enable regulators to have timely and accurate knowledge of the risks and positions created by the dealers. It will provide authorities with the information and evidentiary record needed to take any appropriate action to address such risks and to protect and police market integrity. In this regard, the CFTC and SEC should have clear, unimpeded oversight and enforcement authority to prevent and punish fraud, manipulation and other market abuses. Market transparency should be further enhanced by requiring that aggregated information on positions and trades be made available to the public. No longer should the public be in the dark about the extensive positions and trading in these markets. This public information will improve the price discovery process and market efficiency.Regulating Derivatives Markets In addition to the significant benefits to be gained from broad regulation of derivatives dealers, I believe that additional safety and transparency must be afforded by regulating the derivative market functions as well. All derivatives that can be moved into central clearing should be required to be cleared through regulated central clearinghouses and brought onto regulated exchanges or regulated transparent electronic trading systems. Requiring clearing and trading on exchanges or through regulated electronic trading systems will promote transparency and market integrity and lower systemic risks. To fully achieve these objectives, both of these complementary regimes must be enacted. Regulating both the traders and the trades will ensure that both the actors and the actions that may create significant risks are covered. Exchange-trading and central clearing are the two key and related components of well-functioning markets. Ever since President Roosevelt called for the regulation of the commodities and securities markets in the early 1930s, the CFTC (and its predecessor) and the SEC have each regulated the clearing functions for the exchanges under their respective jurisdiction. The practice of having the agency which regulates an exchange or trade execution facility also regulate the clearinghouses for that market has worked well and should continue as we extend regulations to cover the OTC derivatives market. Central Clearing. Central clearing should help reduce systemic risks in addition to the benefits derived from comprehensive regulation of derivatives dealers. Clearing reduces risks by facilitating the netting of transactions and by mutualizing credit risks. Currently, most of the contracts entered into in the OTC derivatives market are not cleared, and remain as bilateral contracts between individual buyers and sellers. In contrast, when a contract between a buyer and seller is submitted to a clearinghouse for clearing, the contract is ``novated'' to the clearinghouse. This means that the clearinghouse is substituted as the counterparty to the contract and then stands between the buyer and the seller. Clearinghouses then guarantee the performance of each trade that is submitted for clearing. Clearinghouses use a variety of risk management practices to assure the fulfillment of this guarantee function. Foremost, derivatives clearinghouses would lower risk through the daily discipline of marking to market the value of each transaction. They also require the daily posting of margin to cover the daily changes in the value of positions and collect initial margin as extra protection against potential market changes that are not covered by the daily mark-to-market. The regulations applicable to clearing should require that clearinghouses establish and maintain robust margin standards and other necessary risk controls and measures. It is important that we incorporate the lessons from the current crisis as well as the best practices reflected in international standards. Working with Congress, we should consider possible amendments to the CEA to expand and deepen the core principles that registered derivatives clearing organizations must meet to achieve these goals to both strengthen these systems and to reduce the possibility of regulatory arbitrage. Clearinghouses should have transparent governance arrangements that incorporate a broad range of viewpoints from members and other market participants. Central counterparties should also be required to have fair and open access criteria that allow any firm that meets objective, prudent standards to participate regardless of whether it is a dealer or a trading firm. Additionally, central clearinghouses should implement rules that allow indirect participation in central clearing. By novating contracts to a central clearinghouse coupled with effective risk management practices, the failure of a single trader, like AIG, would no longer jeopardize all of the counterparties to its trades. One of the lessons that emerged from this recent crisis was that institutions were not just ``too big to fail,'' but rather too interconnected as well. By mandating the use of central clearinghouses, institutions would become much less interconnected, mitigating risk and increasing transparency. Throughout this entire financial crisis, trades that were carried out through regulated exchanges and clearinghouses continued to be cleared and settled. In implementing these responsibilities, it will be appropriate to consider possible additional oversight requirements that may be imposed by any systemic risk regulator that Congress may establish. Under the Administration's approach, the systemic regulator, would be charged with ensuring consistent and robust standards for all systemically important clearing, settlement and payment systems. For clearinghouses overseen comprehensively by the CFTC and SEC, the CFTC or SEC would remain the primary regulatory, but the systemic regulator would be able to request information from the primary regulator, participate in examinations led by the primary regulator, make recommendations on strengthening standards to the primary regulator and ultimately, after consulting with the primary regulator and the new Financial Services Oversight Council, use emergency authority to compel a clearinghouse to take actions to address financial risks. Exchange-Trading. Beyond the significant transparency afforded the regulators and the public through the record keeping and reporting requirements of derivatives dealers, market transparency and efficiency would be further improved by moving the standardized part of the OTC markets onto regulated exchanges and regulated transparent electronic trading systems. I believe that this should be required of all standardized contracts. Furthermore, a system for the timely reporting of trades and prompt dissemination of prices and other trade information to the public should be required. Both regulated exchanges and regulated transparent trading systems should allow market participants to see all of the bids and offers. A complete audit trail of all transactions on the exchanges or trade execution systems should be available to the regulators. Through a trade reporting system there should be timely public posting of the price, volume and key terms of completed transactions. The Trade Reporting and Compliance Engine (TRACE) system currently required for timely reporting in the OTC corporate bond market may provide a model. The CFTC and SEC also should have authority to impose record keeping and reporting requirements and to police the operations of all exchanges and electronic trading systems to prevent fraud, manipulation and other abuses. In contrast to long established on-exchange futures and securities markets, there is a need to encourage the further development of exchanges and electronic trading systems for OTC derivatives. In order to promote this goal and achieve market efficiency through competition, there should be sufficient product standardization so OTC derivative trades and open positions are fungible and can be transferred between one exchange or electronic trading system to another. Position Limits. Position limits must be applied consistently across all markets, across all trading platforms, and exemptions to them must be limited and well defined. The CFTC should have the ability to impose position limits, including aggregate limits, on all persons trading OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets that the CFTC oversees. Such position limit authority should clearly empower the CFTC to establish aggregate position limits across markets in order to ensure that traders are not able to avoid position limits in a market by moving to a related exchange or market, including international markets.Standardized and Customized Derivatives It is important that tailored or customized swaps that are not able to be cleared or traded on an exchange be sufficiently regulated. Regulations should also ensure that customized derivatives are not used solely as a means to avoid the clearing and exchange requirements. This could be accomplished in two ways. First, regulators should be given full authority to prevent fraud, manipulation and other abuses and to impose record keeping and transparency requirements with respect to the trading of all swaps, including customized swaps. Second, we must ensure that dealers and traders cannot change just a few minor terms of a standardized swap to avoid clearing and the added transparency of exchanges and electronic trading systems. One way to ensure this would be to establish objective criteria for regulators to determine whether, in fact, a swap is standardized. For example, there should be a presumption that if an instrument is accepted for clearing by a fully regulated clearinghouse, then it should be required to be cleared. Additional potential criteria for consideration in determining whether a contract should be considered to be a standardized swap contract could include: The volume of transactions in the contract; The similarity of the terms in the contract to terms in standardized contracts; Whether any differences in terms from a standardized contract are of economic significance; and The extent to which any of the terms in the contract, including price, are disseminated to third parties.Criteria such as these could be helpful in ensuring that parties are not able to avoid the requirements applicable to standardized contracts by tweaking the terms of such contracts and then labeling them ``customized.'' Regardless of whether an instrument is standardized or customized, or traded on an exchange or on a transparent electronic trade execution system, regulators should have clear, unimpeded authority to impose record keeping and reporting requirements, impose margin requirements, and prevent and punish fraud, manipulation and other market abuses. No matter how the instrument is traded, the CFTC and SEC as appropriate also should have clear, unimpeded authority to impose position limits, including aggregate limits, to prevent excessive speculation. A full audit trail should be available to the CFTC, SEC and other Federal regulators.Authority To achieve these goals, the Commodity Exchange Act and security laws should be amended to provide the CFTC and SEC with clear authority to regulate OTC derivatives. The term ``OTC derivative'' should be defined, and clear authority should be given over all such instruments regardless of the regulatory agency. To the extent that specific types of OTC derivatives might overlap agencies' existing jurisdiction, care must be taken to avoid unnecessary duplication. As we enact new laws and regulations, we should be careful not to call into question the enforceability of existing OTC derivatives contracts. New legislation and regulations should not provide excuses for traders to avoid performance under preexisting, valid agreements or to nullify preexisting contractual obligations.Achieving the Four Key Objectives Overall, I believe the complimentary regimes of dealer and market regulation would best achieve the four objectives outlined earlier. As a summary, let me review how this would accomplish the measures applied to both the derivative dealers and the derivative markets. Lower Systemic Risk. This dual regime would lower systemic risk through the following four measures: Setting capital requirements for derivative dealers; Creating initial margin requirements for derivative dealers (whether dealing in standardized or customized swaps); Requiring centralized clearing of standardized swaps; and Requiring business conduct standards for dealers. Promote Market Transparency and Efficiency. This complementary regime would promote market transparency and efficiency by: Requiring that all OTC transactions, both standardized and customized, be reported to a regulated trade repository or central clearinghouses; Requiring clearinghouses and trade repositories to make aggregate data on open positions and trading volumes available to the public; Requiring clearinghouses and trade repositories to make data on any individual counterparty's trades and positions available on a confidential basis to regulators; Requiring centralized clearing of standardized swaps; Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems; and Requiring the timely reporting of trades and prompt dissemination of prices and other trade information; Promote Market Integrity. It would promote market integrity by: Providing regulators with clear, unimpeded authority to impose reporting requirements and to prevent fraud, manipulation and other types of market abuses; Providing regulators with authority to set position limits, including aggregate position limits; Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems; and Requiring business conduct standards for dealers. Protect Against Improper Marketing Practices. It would ensure protection of the public from improper marketing practices by: Business conduct standards applied to derivatives dealers regardless of the type of instrument involved; and Amending the limitations on participating in the OTC derivatives market in current law to tighten them or to impose additional disclosure requirements, or standards of care (e.g., suitability or know your customer requirements) with respect to marketing of derivatives to institutions that infrequently trade in derivatives, such as small municipalities.Conclusion The need for reform of our financial system today has many similarities to the situation facing the country in the 1930s. In 1934, President Roosevelt boldly proposed to the Congress ``the enactment of legislation providing for the regulation by the Federal Government of the operation of exchanges dealing in securities and commodities for the protection of investors, for the safeguarding of values, and so far as it may be possible, for the elimination of unnecessary, unwise, and destructive speculation.'' The Congress swiftly responded to the clear need for reform by enacting the Securities Exchange Act of 1934. Two years later it passed the Commodity Exchange Act of 1936. It is clear that we need the same type of comprehensive regulatory reform today. Today's regulatory reform package should cover all types of OTC derivatives dealers and markets. It should provide regulators with full authority regarding OTC derivatives to lower risk; promote transparency, efficiency, and market integrity and to protect the American public. Today's complex financial markets are global and irreversibly interlinked. We must work with our partners in regulating markets around the world to promote consistent rigor in enforcing standards that we demand of our markets to prevent regulatory arbitrage. These policies are consistent with what I laid out to this Committee in February and the Administration's objectives. I look forward to working with this Committee, and others in Congress, to accomplish these goals. Mr. Chairman, thank you for the opportunity to appear before the Committee today. I look forward to answering any of your questions. ______ CHRG-111hhrg53245--21 Mr. Zandi," Thank you, Mr. Chairman, and members of the committee for the opportunity to be here today. I am an employee of the Moody's Corporation, but my remarks today reflect only my own personal views. I will make five points in my remarks. Point number one: I think the Administration's proposed financial regulatory reforms are much needed and reasonably well designed. The panic that was washing over the financial system earlier this year has subsided, but the system remains in significant disrepair. Our credit remains severely impaired. By my own estimate, credit, household, and non-financial corporate debt outstanding fell in the second quarter. That would be the first time in the data that we have all the way back to World War II, and highlights the severity of the situation. I think regulatory reform is vital to reestablishing confidence in the financial system, and thus reviving it, and thus by extension reviving the economy. The Administration's regulatory reform fills in most of the holes in the current system, and while it would not have forestalled the current crisis, it certainly would have made it much less severe. And most importantly, I think it will reduce the risks and severity of future financial crises. Point number two: A key aspect of the reform is establishing the Federal Reserve as a systemic risk regulator. I think that's a good idea. I think they're well suited for the task. They're in the most central position in the financial system. They have a lot of financial and importantly intellectual resources, and they have what's very key--a history of political independence. They can also address the age-old problem of the procyclicality of regulation; that is, regulators allow very aggressive lending in the good times, allowing the good times to get even better, and tighten up in the bad times, when credit conditions are tough. I also think as a systemic risk regulator, the Fed will have an opportunity to address asset bubbles. I think that's very important for them to do. There's a good reason for them to be reluctant to do so, but better ones for them to weigh against bubbles. They, as a systemic risk regulator, will have the ability to influence the amount of leverage and risk-taking in the financial system, and those are key ingredients into the making of any bubble. Point number three: I think establishing a consumer financial protection agency is a very good idea. It's clear from the current crisis that households really had very little idea of what their financial obligations were when they took on many of these products, a number of very good studies done by the Federal Reserve showing a complete lack of understanding. And even I, looking through some of these products, option ARMs, couldn't get through the spreadsheet. These are very, very difficult products. And I think it's very important that consumers be protected from this. There is certainly going to be a lot of opposition to this. The financial services industry will claim that this will stifle innovation and lead to higher costs. And it's true this agency probably won't get it right all the time, but I think it is important that they do get involved and make sure that households get what they pay for. The Federal Reserve also seems to be a bit reluctant to give up some of its policy sway in this area. I'm a little bit confused by that. You know, I think they showed a lack of interest in this area in the boom and bubble. They have a lot of things on their plate. They'll have even more things on their plate if this reform goes through. As a systemic risk regulator, I think it makes a lot of sense to organize all of these responsibilities in one agency, so that they can focus on it and make sure that it works right. Point number four: The reform proposal does have some serious limitations, in my view. The first limitation is it doesn't rationalize the current alphabet soup of regulators at the Federal and State level. That's a mistake. The one thing it does do is combine the OCC with the OTS. That's a reasonable thing to do, but that's it. And so we now have the same Byzantine structure in place, and there will be regulatory arbitrage, and that ultimately will lead to future problems. I can understand the political problems in trying to combine these agencies, but I think that would be well worth the effort. The second limitation is the reform does not adequately identify the lines of authority among regulators and the mechanisms for resolving difference. The new Financial Services Oversight Council, you know, it doesn't seem to me like it's that much different than these interagency meetings that are in place now, where the regulators get together and decide, you know, how they're going to address certain topics. They can't agree, and it takes time for them to gain consensus. They couldn't gain consensus on stating simply that you can't make a mortgage loan to someone who can't pay you back. That didn't happen until well after the crisis was underway. So I'm not sure that solves the problem. I think the lines of authority need to be ironed out and articulated more clearly. The third limitation is the reform proposal puts the Federal Reserve's political independence at greater risk, given its larger role in the financial system. Ensuring its independence is vital to the appropriate conduct of monetary policy. That's absolutely key; I wouldn't give that up for anything. And the fourth limitation is the crisis has shown an uncomfortably large number of financial institutions are too big to fail. And that is they are failure risks undermining the system, giving policy makers little choice but to intervene. The desire to break up these institutions is understandable, but ultimately it is feudal. There is no going back to the era of Glass-Steagall. Breaking up the banking system's mammoth institutions would be too wrenching and would put U.S. institutions at a distinct competitive disadvantage, vis-a-vis their large global competitors. Large financial institutions are also needed to back-stop and finance the rest of the financial system. It is more efficient and practical for regulators to watch over these large institutions, and by extension, the rest of the system. With the Fed as the systemic risk regulator, more effective oversight of too-big-to-fail institutions is possible. These large institutions should also be required to hold more capital, satisfy stiffer liquidity requirements, have greater disclosure requirements, and to pay deposit and perhaps other insurance premiums, commensurate with the risk they take and the risks that they pose to the entire financial system. Finally, let me just say I think the proposed financial system regulatory reforms are as wide-ranging as anything that has been implemented since the 1930's Great Depression. The reforms are, in my view, generally well balanced, and if largely implemented, will result in a more steadfast, albeit slower-paced, financial system and it will have economic implications. And I think that's important to realize, but I think necessary to take. The Administration's reform proposal does not address a wide range of vital questions, but it is only appropriate that these questions be answered by legislators and regulators after careful deliberation. How these are answered will ultimately determine how well this reform effort will succeed. Thank you. [The prepared statement of Mr. Zandi can be found on page 86 of the appendix.] " FOMC20060131meeting--110 108,VICE CHAIRMAN GEITHNER.," I’d like the record to show that I think you’re pretty terrific, too. [Laughter] And thinking in terms of probabilities, I think the risk that we decide in the future that you’re even better than we think is higher than the alternative. [Laughter] With that, the economy looks pretty good to us, perhaps a bit better than it did at the last meeting. With the near-term monetary policy path that’s now priced into the markets, we think the economy is likely to grow slightly above trend in ’06 and close to trend in ’07. We expect underlying inflation to follow a path close to current levels before slowing to a rate closer to 1.5 percent for the core PCE sometime out there. Relative to the Greenbook, we’re a little softer on growth in ’06 and a little stronger in ’07, but our inflation outlook is similar. The uncertainty around this forecast still seems considerable, perhaps more than the market has priced in. On the positive side, consumer and business confidence still seems pretty high, with employment growth solid and compensation growth likely to pick up. We think that household income growth is likely to be pretty strong. Investment may be strengthening, and it could surprise us with more strength. The tone of the anecdotal to us seems more positive, less cautious than it has been. And just to cite our Empire survey, the six-month-ahead numbers show a fair amount of optimism. Overall, financial conditions, of course, still seem quite supportive of continued expansion. Global growth has strengthened. And like the staff, the market seems to have looked through the negative surprises in the fourth-quarter numbers and priced in a bit more, rather than less, confidence about the strength of demand growth going forward. On the darker side, we have the familiar concerns about potential adverse shocks, energy supply disruptions, terrorism, et cetera. But even in the absence of these events, we face a fair amount of uncertainty about key elements of the forecast. The prevailing expectation of a gradual moderation in housing prices and a relatively small increase in the saving rate could prove too optimistic. Private investment growth could slow further, productivity growth could disappoint, risk premiums could rise sharply. And, of course, that could happen even in the absence of a major deterioration in the growth or inflation outlook. But this, on balance, still leaves us with what looks like a relatively balanced set of risks around what is still a quite favorable growth forecast. The inflation outlook still merits some concern—I think modest concern—about upside risk. Underlying inflation is still somewhat higher than we would be comfortable with over time. The core indexes are running above levels said to define our preference over time. Other measures of underlying inflation are running above the core rates. The behavior of inflation expectations at longer horizons has been reassuringly stable in the face of the elevated headline numbers, but the levels are still at the higher end of comfort. With the economy near potential, unit labor cost growth should accelerate. And, of course, although profit margins still show ample room to absorb more unit cost increases, their behavior suggests continued pricing power. The strength of global demand, the continued rise in commodity prices, other input costs, and the latest increase in energy prices all suggest a possibility of further upward pressure. With this outlook and this set of risks, we believe some further tightening of monetary policy is necessary with another small move today and a signal that some further tightening is probable. We’re comfortable with how the market’s expectations have evolved over the past few weeks and with the present forecast of perhaps one—maybe slightly more than one—move beyond today. It’s hard, though, to understand why the market attaches so little uncertainty to monetary policy in the second half of the year. And this underscores the fact that one of our communication challenges ahead is to make sure we convey enough uncertainty about our view of the outlook and its implications for monetary policy. In this regard, I want to compliment the recent innovations to the Bluebook presentations and hope that they persist." FOMC20081216meeting--222 220,MS. YELLEN.," Thank you, Mr. Chairman. In my view, cumulative recessionary dynamics are deeply entrenched, with mounting job losses leading to weaker consumer spending, tighter credit, more job losses, and so on; and this nasty set of economic linkages is gaining momentum. Like the Greenbook, I anticipate a long period of decline, and in fact, the consensus forecast is that we're now in the longest and one of the deepest postwar recessions. I hope that a recovery will begin in the middle of next year, but the risks seem skewed to the downside for several reasons. First, compared with the average recession, we face unusually difficult financial conditions. My contacts complain bitterly that even firms with sterling credit ratings have difficulty securing credit. Some banks appear reluctant to lend because financial markets are skeptical about the quality of their assets and their reported net worth. An accounting joke concerning the balance sheets of many financial institutions is now making the rounds, and it summarizes the situation as follows: On the left-hand side, nothing is right; and on the right-hand side, nothing is left. [Laughter] The second factor skewing risk to the downside is the unusually fearful and pessimistic psychology that's developed. One director, who heads a national department chain, predicts carnage in the retail sector after year-end, as stores close after trying to hold on through the holidays. Although some stores have been able to keep sales up to reasonable levels, heavy price discounting will translate into huge losses. Businesses have also generally turned very cautious, hoarding cash and slashing capital spending. A third factor that worries me is that, in contrast to many past recessions, this one is global in nature, and the fact that it's a worldwide slowdown--while lowering commodity prices, which is good--is also going to make it harder for us to pull out. Turning just very briefly to the labor market, the Beveridge curve chart that Stephanie presented during her briefing suggests that we have seen an unusually large increase in the unemployment rate recently in comparison with the decline in job openings, at least in the JOLTS data. I think one interpretation might be that the unemployment rate has risen in part because we have had an unusual rise in labor force participation during this recession. Labor force participation has been higher than would be expected, particularly for three demographic groups: young adults, married women, and older workers nearing retirement. Analysis by my staff estimates that this rise in participation could reflect behavioral responses to unusual credit constraints and wealth declines. Specifically, young adults aged 20 to 24 years appear to be entering the labor force in unusual numbers, and that might reflect diminished access to student loans. Similarly, more married women are entering the labor force, and that's a possible reflection of diminished access to home equity and credit card loans. Finally, an unusually large number of older workers are in the labor market, and that may reflect the negative wealth shock associated with the collapse of housing values and the plummeting stock market. All in all, I expect the anomalous increase in labor force participation to put continued upward pressure on the unemployment rate. With respect to inflation, developments since our October meeting have again lowered the outlook. I'm particularly concerned about the disinflationary effect of actual and prospective economic slack. During the postwar period, core PCE inflation has actually fallen at least � percentage point in every single year in which unemployment has averaged 7� percent or more. Given that in each of the next two years the unemployment rate is predicted to average at least 8 percent, it seems quite likely that by the end of 2010 core inflation will have fallen at least 1� percentage points. That creates a very real risk of deflation. So under these circumstances, I definitely believe that we should do everything in our power to stimulate aggregate demand. " FOMC20060328meeting--265 263,CHAIRMAN BERNANKE.," Thank you. Thank you for this very helpful conversation. It helps inform today’s decision and also helps inform how we will be thinking about policy for the next few meetings. As I discussed, I see the economy as still being basically quite strong, and it needs to moderate to become consistent with its long-run potential. The vehicle by which that is going to happen is the slowing in the housing market. I think we ought to raise the rate today and not to signal an immediate end for several reasons. First, we could think of our policy in terms of the mortgage rate rather than the funds rate. The mortgage rate is currently about the same as it was when we began tightening in June 2004, and it is still providing support to the housing market. If we failed to act today or signaled that we are definitely done, we would create a rally in the long- term bond market and in the mortgage market. We would create, I think, some risk of re-igniting what is currently a cooling market. I think that would be a mistake. Second, I talked, as many of us did, about the small but nevertheless probable risk that inflation will rise slightly in the next few quarters and the potential costs of that to our credibility and to our future policy need to respond to higher inflation. So my recommendation to the Committee is that we raise the federal funds rate target 25 basis points today. We are circulating, and you have received, a draft statement that is very close to option B, which I’ll discuss in just a moment. What I would like to emphasize is that section 4, which says that policy firming may be needed is in fact a flexible statement, and I think it’s entirely possible, depending on the intervening data and the evolution of the economy, that we may choose to signal a halt or even to not move in May. It depends very much on what we see in the housing market, what we see in the economy, and what we see in the inflation data. So I believe this does create significant flexibility. A couple of other comments. First, I realize that there are arguments on both sides about expanding even modestly the language in the rationale. I think this language is not more explicit or lengthier than the language we have seen in some statements that this Committee has issued in the past few years. It has the benefit in this particular case of slightly moderating the hawkish tone of the statement and of acknowledging that we see, for example, the economy to be returning to a sustainable pace. So I think it does serve some purpose, and I think it is worth including. I appreciate President Poole’s suggestion, but I do not think that the minutes and the statement are perfect substitutes. The statement, after all, is much more timely, and it represents something closer to a consensus or a median view of the Committee as opposed to the minutes, which try to express the range of views and discussion around the table. One other suggestion about retaining or taking part 5 from statement A. I see the arguments on both sides. But I think the sense around the table is that the change was not sufficient to justify the innovation to the January statement, and so I think we ought to stay with the January language. If you look at the statement, it is very close to B. We did make a couple of changes suggested by President Yellen, which I think clarify what we are trying to say—in particular, in the middle paragraph: “the prices of energy and other commodities appears to have” (Are the subject and the verb mismatched?)—“the run-up . . . appears to have only a modest effect,” and “productivity gains have helped to hold the growth of unit labor costs in check.” So we are obviously not ruling out other influences that are important. So that is my proposal—that we move 25 basis points today, that we issue the statement you have before you, and that we watch very carefully the data during the intermeeting period. The Bluebook presented a number of options—types of language that would allow us to pause, to pause with an upward bias, to move and pause, various combinations. So I think we do have quite a bit of flexibility when we come back to meet in May. We have already had a policy go-round. So I don’t want to do that all again, but if there is anyone who particularly would like to comment, here’s your chance. Yes, President Moskow." FOMC20070628meeting--167 165,CHAIRMAN BERNANKE., I am not so sure about that. [Laughter] Thank you. President Poole. FOMC20060131meeting--61 59,MR. STRUCKMEYER.," Your next two exhibits detail the supply-side assumptions of the staff forecast, starting with the projection of structural labor productivity. In our analysis, structural labor productivity growth is defined as the increment to labor productivity that can be sustained over time. It is a medium- to long-run concept that attempts to eliminate the bulk of the cyclical influences on productivity growth. As shown on the top right, structural labor productivity growth can, in turn, be decomposed into the contributions from capital deepening, labor quality, and structural multifactor productivity growth. As indicated in the middle left panel, the recovery that has occurred in the level of business capital spending over the past four years translates into a pickup in the growth of capital services, although not to the pace that prevailed during the boom years of 1995 to 2000. The contribution of capital deepening to structural productivity growth—that is, the product of the growth in capital services per hour and the capital share of output—picks up gradually over the next two years. Note in the middle right panel that the bulk of this contribution comes from investments in information technology—as has been the case for all of this decade. In contrast, the pace of growth in structural multifactor productivity—shown in the bottom left—has greatly exceeded the pace over the 1995 to 2000 period. This is just the manifestation at the aggregate level of the driving forces shown in Dave’s scatter plot. However, we have allowed for slightly slower growth in 2006 and 2007 than in the preceding years as the marginal gains from additional organizational improvements and embodied technical change begin to wane. In addition, as noted in the right, we’ve seen some leveling-off in expenditures on research and development lately, which may well manifest itself in a somewhat slower pace of technological change in the years ahead. Your next exhibit presents our estimates of potential output growth. As shown on line 1, we expect potential real GDP to expand at a 3¼ percent pace over the next two years. As you can see on line 2, total potential hours worked—or trend labor input— is expected to slow somewhat. Although population growth is expected to be well maintained, the trends in both labor force participation and the average workweek are offsetting factors. As we’ve noted before, the downtrend in the labor force participation rate (shown in the middle left) mainly reflects the changing demographic composition of the workforce. The estimated trend in the workweek (in the middle right panel) shifted down in 2001—reflecting the introduction of NAICS in the payroll survey—and is expected to fall at about the same pace in 2006 and 2007 as it has since 2001. The implications of these supply-side assumptions for the labor market are shown in the bottom two panels. Although nonfarm payrolls are expected to increase briskly in the near term, we expect gains to slow progressively over the next two years, reflecting the moderation in the pace of economic growth and the slower growth in the potential labor force that I just described. Indeed, we expect trend payroll growth to average only 100,000 per month over the next two years. As shown on the bottom right, the unemployment rate holds fairly steady this year and next. Given the pace of economic growth last year, our model of Okun’s law was surprised by the extent of the decline in the unemployment rate—the gap between the red and black lines. We are expecting this error to be worked off over the course of this year, and in 2007 the unemployment rate moves in sync with the Okun’s law simulation. Your next exhibit presents the outlook for the growth in labor compensation. In the January Greenbook, we projected hourly compensation, as measured by both the ECI and P&C compensation per hour, to accelerate over the next two years. We think that continued strong growth in structural labor productivity will elevate wage demands, while labor market slack will be a relatively neutral influence on compensation growth. Inflation expectations to date have remained anchored, but we have allowed for some pass-through into wages of the higher price inflation in 2004 and 2005. This morning’s reading on the ECI showed that hourly compensation in private industry increased 3 percent in the 12 months ending in December—the same as the judgmental projection in the January Greenbook. However, as you can see in the bottom left, our econometric equation for the ECI has overpredicted the actual growth in compensation since the middle of 2004, possibly suggesting that our estimated NAIRU of 5 percent is too high. In looking at the range of econometric wage and price models that we follow, the evidence on a change in the NAIRU is mixed. We have noted a tendency for some models to overpredict inflation lately. But as shown in the bottom right, the random nature (and the smaller absolute size) of the errors from one of our better reduced-form price equations does not yet suggest the need to lower our estimate of the NAIRU. I will return to the implications of this assumption later in my remarks. Your next exhibit presents the outlook for inflation. Recent readings on headline inflation (shown in the top left) have remained at the high end of the elevated range that has prevailed since 2004. Those readings reflect mainly the direct effects of higher energy prices, which have increased at an average pace of 20 percent per year over the past two years. In contrast, we have seen some moderation in the pace of core consumer price inflation, with the twelve-month change in both the core PCE and the core CPI indexes slowing to about 2 percent. Looking ahead, we have had to cope with somewhat greater pressures on inflation in this Greenbook. These pressures stem mainly from the upward revisions to our projections of crude oil prices and core nonfuel import prices that Dave discussed. As a result of these changes, the moderation in PCE energy prices is somewhat less than in past Greenbooks, and we anticipate greater spillovers on the prices of other industrial materials (shown in the middle right). On net, we expect core PCE prices (line 4 in the bottom left panel) to increase 2¼ percent this year before decelerating to 1¾ percent in 2007 as the influence of these cost shocks recedes. The bottom right panel shows two alternative simulations that address key risks to the inflation outlook. The adverse shocks simulation assumes that the economy is hit with additional increases in the prices of oil, non-oil imports, and industrial materials that match those that prevailed in 2004. Under the assumption that the funds rate remains on its baseline path, core PCE inflation moves up to about 2½ percent in 2006 and 2007 (the red line). In contrast, as I noted earlier, our estimate of the NAIRU may be too high, and a second simulation examines the implications of a 4¼ percent NAIRU—essentially one standard deviation below our current estimate. Under this assumption, core PCE price inflation falls to 1½ percent by the end of next year. Even though these two simulations embody some fairly large differences in assumptions from the Greenbook baseline, both simulations remain well inside a 70 percent confidence interval about our forecast. Nathan will now continue with our presentation." fcic_final_report_full--613 House Financial Services Committee, 111th Cong., 2nd sess., April 20, 2010, p. 1. 30. Valukas, 1:8 n. 30: Examiner’s Interview of Timothy F. Geithner, Nov. 24, 2009, p. 4. 31. Valukas, 4:1486. 32. Sirri, interview. 33. William Brodows and Til Schuermann, Federal Reserve Bank of New York, “Primary Dealer Mon- itoring: Initial Assessment of CSEs,” May 12, 2008, slides 9–10, 15–16. 34. Federal Reserve Bank of New York, “Primary Dealer Monitoring: Liquidity Stress Analysis,” June 25, 2008, p. 3. 35. Ibid., p. 5. 36. Valukas, 4:1489. 37. Ibid., 4:1496, 1497. 38. Christopher Cox, statement before the House Financial Services Committee, 111th Cong., 2nd sess., April 20, 2010, p. 5. 39. Patrick Parkinson, email to Steven Shafran, August 8, 2008. 40. Counterparty Risk Management Policy Group, “Toward Greater Financial Stability: A Private Sec- tor Perspective, The Report of the CRMPG II,” July 27, 2005. 41. Federal Reserve Bank of New York, “Statement Regarding Meeting on Credit Derivatives,” Sep- tember 15, 2005; Federal Reserve Bank of New York, “New York Fed Welcomes New Industry Commit- ments on Credit Derivatives,” March 13, 2006; Federal Reserve Bank of New York, “Third Industry Meeting Hosted by the Federal Reserve Bank of New York,” September 27, 2006. 42. See Comptroller of the Currency, “OCC’s Quarterly Report on Bank Trading and Derivatives Ac- tivities, First Quarter 2009,” Table 1; the figures in the text are reached by subtracting exchange traded fu- tures and options from total derivatives. 43. Chris Mewbourne, interview by FCIC, July 28, 2010. 44. This figure compares with a low in 2005, at the height of the mortgage boom, of $7 billion in prob- lem assets. “Problem” institutions are those with financial, operational, or managerial weaknesses that threaten their continued financial viability; they are rated either a 4 or 5 under the Uniform Financial In- stitutions Rating System. FDIC reporting for insured institutions—i.e., the regulated banking and thrift industry overall. See Quarterly Banking Profile: Fourth Quarter 2007= FDIC Quarterly 2, no. 1 (Decem- ber 31, 2007): 1, 4; Quarterly Banking Profile: First Quarter 2008 = FDIC Quarterly 2, no. 2 (March 31, 2008): 2, 4; Quarterly Banking Profile: Second Quarter 2008 = FDIC Quarterly 2, no. 3 (June 30, 2008): 1. 45. By 2009, the problem list would swell to 702 banks, with assets of $403 billion. Quarterly Banking Profile: Fourth Quarter 2009 = FDIC Quarterly 4, no. 1 (December 31, 2009): 4. 46. Quarterly Banking Profile: First Quarter 2008, p. 4. 47. Roger Cole, interview by FCIC, August 2, 2010. 48. FCIC interview with Michael Solomon and Fred Phillips-Patrick, September 20, 2010. 49. Federal Reserve Bank of New York, letter to Charles Prince, April 9, 2007. 50. Federal Reserve Bank of New York, Federal Reserve Board, Office of the Comptroller of the Cur- rency, Securities and Exchange Commission, U.K. Financial Services Authority, and Japan Financial Services Authority, “Notes on Senior Supervisors’ Meetings with Firms,” November 19, 2007, p. 3. 51. Federal Reserve Board, “FRB New York 2009 Operations Review: Close Out Report,” p. 3. 52. Timothy Geithner, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 1: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 210. 53. Steve Manzari and Dianne Dobbeck, interview by FCIC, April 26, 2010. 54. Federal Reserve Board, “Wachovia Case Study,” November 12 and 13, p. 20; 55. Angus McBryde, interview by FCIC, July 30, 2007. 56. Thompson received a severance package worth about $8.7 million in compensation and acceler- ated vesting of stock. In addition, he negotiated himself three years of office space and a personal assis- tant at Wachovia’s expense. Thompson had previously received more than $21 million in salary and stock compensation in 2007 and more than $23 million in 2006; his total compensation from 2002 through 2008 exceeded $112 million. 57. Federal Reserve Bank of Richmond, letter to Wachovia, July 22, 2008, pp. 3–5. 58. Comptroller of the Currency, letter to Wachovia, August 4, 2008, with Report of Examination; let- ter, pp. 8, 3. 59. Ibid., pp. 3–6. 60. Ibid., letter, p. 2; Report of Examination, p. 18. 61. Ibid., Report of Examination, p. 12. 62. “Home Loans Discussion,” materials prepared for WaMu Board of Directors meeting, April 18, 2006, p. 4; Senate Permanent Subcommittee on Investigations, Wall Street and the Financial Crisis: The Role of High Risk Home Loans, 111th Cong., 2nd sess., April 13, 2010, Exhibits, p. 83. 63. Senate Permanent Subcommittee on Investigations, Wall Street and the Financial Crisis: Role of the FOMC20080625meeting--73 71,MR. LOCKHART.," Thank you, Mr. Chairman. I would like to start with some anecdotal feedback from the region. As you know, we have a lot of Branches, so we have a lot of directors, and we ask our directors a lot of questions. The anecdotal feedback from our 44 directors about the second half can be characterized as subdued. Almost all reported that they expect economic activity to be flat or slower, and I took special note that these expectations deteriorated in June after having actually improved a bit in May. The residential housing situation in the District resembles the national picture. Both sales and new construction are weak. High levels of inventories are being exacerbated by foreclosures, which are adding to downward pressure on prices. However, there are tentative signs of a bottom forming. Our survey of Realtors across the District indicates that the pace of decline of single-family home sales may be abating. Industry contacts tell us that foot traffic and buyer interest are picking up, particularly in Florida, although I would say that what constitutes progress in Florida would not be considered very encouraging elsewhere. Nevertheless, our view is that the beginning of an adjustment process is under way, but the end of the process looks to be a long way off. Some further home-price deterioration is likely to accompany this bottoming process. Credit conditions in the District continue to tighten because of perceived risk and also liquidity pressure on our banks. Our banks indicate that the process of deleveraging continues, which is affecting lending for residential real estate and, to some extent, commercial real estate. We are also hearing from several sources that funding of community banks is becoming an increasing problem because of their previous dependence on wholesale and correspondent bank sources. Higher energy prices are, not surprisingly, affecting our outlook. Hospitality industry contacts, for instance, expressed concern about low summer bookings. Although most tourist destinations have reported solid activity to date, few expect this to continue. The reacceleration of energy and commodity price inflation has businesses focused on cost pressures. Several business contacts indicated that price increases had been relatively easy to pass through and make stick in this environment. I wouldn't say that it's widespread yet, but I do hear some reports that businesses are expecting wage increases to eventually reflect the recent increases in the cost of living. This could be a significant factor, particularly in service price inflation. This and other anecdotal input has colored my outlook for the national economy for the balance of the year and into 2009. I have revised up my forecast for headline inflation in 2008 and 2009 by 50 and 25 basis points, respectively. I am also assuming that the recent inflationary pressures from elevated energy and food prices will unwind more slowly than I previously projected--a view reinforced by expectations expressed by my District contacts. Like everyone else, I am deeply concerned that inflation expectations seem to be rising and that expectations of general price inflation, reflecting second-, third-, and fourth-order effects of recent oil and commodity price rises, risk becoming institutionalized. I am prepared in the near term to think tactically regarding the conflict between growth and employment policy objectives and inflation objectives; but sustained inflationary pressures that extend well into the fourth quarter and rising expectation readings may force, at least on my part, a more strategic look at the tradeoff. I would like to talk for a moment about financial markets. I made a number of calls during the intermeeting period, and the growth-versus-inflation tactical dilemma is complicated further by a very mixed picture in financial markets. My contacts all acknowledge improved conditions since mid-March, but discussion of the current market circumstances and the outlook had a sort of half-full/half-empty quality. My contacts, taken together, pointed to several positives, including the health of the corporate loan market, improved CDO pricing, the readiness of forming distressed funds to buy asset-backed securities, alt-A mortgage demand, the growing perception that subprime loss estimates have been overstated, and some comment on Goldman's Cheyne deal, which they believe will help create price determination for certain securities. At the same time, these contacts cited areas of continuing or worsening weakness, including: HELOCs and second mortgages; option ARMs and alt-A hybrids; indirect auto, given the collateral value of SUVs in current circumstances; in contrast to CDO pricing, CDO squared pricing is very weak and deteriorating; the obvious concern about the growing liquidity issues of regional banks; and the view that the auction rate securities market valuations, given illiquidity, are suggesting that this market has little probability of returning to normalcy. Overall, my contacts in financial markets were encouraged but expressed worries over still-substantial downside potential. Let me turn now to my national forecast compared with the Greenbook forecast. The Atlanta projections for the national economy are broadly similar to those of the Greenbook. We have the same general narrative of slow growth for the balance of the year followed by a gradual pickup through 2009 and 2010. My projections for headline and core inflation are virtually identical to the baseline Greenbook projections. However, I believe that there may be less disinflationary pressure than seems implicit in the Board staff's forecast. As a consequence, the fed funds rate path that supports my inflation outlook is well above the Greenbook's at the end of 2009 and 2010. We are 75 basis points higher at year-end 2009 and 100 basis points higher at year-end 2010. Notwithstanding the upward revision of the first-quarter GDP number and the better expectations for this quarter, I still believe the near-term risks to growth are weighted to the downside. At the same time, as suggested by my revised forecast, I see the risks to our inflation objective as weighted to the upside. On the subject of the long-term projections, I favor the third approach, which is three years plus long-term averages, and certainly would be comfortable with approach number 2. I'm generally dubious about the ability to do actual forecasting for the outyears, even as near-term as the third year. So I really don't favor approach number 1. My experience, in the brief time I have been with the Fed, has at least personally been, shall I say, challenging from the point of view of forecasting. I tend to think of the long-term projections as being roughly equivalent to our targets or policy goals. In fact, the approach we have generally taken with our three-year forecasts is making the outyear approaching at least what we would consider to be the trend rate for growth and the employment and inflation objective. So I think long-term projections really do amount to more-explicit targeting, and very likely the first question we get when we come out of the blocks--if we have this kind of approach--will be, Is this your target? I am comfortable saying ""yes"" to that question and, therefore, would support the third approach. Thank you, Mr. Chairman. " CHRG-110shrg38109--34 Chairman Bernanke," Thank you. Chairman Dodd, Senator Shelby, and other Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. Real activity in the United States expanded at a solid pace in 2006, although the pattern of growth was uneven. After a first-quarter rebound from weakness associated with the effects of the hurricanes that ravaged the Gulf Coast the previous summer, output growth moderated somewhat on average over the remainder of 2006. Real gross domestic product is currently estimated to have increased at an annual rate of about 2.75 percent in the second half of the year. As we anticipated in our July report, the U.S. economy appears to be making a transition from the rapid rate of expansion experienced over the preceding several years to a more sustainable average pace of growth. The principal source of the ongoing moderation has been a substantial cooling of the housing market, which has led to a marked slowdown in the pace of residential construction. However, the weakness in housing market activity and the slower appreciation of house prices do not seem to have spilled over to any significant extent to other sectors of the economy. Consumer spending has continued to expand at a solid rate, and the demand for labor has remained strong. On average, about 165,000 jobs per month have been added to nonfarm payrolls over the past 6 months, and the unemployment rate, at 4.6 percent in January, remains low. Inflation pressures appear to have abated somewhat following a run-up during the first half of 2006. Overall inflation has fallen in large part as a result of declines in the price of crude oil. Readings on core inflation--that is, inflation excluding the prices of food and energy--have improved modestly in recent months. Nevertheless, the core inflation rate remains somewhat elevated. In the five policy meetings since the July report, the Federal Open Market Committee, or FOMC, has maintained the Federal funds rate at 5.25 percent. So far the incoming data have supported the view that the current stance of policy is likely to foster sustainable economic growth and the gradual ebbing of core inflation. However, in the statement accompanying last month's policy decision, the FOMC again indicated that its predominant policy concern is the risk that inflation will fail to ease as expected and that it is prepared to take action to address inflation risks if developments warrant. Let me now discuss the economic outlook in a little more detail, beginning with developments in the real economy and then turning to inflation. I will conclude with some brief comments on monetary policy. Consumer spending continues to be the mainstay of the current economic expansion. Personal consumption expenditures, which account of more than two-thirds of aggregate demand, increased at an annual rate of about 3.5 percent in real terms during the second half of last year, broadly matching the brisk pace of the previous 3 years. Consumer outlays were supported by strong gains in personal income, reflecting both the ongoing increases in payrolled employment and a pick-up in the growth of real wages. Real hourly compensation, as measured by compensation per hour in the nonfarm business sector deflated by the personal consumption expenditures price index, rose at an annual rate of around 3 percent in the latter half of 2006. The resilience of consumer spending is all the more striking given the backdrop of the substantial correction in the housing market that became increasingly evident during the spring and summer of last year. By the middle of 2006, monthly sales of new and existing homes were about 15 percent lower than a year earlier, and the previously rapid rate of house price appreciation had slowed markedly. The fall in housing demand in turn prompted a sharp slowing in the pace of construction of new homes. Even so, the backlog of unsold homes rose from about 4\1/2\ months' supply in 2005 to nearly 7 months' supply by the third quarter of last year. Single-family housing starts have dropped more than 30 percent since the beginning of last year, and employment growth in the construction sector has slowed substantially. Some tentative signs of stabilization have recently appeared in the housing market. New and existing home sales have flattened out in recent months. Mortgage applications have picked up, and some surveys find that homebuyers' sentiment has improved. However, even if housing demand falls no further, weakness in residential investment is likely to continue to weigh on economic growth over the next few quarters as homebuilders seek to reduce their inventories of unsold homes to more comfortable levels. Despite the ongoing adjustments in the housing sector, overall economic prospects for households remain good. Household finances appear generally solid, and delinquency rates on most types of consumer loans and residential mortgages remain low. The exception is subprime mortgages with variable interest rates, for which delinquency rates have increased appreciably. The labor market is expected to stay healthy, and real incomes should continue to rise, although the pace of employment gains may be slower than that to which we have become accustomed in recent years. In part, slower average job growth may simply reflect the moderation of economic activity. Also, the impending retirement of the leading edge of the baby-boom generation and an apparent leveling out from women's participation in the workforce, which had risen for several decades, will likely restrain the growth of the labor force in coming years. With fewer job seekers entering the labor force, the rate of job creation associated with the maintenance of stable conditions in the labor market will decline. All told, consumer expenditures appear likely to expand solidly in coming quarters, albeit a little less rapidly than the growth in personal incomes, if, as we expect, households respond to the slow pace of home equity appreciation by saving more out of current income. The business sector remains in excellent financial condition with strong growth and profits, liquid balance sheets, and corporate leverage near historical lows. Last year, those factors helped to support continued advances in business capital expenditures. Notably, investment in high-tech equipment rose 9 percent in 2006, and spending on nonresidential structures, such as office buildings, factories, and retail space, increased rapidly through much of the year, after several years of weakness. Growth in business spending slowed toward the end of last year, reflecting mainly a deceleration of spending on business structures, a drop in outlays in the transportation sector where spending is notably volatile, and some weakness in purchases of equipment related to construction and motor vehicle manufacturing. Over the coming year, capital spending is poised to expand at a moderate pace, supported by steady gains in business output and favorable financial conditions. Inventory levels in some sectors, most notably at motor vehicle dealers and in some construction-related manufacturing industries, rose over the course of last year, leaving some firms to cut production to better align inventories with sales. Remaining imbalances may continue to impose modest restraint on industrial production during the early part of this year. Outside the United States, economic activity in our major trading partners has continued to grow briskly. The strength of demand abroad helped stir a robust expansion in U.S. real exports, which grew about 9 percent last year. The pattern of real U.S. imports was somewhat uneven, partly because of fluctuations in oil imports over the course of the year. On balance, import growth slowed in 2006 to 3 percent. Economic growth abroad should further support steady growth in U.S. exports this year. Despite the improvements in trade performance, the U.S. current account deficit remains large, averaging about 6.5 percent of nominal GDP during the first three quarters of 2006. Overall, the U.S. economy seems likely to expand at a moderate pace this year and next, with growth strengthening somewhat as the drag from housing diminishes. Such an outlook is reflected in the projections that the members of the Board of Governors and presidents of the Federal Reserve Banks made around the time of the FOMC meeting late last month. The central tendency of those forecasts, which are based on the information available at that time and on the assumption of appropriate monetary policy, is for real GDP to increase about 2.5 to 3 percent in 2007 and about 2.75 to 3 percent in 2008. The projection for GDP growth in 2007 is slightly lower than our projection last July. The difference partly reflects an expectation of somewhat greater weakness in residential construction during the first part of this year than we anticipated last summer. The civilian unemployment rate is expected to finish both 2007 and 2008 around 4.5 to 4.75 percent. The risks to this outlook are significant. To the downside, the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate. Similarly, spillover effects from developments in the housing market onto consumer spending and employment in housing-related industries may be more pronounced than expected. To the upside, output may expand more quickly than expected if consumer spending continues to increase at the brisk pace seen in the second half of 2006. I turn now to the inflation situation. As I noted earlier, there are some indications that inflation pressures are beginning to diminish. The monthly data are noisy, however, and it will consequently be some time before we can be confident that underlying inflation is moderating as anticipated. Recent declines in overall inflation have primarily reflected lower prices for crude oil, which have fed through to the prices of gasoline, heating oil, and other energy products used by consumers. After moving higher in the first half of 2006, core consumer price inflation has also edged lower recently, reflecting a relatively broad-based deceleration in the prices of core goods. That deceleration is probably also due to some extent to lower energy prices, which have reduced costs of production and thereby lessened one source of pressure on the prices of final goods and services. The ebbing of core inflation has likely been promoted as well by the stability of inflation expectations. A waning of the temporary factors that boosted inflation in recent years will probably help to foster a continued edging down of core inflation. In particular, futures quotes imply that oil prices are expected to remain well below last year's peak. If actual prices follow the path currently indicated by futures prices, inflation pressures would be reduced further as the benefits of the decline in oil prices from last year's high levels are passed through to a broader range of core goods and services. Non-fuel import prices may also put less pressure on core inflation, particularly if price increases for some other commodities, such as metals, slow from last year's rapid rates. But as we have been reminded only too well in recent years, the prices of oil and other commodities are notoriously difficult to predict, and they remain a key source of uncertainty to the inflation outlook. The contribution from rents and shelter costs should also fall back following a step-up last year. The faster pace of rent increases last year may have been attributable in part to reduced affordability of owner-occupied housing, which led to a greater demand for rental housing. Rents should rise somewhat less quickly this year and next, reflecting recovering demand for owner-occupied housing as well as increases in the supply of rental units, but the extent and pace of that adjustment are not yet clear. Upward pressure on inflation could materialize if final demand were to exceed the underlying productive capacity of the economy for a sustained period. The rate of resource utilization is high, as can be seen in rates of capacity utilization above their long-term average, and most evidently in the tightness of the labor market. Indeed, anecdotal reports suggest that businesses are having difficulty recruiting well-qualified workers in certain occupations. Measures of labor compensation, though still growing at a moderate pace, have shown some signs of acceleration over the past year, likely in part the result of tight labor market conditions. The implications for inflation of faster growth in nominal labor compensation depend on several factors. Increases in compensation might be offset by higher labor productivity or absorbed by a narrowing of firms' profit margins rather than passed on to consumers in the form of higher prices. In these circumstances, gains in nominal compensation would translate into gains in real compensation as well. Underlying productivity trends appear favorable, and the mark-up of prices over unit labor cost is high by historical standards, so such an outcome is certainly possible. Moreover, as activity expands over the next year or so at the moderate pace anticipated by the FOMC, pressures in both labor and product markets should ease modestly. That said, the possibility remains that tightness in product markets could allow firms to pass higher labor costs through their prices, adding to inflation and effectively nullifying the purchasing power of at least some portion of the increase in labor compensation. Thus, the high level of resource utilization remains an important upside risk to continued progress on inflation. Another significant factor influencing medium-term trends in inflation is the public's expectations of inflation. These expectations have an important bearing on whether transitory influences on prices, such as those created by changes in energy costs, become embedded in wage and price decisions and so leave a lasting imprint on the rate of inflation. It is encouraging that inflation expectations appear to have remain contained. The projections of the members of the Board of Governors and the presidents of the Federal Reserve Banks are for inflation to continue to ebb over this year and next. In particular, the central tendency of those forecasts is for core inflation, as measured by the price index for personal consumption expenditures, excluding food and energy, to be 2 to 2.25 percent this year and to edge lower to 1.75 to 2 percent next year. But as I noted earlier, the FOMC has continued to view the risk that inflation will not moderate as expected as the predominant policy concern. Monetary policy affects spending and inflation with long and variable lags. Consequently, policy decisions must be based on an assessment of medium-term economic prospects. At the same time, because economic forecasting is an uncertain enterprise, policymakers must be prepared to respond flexibly to developments in the economy when those developments lead to a reassessment of the outlook. The dependence of monetary policy actions on a broad range of incoming information complicates the public's attempts to understand and anticipate policy decisions. Clear communication by the central bank about the economic outlook, the risks to that outlook, and its monetary policy strategy can help the public to understand the rationale that is behind policy decisions and to anticipate better the central bank's reaction to new information. This understanding should in turn enhance the effectiveness of policy and lead to improved economic outcomes. By reducing uncertainty, central bank transparency may also help anchor the public's longer-term expectations of inflation. Much experience has shown that while anchored inflation expectations tend to help stabilize inflation and promote maximum sustainable economic growth, good communication by the central bank is also vital for ensuring appropriate accountability for its policy actions, the full effects of which can be observed only after a lengthy period. A transparent policy process improves accountability by clarifying how a central bank expects to attain its policy objectives and by ensuring that policy is conducted in a manner that can be seen to be consistent with achieving those objectives. Over the past decade or so, the Federal Reserve has significantly improved its methods of communication, but further progress is possible. As you know, the FOMC last year, established a subcommittee to help the full committee evaluate the next steps in this continuing process. Our discussions are directed at examining all aspects of our communications and have been deliberate and thorough. These discussions are continuing, and no decisions have been reached. My colleagues and I remain firmly committed to an open and transparent monetary policy process that enhances our ability to achieve our dual objectives of stable prices and maximum sustainable employment. I will keep Committee Members apprised of the developments as our deliberations move forward. I look forward to continuing to work closely with the Members of the Committee and your colleagues in the Senate and the House on the important issues pertaining to monetary policy and the other responsibilities with which the Congress has charged the Federal Reserve. Thank you. I would be happy to take questions. " FOMC20060510meeting--3 1,MR. KOS.,"1 Thank you, Mr. Chairman. We all know that asset prices can be volatile, sometimes too volatile. Well, the last few months have not had that quality. Volatility in all asset classes, with the exception of commodities, continues to be low. And yet, despite that low volatility, over the past six months investors, traders, and strategists have already been through three very different phases. Late last year, market participants were confident that monetary policy in the United States was at or near neutrality and that once neutrality was achieved—at 4 or 4¼ percent—the Committee would stop tightening. Then the market temporarily got worked up that monetary policy was getting too tight and that the inevitable slowdown would cause the Committee to be easing later this year. Now we are in a new phase, in which worries about nascent inflation have supplanted the earlier fears of a slowdown and the discussion about neutrality has all but evaporated. Markets haven’t been volatile, but sentiment has. On page 1, the top two panels graph the three-month deposit rate for dollar, euro, and yen deposits and three-, six-, and nine-month forward rates for each. U.S. dollar forward rates are trading on top of each other, anticipating either the end of the tightening cycle or a lengthy pause starting sometime soon. The minutes of the Committee’s March meeting made public in mid-April and the Chairman’s JEC testimony were both taken as signals that a pause was on the horizon, despite the qualified language in both and despite other data that were generally strong and that contributed to the rise in long-term yields, which I’ll talk about later. In the euro area, forward rates continued their steady upward climb as growth forecasts increased, business confidence improved, and the European Central Bank signaled that more tightening was likely. Markets anticipate roughly 25 basis points of tightening per quarter through year-end. The list of central banks that have tightened recently includes Canada, 1 The materials used by Mr. Kos are appended to this transcript (appendix 1). Switzerland, Australia, Norway, Thailand, and Malaysia. The People’s Bank of China raised the minimum lending rate that financial institutions can charge 27 basis points, to 5.85 percent, though I’m not sure that qualifies as a tightening for an economy with real growth in double digits. The Bank of Japan is working to slowly bring down the current account balances. From about ¥30 trillion, balances have now been reduced to about half that level. The BOJ will continue to bring them down over the next month and then will likely maintain a buffer above required reserves for a period to give banks more time to adjust to the interest rate targeting framework that will follow. As the middle panel shows, yen forward rates have continued to rise, and markets now presume that the BOJ will bring the overnight call rate to 25 basis points sometime this autumn—but rumors circulated overnight that the first increase could come as early as July. Those rumors fueled a rise of 9 basis points in two-year Japanese government bond yields and Euroyen futures. The bottom panel graphs the two- and ten-year Treasury yields and the target fed funds rate. Since the last meeting, the ten-year yield has risen 34 basis points, and the curve has steepened. This is consistent with the ebbing of worries about a policy-induced slowdown. The curve steepening was given a push by news, particularly the release of the minutes, of a possible pause in the cycle. Page 2 breaks down the increase in ten-year yields. The top left panel graphs the real ten- year yield. Real yields have risen about 40 basis points since early March and 14 basis points since the last FOMC meeting. The top right panel graphs the ten-year breakeven rate (the blue line) and five-year breakeven rate five years forward (the green line). Both have risen since early April with the five-year forward rate rising somewhat more. On a technical note, these are straight breakeven rates without adjustments for carry. The picture of rising real and rising breakeven rates is also visible internationally—at least for those countries with inflation-linked bonds. The middle left panel graphs the change in the real yield this year for France, the United Kingdom, and Japan. Real yields have risen in all three by varying degrees. The middle right panel graphs the change in their breakeven rates. All three have moved about 20 basis points so far this year—somewhat less than the 36 basis point increase for the United States. Fueling the sentiment about inflation expectations has been the rise in commodity prices. The bottom left panel graphs selected metal prices indexed from January 1. Some of these are at record highs or, in the case of gold, multidecade highs. The right panel graphs the movement of energy prices so far this year. The one outlier is natural gas, which rose sharply after Katrina but fell back when consumption did not meet forecasts because of an unseasonably warm winter. Let us turn to page 3 and the other element that has garnered substantial attention: the recent weakness of the dollar. After being stuck in a narrow $1.18 to $1.22 range, the euro appreciated out of that range in mid-April as sentiment turned against the dollar, as shown in the top left panel. This morning it was trading just below $1.28. Meanwhile, the yen appreciated from ¥118 to the dollar in early April to about ¥110.60 this morning. It’s tempting to conclude that the current account deficit is finally exerting itself on the exchange rate. Call me skeptical, but I find it hard to believe that markets awoke to the scale of the imbalances only when reading the now-famous annex in the G7 communiqué. And yet that there was a shift in sentiment can be felt if not visibly observed. One place this shift in sentiment can be felt is in options markets. The middle left panel graphs one-month risk reversals, where dollar puts are bid relative to dollar calls, especially against the yen, and suggests that market participants are more concerned about further downside for the dollar. Another view into this phenomenon is through interest rate differentials. The middle right panel graphs the euro–dollar exchange rate and the differential between December 2006 Eurodollar and Euribor futures. The two tracked pretty closely in 2005 and most of this year but started to diverge in mid-April, suggesting that the effect of interest rate differentials on the exchange rate had lessened and, hence, that something else was exerting greater force. So what are some possible explanations for the shift in sentiment? At the macro level, most forecasts have the United States slowing down in the second half while Japan and Europe do not slow, even if in level terms the United States is still growing faster. Second, the strong growth of the global economy is being interpreted by some in the leveraged community as increasing the odds that emerging Asian countries in particular will allow a rise in their currencies—and hence less dollar accumulation—in the period ahead. Some countries are apparently struggling with sterilization of accumulated reserves. A third explanation is the continued nagging fear that central banks will diversify their dollar holdings. During much of April there were rumors that a large central bank—presumed to be from the Middle East—was selling dollars. Whether that’s true or not, I don’t know. However, it is true that a central bank from Europe—the Swedish Riksbank—was in the midst of lowering its dollar holdings, eliminating its yen holdings, and increasing holdings of European and other currencies. The Swedes made their changes public on April 21. Whether other central banks will follow is an open question; but analysts have noted the prisoner’s dilemma that the large holders of dollars face on this question of diversification, and it is one the markets focus on intensely and are acutely sensitive to. Finally, the markets noted the Treasury’s report on foreign holdings of U.S. securities for the year through June 2005 and the unfavorable revisions it contained. This report corrects the estimations in the monthly TIC data. Whereas the TIC data reported that private investors were the large buyers in that twelve-month span, it now turns out that private demand was minimal and that most of the buying was by official accounts. The bottom panel charts the appreciation against the dollar by a range of currencies in the intermeeting period. Several of these are commodity based, but many are not. And even some of the currencies I talked about last time that had been caught in the liquidation of carry trades made strong comebacks. Yes, even the Icelandic krona, which fell another 10 percent after your last meeting, has reversed course and, on balance, has risen slightly since March 28. I should note that the Canadian dollar is at its strongest level against the U.S. dollar since 1977. Besides the positive terms-of-trade shock, the Canadians have both strong growth and low inflation and something we don’t have: a current account surplus and an ongoing budget surplus that is being used to pay down debt. Changing pace a bit, if you turn to page 4, the top panel graphs the evolution of required operating balances since 2001 and the target fed funds rate. Required operating balances (ROBs) have fallen sharply as the opportunity cost of holding demand deposits has risen. From a peak of about $23 billion, required balances have fallen to about $15 billion. Significant changes in the level of ROBs have been associated with changes in fed funds rate volatility because lower levels of such balances give banks less scope for absorbing daily shocks to their reserve holdings at the Fed. Meanwhile, a lower level of ROBs provides the Desk with less scope to manage the funds rate by adjusting the daily reserves supplied without forcing banks either to borrow at the discount window or to accumulate unwanted excess reserves. So far the effect of the decline in required operating balances has been muted, and we do have some experience in operating in such an environment from the last time that required balances were at such levels in the late 1990s and the early part of this decade. Finally, I want to inform the Committee that the Desk has just finished implementing a new electronic trading system that we call FedTrade and through which we conduct open market operations with the primary dealers. This system replaces a legacy mainframe system that was inflexible and no longer suited our needs. The bottom panel lists some of FedTrade’s main features. Mr. Chairman, there were no foreign operations. I will need approval of domestic operations." FOMC20060131meeting--128 126,MR. POOLE., Do you have someplace to go? [Laughter] FOMC20051101meeting--149 147,MR. POOLE., Please don’t. [Laughter] FOMC20071031meeting--163 161,MR. PLOSSER.," Thank you, Mr. Chairman. The last time we sat around this table, I and many of you argued for what the markets described as a surprisingly aggressive 50 basis point rate cut. At that time, the baseline Greenbook forecast was for 25 basis points, 25 in subsequent meetings, and then flat thereafter. Our rationale was that we were trying to act preemptively, trying to get ahead of the curve, to limit some of the potential spillover effects from what we then believed to be a weakening housing market, perhaps a somewhat softer labor market, and the financial turmoil. We also argued that higher-than-normal tail risk loomed out there, that it was associated with the financial market meltdown, and that it warranted aggressive action to help forestall the possibility of that. In the forecast that we submitted in September, and we all submitted a forecast, the appropriate policy varied. Nine of us submitted appropriate policy as being consistent with the Greenbook, which was 25, 25, and then constant. Of the remaining eight, seven of us had a 50 basis point cut in September, which we did. Many of those, including myself, had some further cuts to the funds rate but further out in the economy, more like in ’08, later in ’08, and ’09, as we move toward more-stable inflation, expectations coming down, a recovered economy, and so forth. I was certainly in that camp as well, and in fact, most people ended up with a funds rate forecasted at either 4¼ or 4½ percent—little differences but not much. In September, only two of us anticipated appropriate policy as dropping 75 basis points before the end of ’07. Of course, we all have the luxury, fortunately, of changing our minds in response to data and other things, and certainly all of us are doing our best to read the tea leaves of the economy, both aggregate and within our regions, and that influences the color and texture that we put around our forecast. We all work very hard at that, and I respect those efforts. But I think it is important that, as a Committee, we enforce discipline and systematic behavior on ourselves as our views evolve, particularly as those views influence policy choices. Without that discipline, without that systematic behavior, I find it very difficult to figure out how I am going to communicate to the public about what monetary policy is doing and why. It makes both our commitment and our credibility, either to inflation or to employment growth, more difficult to substantiate. It makes transparency in general more difficult. All of those things—commitment, credibility, and transparency—are important elements of what contributes to a stable economic environment. Now I have tried to impose that discipline about policy on myself by focusing on the incoming data, trying to focus on how those data cause me to revise my outlook for the real economy, not for tomorrow or next month particularly but for the coming quarters. After all, the monetary policies we have just been talking about operate with somewhat of a lag. In that sense, I think there has been a lot of discussion by myself and others around the table that we are data- driven, that we are forecast-based in how we think about our policy choices, and that we try to take a somewhat longer run view. I think that view is important to communicate to the public. I suspect that at the end of our last meeting—certainly I can speak for myself—many, if not most, of us probably would not have anticipated that we would cut again at this meeting. Perhaps some of you did. Certainly, your appropriate policy paths in our forecast at the last meeting didn’t suggest that. But we wouldn’t have anticipated cutting unless we thought that the outlook for the economy had noticeably deteriorated. So what has really happened since the last meeting? Well, the collective forecasts that we submitted—in terms of risk assessments, ranges, medians, and however you want to look at them—hardly budged. The Greenbook forecast didn’t change very much. The economy generally had better-than-expected news on many fronts—not hugely better but certainly the surprises were on average to the upside for most of us given our forecast from last time. I thought we generally agreed that the risk of serious financial meltdown, while perhaps it hadn’t vanished, had mitigated at least somewhat. As a consequence, neither the Greenbook nor our collective FOMC forecasts moved very much. To the extent that they did, they actually moved up a little. Based on that forecast and on the data that came in, I’m in a very troubled position in figuring out how to justify in my mind additional rate cuts at this meeting. Had this meeting been held two weeks ago, as President Poole suggested, before the market’s reaction to the write- downs in some of the financial institutions, before the fairly dramatic flip-flop in the fed funds rate futures market about the assessment of a future rate cut, I certainly would not have been in favor of a rate cut at that time, and I suggest that each of you should ask yourself the question that Bill did: Would I have chosen to cut rates at that time? I certainly would have also resisted the temptation, arising from those data and what has happened over the past two weeks, to be in any great rush to think we needed to call a special meeting of the FOMC to consider additional rate cuts. My attitude would have been that these financial markets are volatile and they are bouncing around an awful lot, we understand that there are risks, but let’s wait and get the data on the real economy and see how it is evolving and make appropriate decisions at the time. What worries me is that we run the risk of being whipsawed here by market expectations or by the financial markets that are moving around in a very volatile way. That leaves me with some concern that we may be putting ourselves in a position of either responding too much to these volatile markets or being accused by markets of being bullied by the financial markets. So at this point, my take is to say that we are going to get a lot of data between now and December. We are going to get two more employment reports, as we have discussed. We are going to get some more information about retail sales and consumption. I would prefer to keep my own approach to discipline-based policymaking by looking at the forecast and waiting for the data to tell me whether my forecast deteriorated significantly. If it has, I will be the first to argue for an additional rate cut in December if I think it is called for. Right now we have a difficult time justifying a decision. On what grounds are we going to justify it, particularly in a more systematic fashion? I think that creates problems for us. As we have already been discussing, it is creating somewhat of a problem in the language of the statement, and I will come back to that in a minute. But I also think that, without a very articulate rationale in the data and in reasoning that supports a systematic approach to policy, we run the risk of being capricious or arbitrary. I think we are in a situation, as Kevin Warsh said yesterday and Tom Hoenig spoke about, when many of us view inflation risks as more fragile perhaps than they have been recently, particularly more fragile in an environment in which we are cutting rates. I think that we run the risk, more so now perhaps than in other times, that inflation expectations might be at risk. I don’t want to raise those inflation expectations. They are much harder to get down. You can’t act nimbly to deal with movements in expected inflation. I also think we have to ask ourselves the question—and this ties into the balance of risks issue—if we choose to cut today when our forecast hasn’t declined and suppose the data between now and December look as they have for the past six weeks—kind of in line with what we expected, not much different one way or another with nothing really falling out of bed or booming—on what basis in that meeting would we choose or not choose to cut again? At this meeting we have had a hard time grappling with the criteria that we are using. If we are not very explicit about those criteria, we could find ourselves in the same boat next time. I think this is related to Tom’s point that, once we start on the path of making explicit what our expectations are or what the market is going to be expecting us to do without having a firm basis for saying we are doing this because of X or Y, we are going to find ourselves in an awkward position in December. So I share Brian’s concern about the assessment of risk language in alternative A being balanced when it seems to be out of touch with the way the Committee has described things. Again, I think that puts us in an awkward position of trying to balance those two things. So with that, I appreciate the time, Mr. Chairman. On net, I am troubled by a cut today. I would much prefer to wait until December and to assess the data that come in. If a 50 basis point cut in December is required, so be it; but I feel as though we would have a firmer basis then for making that decision. Thank you." FOMC20080430meeting--116 114,MR. KROSZNER.," Thank you very much. As I have talked about many times before, I see what is happening as a continuing slow burn after the fires really heated up for a little while back in March. Things have cooled off again. But exactly as Governor Kohn said, we now seem to be comforted at levels that caused us extreme distress last fall and in January. So I think it is important to put it into that context. There certainly has been improvement, but it is a little early to declare victory--not that anyone has, but I think we just have to be very mindful of that. Some of the discussion reminds me a little of the discussions that we had at the end of October, when we thought that things were improving and then they deteriorated in a way that had us very concerned. But my central tendency scenario has always been not for a financial cataclysm, although that is certainly a real downside risk, but for a sort of slow burn that is just going to continue to weigh heavily on consumption. I think it is negative feedback between housing and finance, but not necessarily a broader cataclysm. I very much agree with President Evans that the chance of a significant nonlinear break to the downside is not gone but lower than it has been. But the tightening credit conditions are going to make it very difficult for the markets to repair and recover as rapidly as perhaps they do in the Greenbook. On housing, we know there are direct and indirect effects. We have all the signs that the contraction is continuing. Even after housing starts have fallen more than 60 percent, we are still seeing them in near free fall. But that hasn't helped to alleviate the inventories of unsold homes, which remain at extremely elevated levels--although not moving up dramatically. Part of the concern is that some of the sales may be due to forced sales related to foreclosures because we know that foreclosures are up quite a bit. So we have to be a bit cautious there. Almost all the measures suggest that expectations of future housing prices are lower, which is causing people to be very cautious about buying. The anecdotal evidence that I have is that walk-throughs are fine but that actually closing the deal is much more difficult, both because of difficulty in finding credit and because people are unwilling to make a commitment now. They think that prices may be 10 percent lower in 6, 9, or 12 months. For many people, this is the largest investment that they will make, and trying to explain to a loved one that they just lost 10 percent of their nest egg is not an easy thing to do. So people are being more cautious. We also see some of this in the ABX measures that Bill put forward. Those numbers have come off their extreme lows, but they are still much lower than they were before. It is hard to believe that the actual default and delinquency performance will be as bad as those measures are suggesting, but they are still suggesting that things are going to be pretty tough, and so we still need to be very wary there. We are still seeing a difference in consumer behavior--people being willing to walk away from their houses before they walk away from their credit cards or from their cars. That is suggesting that people are just operating somewhat differently from the way they did before. The jumbo spreads are still extremely wide, as the charts showed. We may be getting some offset from the new FHA programs and from Freddie Mac and Fannie Mae, but I am still not optimistic that much of this can come in before the end of the year. That suggests that we have tightness on that part. We also have tightness in the credit card market, exactly as Governor Warsh said. The credit card companies I have spoken to see continuing deterioration. We didn't see any sort of nonlinear changes but just a continuing downward trend of real challenges and increasing roll rates of people going 30, 60, 90, and more days delinquent. Spending is up a bit, but they usually say that's mostly because of increases for gasoline and groceries due to the high commodity prices. Also, as President Yellen mentioned, there is more tightening in the HELOC market. More challenges are there, so the banks are pulling back, and more people are getting into trouble. I have an anecdote from one of the large companies. A number of large investment-grade firms have drawn down significant parts of their revolvers, not because they actually needed them but because they thought that they better do it now before they are pulled back. Even these large institutions seem to be hoarding liquidity, much as the banks are doing. I think the banks are doing that because we still see CDS spreads that are very high even though they are lower than their peaks. The LIBOR�OIS spread that a number of people have mentioned still is high and is continuing to increase. That is the most troubling for me--that we are moving back to the extreme highs we saw when we had the end-of-the-year problem. But then we had an explanation for its going away. Now we don't have an end-of-the-year problem, so unfortunately, it is difficult for me to understand what is going to make this go away. I think we can provide more liquidity through some of our various facilities, but I am not sure that that, in and of itself, will be the cure. We have seen more capital come in and help out some of the institutions. But a lot of fragility is still there, as President Pianalto well knows. The issues with respect to National City were liquidity issues, not necessarily short-term concerns about solvency, although I think there are longer-term concerns about solvency. Liquidity and solvency issues are ultimately related, but there is a real concern that many of the money market mutual funds that hold between $3 trillion and $4 trillion will just walk away. We saw this with Bear Stearns. We can see this with other institutions. I think that it's fragility that accounts for some of these very high levels. We used to worry primarily about deposit runs, but deposit runs are extremely slow. Deposit runs are leisurely strolls compared with what could happen in these liquidity markets. So I do think that issues are there precisely because still more challenges are coming with commercial real estate construction, as a number of other people have mentioned. There will still be a lot of provisioning that will have to come up, putting more pressure on the balance sheets and making it more difficult for people to borrow. I also very much agree with Vice Chairman Geithner that the rest of the world is a little behind us and that the boost that we are getting right now from exports isn't going to persist. Turning to inflation, as I think a number of people have mentioned, we haven't seen a lot of pressure on the labor side. As labor markets soften, it is unlikely that we are going to see more pressure there. So that seems to be a positive. But we do see these very elevated commodity price levels, which don't seem to have fed through to core. But exactly as Governor Kohn said, it is a bit of a puzzle how they continue to increase, and that certainly puts some risks ahead of us. It is a particularly difficult time to get a good reading on inflation expectations because there have been lots of changes in liquidity issues and in other particular factors. Some of the survey-based measures are up, but they tend to be very closely related to gasoline prices, and we know that those are at extremely high levels. So I think it is extremely difficult for us now to make a solid determination about where inflation expectations are. Certainly that raises a caution because we don't want to have inflation expectations become unmoored. But I think it is more difficult for us to identify right now exactly how they are evolving, and obviously, this will be important for us in our decisions tomorrow. Thank you, Mr. Chairman. " CHRG-110hhrg34673--10 Mr. Bernanke," Chairman Frank, Representative Bachus, and other members of the committee, I am pleased to present the Federal Reserve Monetary Policy Report to the Congress. Real activity in the United States expanded at a solid pace in 2006, although the pattern of growth was uneven. After a first quarter rebound from weakness associated with the effects of the hurricanes that ravaged the Gulf Coast in the previous summer, output growth moderated somewhat on average over the remainder of 2006. Real Gross Domestic Product is currently estimated to have increased at an annual rate of about 2\3/4\ percent in the second half of the year. As we anticipated in our July report, the U.S. economy appears to be making a transition from the rapid rate of expansion experienced over the preceding several years to a more sustainable average pace of growth. The principal source of the ongoing moderation has been a substantial cooling in the housing market which has led to a marked slowdown in the pace of residential construction. However, the weakness in housing market activity and the slower appreciation of house prices do not seem to have spilled over to any significant extent to other sectors of the economy. Consumer spending has continued to expand at a solid rate, and the demand for labor remains strong. On average, about 165,000 jobs per month have been added to nonfarm payrolls over the past 6 months. And the unemployment rate, at 4.6 percent in January, remains low. Inflation pressures appear to have abated somewhat following a run-up during the first half of 2006. Overall, inflation has fallen in large part as a result of declines in the price of crude oil. Readings on core inflation--that is inflation excluding the prices of food and energy--have improved modestly in recent months. Nevertheless, the core inflation rate remains somewhat elevated. In the five policy meetings since the July report, the Federal open market committee, or FOMC, has maintained the Federal funds rate at 5\1/4\ percent. So far, the incoming data have supported the view that the current stance of policy is likely to foster sustainable economic growth and a gradual ebbing of core inflation. However, in the statement accompanying last month's policy decision, the FMOC again indicated that its predominant policy concern is the risk that inflation will fail to ease as expected, and that it is prepared to take action to address inflation risks, if developments warrant. Let me now discuss the economic outlook in a little more detail beginning with developments in the real economy and then turning to inflation. I will conclude with some brief comments on monetary policy. Consumer spending continues to be the mainstay of the current economic expansion. Personal consumption expenditures, which account for more than two-thirds of aggregate demand, increased at an annual rate of around 3\1/2\ percent in real terms during the second half of last year, broadly matching the brisk pace of the previous 3 years. Consumer outlays were supported by strong gains in personal income reflecting both the ongoing increases in payroll employment and a pickup in the growth of real wages. Real hourly compensation, as measured by compensation per hour in the nonfarm business sector deflated by the personal consumption expenditures price index, rose at an annual rate of about 3 percent in the latter half of 2006. The resilience of consumer spending is all the more striking, given the backdrop of the substantial correction in the housing market that became increasingly evident during the spring and summer of last year. By the middle of 2006, monthly sales of new and existing homes were about 15 percent lower than a year earlier, when the previously rapid rate of house price appreciation had slowed markedly. The fall in housing demand in turn prompted a sharp slowing in the pace of construction of new homes. Even so, the backlog of unsold homes rose from about 4\1/2\ months' supply in 2005 to nearly 7 months' supply by the third quarter of last year. Single family housing starts have dropped more than 30 percent since the beginning of last year. And employment growth in the construction sector has slowed substantially. Some tentative signs of stabilization have recently appeared in the housing market. New and existing home sales have flattened out in recent months. Mortgage applications have picked up. And some surveys find that homebuyers' sentiment has improved. However even if housing demand falls no further, weakness in residential investment is likely to continue to weigh on economic growth over the next few quarters as homebuilders seek to reduce their inventory of unsold homes to more comfortable levels. Despite the ongoing adjustments in the housing sector, overall economic prospects for households remain good. Household finances appear generally solid. And delinquency rates on most types of consumer loans and residential mortgages remain low. The exception is subprime mortgages with variable interest rates for which delinquency rates have increased appreciably. The labor market is expected to stay healthy. And real incomes should continue to rise, although the pace of employment gains may be slower than those to which we have become accustomed in recent years. In part, slower average job growth may simply reflect a moderation in economic activity. Also, the impending retirement of the leading edge of the baby boom generation, and an apparent leveling out of women's participation in the workforce, which had risen for several decades, will likely restrain the growth of the labor force in coming years. With fewer job seekers entering the labor force, the rate of job creation associated with the maintenance of stable conditions in the labor market will decline. All told, consumer expenditures appear likely to expand solidly in coming quarters, albeit a little less rapidly than the growth in personal incomes if, as we expect, households respond to the slow pace of home equity appreciation by saving more out of current income. The business sector remains in excellent financial condition with strong growth in profits, liquid balance sheets, and corporate leverage near historical lows. Last year, those factors helped support continued advances in business capital expenditures. Notably, investment in high tech equipment rose 9 percent in 2006. And spending on nonresidential structures such as office buildings, factories, and retail space increased rapidly through much of the year after several years of weakness. Growth in business spending slowed toward the end of last year, reflecting mainly a deceleration of spending on business structures, a drop in outlays in the transportation sector where spending is notably volatile, and some weakness in purchases of equipment related to construction and motor vehicle manufacturing. Over the coming year, capital spending is poised to expand at a moderate pace, supported by steady gains in business output and favorable financial conditions. Inventory levels in some sectors, most notably in motor vehicle dealers and in some construction-related manufacturing industries, rose over the course of last year leading some firms to cut production to better align inventories with sales. Remaining imbalances may continue to impose modest restraints on industrial production during the early part of this year. Outside the United States, economic activity in our major trading partners has continued to grow briskly. The strength of demand abroad helped spur a robust expansion in U.S. real exports, which grew about 9 percent last year. The pattern of real U.S. imports was somewhat uneven partly because of fluctuations in oil imports over the course of the year. On balance, import growth slowed in 2006 to 3 percent. Economic growth abroad should further support steady growth in U.S. exports this year. Despite the improvements in trade performance, the U.S. current account deficit remains large, averaging about 6\1/2\ percent of nominal GDP during the first three quarters of 2006. Overall, the U.S. economy seems likely to expand at a moderate pace this year and next with growth strengthening somewhat as the drag from housing diminishes. Such an outlook is reflected in the projections that the members of the Board of Governors and presidents of the Reserve Banks made around the time of the FOMC meeting late last month. The central tendency of those forecasts--which are based on information available at that time and on the assumption of appropriate monetary policy--is for real GDP to increase about 2\1/2\ to 3 percent in 2007, and about two- or three-quarters to 3 percent in 2008. The projection for GDP growth in 2007 is slightly lower than our projection last July. This difference partly reflects an expectation of somewhat greater weakness in residential construction during the first part of this year than we anticipated last summer. The civilian unemployment rate is expected to finish both 2007 and 2008 around 4\1/2\ to 4\3/4\ percent. The risks to this outlook are significant. To the downside, the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate. Similarly, spillover effects from the developments in the housing market onto consumer spending and employment and housing related industries may be more pronounced than expected. To the upside, output may expand more quickly than expected if consumer spending continues to increase at the brisk pace seen in the second half of 2006. I turn now to the inflation situation. As I noted earlier, there are some indications that inflation pressures are beginning to diminish. The monthly data are noisy, however, and it will consequently be some time before we can be confident that underlying inflation is moderating as anticipated. Recent declines in overall inflation have primarily reflected lower prices for crude oil, which have fed through to the prices of gasoline, heating oil and other energy products used by consumers. After moving higher in the first half of 2006, core consumer price inflation has also edged lower recently reflecting a relatively broad-based deceleration in the prices of core goods. That deceleration is probably also due, to some extent, to lower energy prices, which have reduced costs of production, and thereby lessened one source of pressure on the prices of final goods and services. The ebbing of core inflation has likely been promoted as well by the stability of inflation expectations. A waning of the temporary factors that boosted inflation in recent years will probably help foster a continued edging down of core inflation. In particular, futures quotes imply that oil prices are expected to remain well below last year's peak. If actual prices follow the path currently indicated by futures prices, inflation pressures would be reduced further as the benefits of the decline in oil prices from last year's high levels are passed through to a broader range of core goods and services. Nonfuel import prices may also put less pressure on core inflation particularly if price increases for some other commodities, such as metals, slow from last year's rapid rates. But as we have been reminded only too well in recent years, the prices of oil and other commodities are notoriously difficult to predict. And they remain a key source of uncertainty in the inflation outlook. The contribution from rents and shelter costs should also fall back following a step up last year. The faster pace of rent increases last year may have been attributable in part to the reduced affordability of owner-occupied housing which led to a greater demand for rental housing. Rents should rise somewhat less quickly this year and next reflecting recovering demand for owner-occupied housing as well as increases in the supply rental units. But the extent and pace that of that adjustment is not yet clear. Upward pressure on inflation could materialize if final demand were to exceed the underlying productive capacity of the economy for a sustained period. The rate of resource utilization is high, as can be seen in rates of capacity utilization above their long term average, and most evidently, in the tightness of the labor market. Indeed anecdotal reports suggest that businesses are having difficulty recruiting well-qualified workers in certain occupations. Measures of labor compensation--though still growing at a moderate pace--have shown some signs of acceleration over the last year, likely, in part, as the result of tight labor market conditions. The implications for inflation of faster growth in nominal labor compensation depend on several factors. Increases in compensation might be offset by higher labor productivity or absorbed by a narrowing of firm's profit margins rather than passed on to consumers in the form of higher prices. In these circumstances, gains in nominal compensation would translate into gains in real compensation as well. Underlying productivity trends appear favorable. And the markup of prices over unit labor costs is high by historical standards, so such an outcome is certainly possible. Moreover, if activity expands over the next year or so at the moderate pace anticipated by the FOMC, pressures in both labor and product markets should ease modestly. That said, the possibility remains that tightness in product markets could allow firms to pass higher labor costs through to prices, adding to inflation and effectively nullifying the purchasing power of at least some portion of the increase in labor compensation. Thus, the high level of resource utilization remains an important upside risk to continued progress on inflation. Another significant factor influencing medium term trends in inflation is the public's expectations of inflation. These expectations have an important bearing on whether transitory influences on prices, such as those created by changes in energy costs, become embedded in wage and price decisions, and so leave a lasting imprint on the rate of inflation. It is encouraging that inflation expectations appear to have remained contained. The projections of the members of the Board of Governors and the presidents of the Federal Reserve Banks are for inflation to continue to ebb over this year and next. In particular, the central tendency of those forecasts is for core inflation--as measured by the price index for personal consumption expenditures excluding food and energy--to be 2 to 2\1/4\ percent this year and to edge lower to 1\3/4\ to 2 percent next year. But as I noted earlier, the FMOC has continued to view the risk that inflation will not moderate as expected as the predominant policy concern. Monetary policy affects spending and inflation with long and variable lags. Consequently, policy decisions must be based on an assessment of medium term economic prospects. At the same time, because economic forecasting is an uncertain enterprise, policy makers must be prepared to respond flexibly to developments in the economy when those developments lead to a reassessment of the outlook. The dependence of monetary policy actions on a broad range of incoming information complicates the public's attempts to understand and anticipate policy decisions. Clear communication by the central bank about the economic outlook, the risk to that outlook, and its monetary policy strategy, can help the public to understand the rationale behind policy decisions and to anticipate better the central bank's reaction to new information. This understanding should, in turn, enhance the effectiveness of policy and lead to improved economic outcomes. By reducing uncertainty, central bank transparency may also help anchor the public's longer term expectations of inflation. Much experience has shown that well-anchored inflation expectations help to stabilize inflation and promote maximum sustainable economic growth. Good communication by the central bank is also vital for ensuring appropriate accountability for its policy actions, the full effects of which can be observed only after a lengthy period. A transparent policy process improves accountability by clarifying how a central bank expects to attain its policy objectives and by ensuring that policies are conducted in a manner that can seen to be consistent with achieving those objectives. Over the past decade or so, the Federal Reserve has significantly improved its methods of communication, but further progress is possible. As you know, the FOMC last year established a subcommittee to help the full committee evaluate the next steps in this continuing process. Our discussions are directed at examining all aspects of our communications and have been deliberate and thorough. These discussions are continuing and no decisions have been reached. My colleagues and I remain firmly committed to an open and transparent monetary policy process that enhances our ability to achieve our dual objectives of stable prices and maximum sustainable employment. I will keep members of this committee apprised of developments as our deliberations move forward. I look forward to continuing to work closely with the members of this committee and your colleagues in the Senate and the House on the important issues pertaining to monetary policy and the other responsibilities with which the Congress has charged the Federal Reserve. Thank you. I would be happy to take questions. [The prepared statement of Chairman Bernanke can be found on page 71 of the appendix.] " FOMC20080625meeting--94 92,MR. WARSH.," Thank you, Mr. Chairman. At this point everything has been said, but everybody hasn't said it. So let me try. [Laughter] Let me make three summary points, and then I will talk about three issues that I think are harder. First, on the economy, through late May, as the Greenbook suggests, the real economy proved more resilient and more dynamic than the consensus had anticipated. Consumer spending was moderate but positive, and the labor markets were soft, but neither was necessarily indicative of a recession through late May. Business fixed investment and corporate profits ex financials look all right. Productivity growth looks, frankly, impressive, and corporations, unlike consumers, still appear okay through the month of June--but I'm going to return to June in just a short while. In sum, my assessment of the economy reasonably approximates the average GDP from the Greenbook for 2008, but I remain considerably more cautious on the catalyst for return-to-trend growth in the forecast period of 2009 and beyond. I suspect that this is a long, slow climb with the credit channels needing to be rebuilt and that the process is still in its very early stages. Second, let me talk about the financial markets. Financial markets continue to show tenuous but real improvements in market functioning--which, as Bill Dudley suggested, is remarkable given the weakness among financial institutions themselves. Leveraged loans and high-yield markets continue to trend toward improved market functioning. Credit spreads are well off their March highs. Credit markets, in particular, are holding up well, despite the broad weakness across equities. Third, let me turn to inflation risks. Inflation risks, in my view, continue to predominate as the greater risk to the economy. There is more evidence of a global secular reversal of inflation trends, making the jobs of central bankers worldwide considerably more difficult. I remain worried about energy and food pass-through and the effect of a weakening dollar if our policy rates and those of our major trading partners are perceived to diverge. I would expect import prices, core inflation, and expectations to move up in the coming months even more than in the Greenbook, likely causing a policy response by our foreign peers. Commodity prices, again, with the exception of metals, have been moving up while global demand is falling, and markets have come to see this rise of some, if not most, commodities as essentially permanent. So at the end of the day, we have to be concerned about this period of above-acceptable inflation. It's crucial that broader prices do not start to rise at still-faster rates, and that could well happen if those making decisions about prices and pay expect higher inflation in the future. Anecdotes are not comforting, particularly on the price front. As a result, I think the trajectory of inflation is less favorable than in the Greenbook, thereby necessitating a policy response more significant than the Greenbook would suggest. Let me turn to three even harder issues. One is consumer spending. We're not done with the second quarter, and my sense of what's happened in the first three weeks of June is pretty miserable. I hate to extrapolate based on three weeks of data to the trajectory of the economy. But from a discussion with contacts from three credit card companies that constitute a little more than half of the credit card spend, I would say that the views from these guys were shocking in how bad things looked in the past three to four weeks, particularly in comparison to reasonably positive news from the previous two months. It is suggestive that June will be much weaker than May, and if I add that to the figures on autos that are coming out of the Detroit Three, those are a couple of anecdotes that make me a little hesitant to declare with an exclamation mark what an enviable second quarter we've had. I also look at equity market prices sometimes as maybe telling us something. I would say that consumer companies and retailers over the last three weeks have gotten killed. So I'm a little hesitant to suggest that the second quarter is going to be strong. Delinquencies and charge-offs have also moved meaningfully to the downside in the last three or four weeks among these credit card companies, and this weakness appears to be much more focused on the coasts than it is in the center of the country. I heard that from three of three. My own view may be influenced by my take on the fiscal stimulus--it sure doesn't appear to be helping very much. The second issue that I continue to struggle with is financial institutions. Financial institution equity prices showed significant underperformance, and some people say that is the Federal Reserve's fault. We're talking up our concerns about inflation. We're changing the Treasury curve going forward. I think that is a total red herring. The reason that financials are getting killed is an equity story. They have business models that are having a hard time delivering profits in this environment. They have had to show a very tough quarterly set of losses. I think the problems on financials have to do with financials and not with the Fed, though there is a disturbing amount of chatter in the markets that somehow we're the cause of that. I am comforted, again as Bill Dudley reminded us, that the broader market functioning has been able to withstand this dramatic financial institution weakness. Whether at some point that will give out I don't know, but I'd say that's extremely encouraging. In addition, we have to recognize that massive amounts of new capital are going to be needed for financial institutions of all sizes. Given the weak performance of virtually every financial investment from November till now, I think it is very easy to see a supply�demand problem. It is very easy to see that, with the number of banks that come to these markets, some of them at some point might not be able to find capital even at dramatically lower prices than their expectations. It is prudent for us at the Fed to think about alternative sources of more-patient institutional funding during this period. The third issue for discussion is credit availability, especially for small businesses. This strikes me as being key to the labor market situation. Credit availability for small businesses has held up better than I would have expected four or five months ago, but pockets of weakness remain, particularly among the regional banks, which are a source of concern. I guess I've become convinced that credit lines have not been tapped out. There was a theory, one that I even had some sympathy toward, that increases in C&I lending in the last few quarters were involuntary, reflecting existing credit lines that were called upon. That strikes me as being somewhat overstated. According to anecdotes and our own survey of the terms of business lending, it does suggest that capital is still available for these small businesses to provide some strength to the economy; but again, continued weakness among the regionals could call that into question. Let me turn finally, Mr. Chairman, to the projections. I have some sympathy for the view that Vice Chairman Geithner put forth. It strikes me that at this time the markets will see the benefits of changing our communication strategy as, yet again, pretty small. The costs are harder for me to be certain about. So if anyone is proposing to do this during the next six months, I would have real hesitancy about introducing this variable into our communication strategy amid our assessment of all the other challenges that we have. So I favor having a trial run come October, but I think we should revisit where we stand on the inflation front, the financial institution front, and the growth front before adding this to the mix. To the extent that we find the appropriate time to go down this path, I would favor option 3. Thank you, Mr. Chairman. " CHRG-110shrg38109--170 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System February 14, 2007 Chairman Dodd, Senator Shelby, and other Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. Real activity in the United States expanded at a solid pace in 2006, although the pattern of growth was uneven. After a first-quarter rebound from weakness associated with the effects of the hurricanes that ravaged the Gulf Coast the previous summer, output growth moderated somewhat on average over the remainder of 2006. Real gross domestic product (GDP) is currently estimated to have increased at an annual rate of about 2\3/4\ percent in the second half of the year. As we anticipated in our July report, the U.S. economy appears to be making a transition from the rapid rate of expansion experienced over the preceding several years to a more sustainable average pace of growth. The principal source of the ongoing moderation has been a substantial cooling in the housing market, which has led to a marked slowdown in the pace of residential construction. However, the weakness in housing market activity and the slower appreciation of house prices do not seem to have spilled over to any significant extent to other sectors of the economy. Consumer spending has continued to expand at a solid rate, and the demand for labor has remained strong. On average, about 165,000 jobs per month have been added to nonfarm payrolls over the past 6 months, and the unemployment rate, at 4.6 percent in January, remains low. Inflation pressures appear to have abated somewhat following a run-up during the first half of 2006. Overall inflation has fallen, in large part as a result of declines in the price of crude oil. Readings on core inflation--that is, inflation excluding the prices of food and energy--have improved modestly in recent months. Nevertheless, the core inflation rate remains somewhat elevated. In the five policy meetings since the July report, the Federal Open Market Committee (FOMC) has maintained the Federal funds rate at 5\1/4\ percent. So far, the incoming data have supported the view that the current stance of policy is likely to foster sustainable economic growth and a gradual ebbing of core inflation. However, in the statement accompanying last month's policy decision, the FOMC again indicated that its predominant policy concern is the risk that inflation will fail to ease as expected and that it is prepared to take action to address inflation risks if developments warrant. Let me now discuss the economic outlook in a little more detail, beginning with developments in the real economy and then turning to inflation. I will conclude with some brief comments on monetary policy. Consumer spending continues to be the mainstay of the current economic expansion. Personal consumption expenditures, which account for more than two-thirds of aggregate demand, increased at an annual rate of around 3\1/2\ percent in real terms during the second half of last year, broadly matching the brisk pace of the previous 3 years. Consumer outlays were supported by strong gains in personal income, reflecting both the ongoing increases in payroll employment and a pickup in the growth of real wages. Real hourly compensation--as measured by compensation per hour in the nonfarm business sector deflated by the personal consumption expenditures price index--rose at an annual rate of around 3 percent in the latter half of 2006. The resilience of consumer spending is all the more striking given the backdrop of the substantial correction in the housing market that became increasingly evident during the spring and summer of last year. By the middle of 2006, monthly sales of new and existing homes were about 15 percent lower than a year earlier, and the previously rapid rate of house-price appreciation had slowed markedly. The fall in housing demand in turn prompted a sharp slowing in the pace of construction of new homes. Even so, the backlog of unsold homes rose from about 4\1/2\ months' supply in 2005 to nearly 7 months' supply by the third quarter of last year. Single-family housing starts have dropped more than 30 percent since the beginning of last year, and employment growth in the construction sector has slowed substantially. Some tentative signs of stabilization have recently appeared in the housing market: New and existing home sales have flattened out in recent months, mortgage applications have picked up, and some surveys find that homebuyers' sentiment has improved. However, even if housing demand falls no further, weakness in residential investment is likely to continue to weigh on economic growth over the next few quarters as homebuilders seek to reduce their inventories of unsold homes to morecomfortable levels. Despite the ongoing adjustments in the housing sector, overall economic prospects for households remain good. Household finances appear generally solid, and delinquency rates on most types of consumer loans and residential mortgages remain low. The exception is subprime mortgages with variable interest rates, for which delinquency rates have increased appreciably. The labor market is expected to stay healthy, and real incomes should continue to rise, although the pace of employment gains may be slower than that to which we have become accustomed in recent years. In part, slower average job growth may simply reflect the moderation of economic activity. Also, the impending retirement of the leading edge of the baby-boom generation, and an apparent leveling out of women's participation rate in the workforce, which had risen for several decades, will likely restrain the growth of the labor force in coming years. With fewer jobseekers entering the labor force, the rate of job creation associated with the maintenance of stable conditions in the labor market will decline. All told, consumer expenditures appear likely to expand solidly in coming quarters, albeit a little less rapidly than the growth in personal incomes if, as we expect, households respond to the slow pace of home-equity appreciation by saving more out of current income. The business sector remains in excellent financial condition, with strong growth in profits, liquid balance sheets, and corporate leverage near historical lows. Last year, those factors helped to support continued advances in business capital expenditures. Notably, investment in high-tech equipment rose 9 percent in 2006, and spending on nonresidential structures (such as office buildings, factories, and retail space) increased rapidly through much of the year after several years of weakness. Growth in business spending slowed toward the end of last year, reflecting mainly a deceleration of spending on business structures; a drop in outlays in the transportation sector, where spending is notably volatile; and some weakness in purchases of equipment related to construction and motor vehicle manufacturing. Over the coming year, capital spending is poised to expand at a moderate pace, supported by steady gains in business output and favorable financial conditions. Inventory levels in some sectors--most notably at motor vehicle dealers and in some construction-related manufacturing industries--rose over the course of last year, leading some firms to cut production to better align inventories with sales. Remaining imbalances may continue to impose modest restraint on industrial production during the early part of this year. Outside the United States, economic activity in our major trading partners has continued to grow briskly. The strength of demand abroad helped spur a robust expansion in U.S. real exports, which grew about 9 percent last year. The pattern of real U.S imports was somewhat uneven, partly because of fluctuations in oil imports over the course of the year. On balance, import growth slowed in 2006, to 3 percent. Economic growth abroad should support further steady growth in U.S. exports this year. Despite the improvements in trade performance, the U.S. current account deficit remains large, averaging about 6\1/2\ percent of nominal GDP during the first three quarters of 2006 (the latest available data). Overall, the U.S. economy seems likely to expand at a moderate pace this year and next, with growth strengthening somewhat as the drag from housing diminishes. Such an outlook is reflected in the projections that the Members of the Board of Governors and Presidents of the Federal Reserve Banks made around the time of the FOMC meeting late last month. The central tendency of those forecasts--which are based on the information available at that time and on the assumption of appropriate monetary policy--is for real GDP to increase about 2\1/2\ to 3 percent in 2007 and about 2\3/4\ to 3 percent in 2008. The projection for GDP growth in 2007 is slightly lower than our projection last July. This difference partly reflects an expectation of somewhat greater weakness in residential construction during the first part of this year than we anticipated last summer. The civilian unemployment rate is expected to finish both 2007 and 2008 around 4\1/2\ to 4\3/4\ percent. The risks to this outlook are significant. To the downside, the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate. Similarly, spillover effects from developments in the housing market onto consumer spending and employment in housing-related industries may be more pronounced than expected. To the upside, output may expand more quickly than expected if consumer spending continues to increase at the brisk pace seen in the second half of 2006. I turn now to the inflation situation. As I noted earlier, there are some indications that inflation pressures are beginning to diminish. The monthly data are noisy, however, and it will consequently be some time before we can be confident that underlying inflation is moderating as anticipated. Recent declines in overall inflation have primarily reflected lower prices for crude oil, which have fed through to the prices of gasoline, heating oil, and other energy products used by consumers. After moving higher in the first half of 2006, core consumer price inflation has also edged lower recently, reflecting a relatively broad-based deceleration in the prices of core goods. That deceleration is probably also due to some extent to lower energy prices, which have reduced costs of production and thereby lessened one source of pressure on the prices of final goods and services. The ebbing of core inflation has likely been promoted as well by the stability of inflation expectations. A waning of the temporary factors that boosted inflation in recent years will probably help foster a continued edging down of core inflation. In particular, futures quotes imply that oil prices are expected to remain well below last year's peak. If actual prices follow the path currently indicated by futures prices, inflation pressures would be reduced further as the benefits of the decline in oil prices from last year's high levels are passed through to a broader range of core goods and services. Nonfuel import prices may also put less pressure on core inflation, particularly if price increases for some other commodities, such as metals, slow from last year's rapid rates. But as we have been reminded only too well in recent years, the prices of oil and other commodities are notoriously difficult to predict, and they remain a key source of uncertainty to the inflation outlook. The contribution from rents and shelter costs should also fall back, following a step-up last year. The faster pace of rent increases last year may have been attributable in part to the reduced affordability of owner-occupied housing, which led to a greater demand for rental housing. Rents should rise somewhat less quickly this year and next, reflecting recovering demand for owner-occupied housing as well as increases in the supply of rental units, but the extent and pace of that adjustment is not yet clear. Upward pressure on inflation could materialize if final demand were to exceed the underlying productive capacity of the economy for a sustained period. The rate of resource utilization is high, as can be seen in rates of capacity utilization above their long-term average and, most evidently, in the tightness of the labor market. Indeed, anecdotal reports suggest that businesses are having difficulty recruiting well-qualified workers in certain occupations. Measures of labor compensation, though still growing at a moderate pace, have shown some signs of acceleration over the past year, likely in part the result of tight labor market conditions. The implications for inflation of faster growth in nominal labor compensation depend on several factors. Increases in compensation might be offset by higher labor productivity or absorbed by a narrowing of firms' profit margins rather than passed on to consumers in the form of higher prices; in these circumstances, gains in nominal compensation would translate into gains in real compensation as well. Underlying productivity trends appear favorable, and the markup of prices over unit labor costs is high by historical standards, so such an outcome is certainly possible. Moreover, if activity expands over the next year or so at the moderate pace anticipated by the FOMC, pressures in both labor and product markets should ease modestly. That said, the possibility remains that tightness in product markets could allow firms to pass higher labor costs through to prices, adding to inflation and effectively nullifying the purchasing power of at least some portion of the increase in labor compensation. Thus, the high level of resource utilization remains an important upside risk to continued progress on inflation. Another significant factor influencing medium-term trends in inflation is the public's expectations of inflation. These expectations have an important bearing on whether transitory influences on prices, such as those created by changes in energy costs, become embedded in wage and price decisions and so leave a lasting imprint on the rate of inflation. It is encouraging that inflation expectations appear to have remained contained. The projections of the Members of the Board of Governors and the Presidents of the Federal Reserve Banks are for inflation to continue to ebb over this year and next. In particular, the central tendency of those forecasts is for core inflation--as measured by the price index for personal consumption expenditures excluding food and energy--to be 2 to 2\1/4\ percent this year and to edge lower, to 1\3/4\ to 2 percent, next year. But as I noted earlier, the FOMC has continued to view the risk that inflation will not moderate as expected as the predominant policy concern. Monetary policy affects spending and inflation with long and variable lags. Consequently, policy decisions must be based on an assessment of medium-term economic prospects. At the same time, because economic forecasting is an uncertain enterprise, policymakers must be prepared to respond flexibly to developments in the economy when those developments lead to a reassessment of the outlook. The dependence of monetary policy actions on a broad range of incoming information complicates the public's attempts to understand and anticipate policy decisions. Clear communication by the central bank about the economic outlook, the risks to that outlook, and its monetary policy strategy can help the public to understand the rationale behind policy decisions and to anticipate better the central bank's reaction to new information. This understanding should, in turn, enhance the effectiveness of policy and lead to improved economic outcomes. By reducing uncertainty, central bank transparency may also help anchor the public's longer-term expectations of inflation. Much experience has shown that well-anchored inflation expectations tend to help stabilize inflation and promote maximum sustainable economic growth. Good communication by the central bank is also vital for ensuring appropriate accountability for its policy actions, the full effects of which can be observed only after a lengthy period. A transparent policy process improves accountability by clarifying how a central bank expects to attain its policy objectives and by ensuring that policy is conducted in a manner that can be seen to be consistent with achieving those objectives. Over the past decade or so, the Federal Reserve has significantly improved its methods of communication, but further progress is possible. As you know, the FOMC last year established a subcommittee to help the full Committee evaluate the next steps in this continuing process. Our discussions are directed at examining all aspects of our communications and have been deliberate and thorough. These discussions are continuing, and no decisions have been reached. My colleagues and I remain firmly committed to an open and transparent monetary policy process that enhances our ability to achieve our dual objectives of stable prices and maximum sustainable employment. I will keep Members of this Committee apprised of developments as our deliberations move forward. I look forward to continuing to work closely with the Members of this Committee and your colleagues in the Senate and House on the important issues pertaining to monetary policy and the other responsibilities with which the Congress has charged the Federal Reserve. Thank you. I would be happy to take questions. FOMC20080130meeting--101 99,MR. POOLE., Okay. What are they telling us? [Laughter] CHRG-111hhrg74855--276 Mr. English," And also as the chairman pointed out, electric cooperatives, of course, are very important to rural America. I am the CEO of the National Rural Electric Cooperative Association. We have 47 States in which we have some 930 co-ops, 42 million consumers. We are not for-profit and consumer-owned, and we are very proud of that so as you can imagine has been the case all this year, Mr. Chairman, our focus has been on the issue of affordability, and once again, I come to talk to you about the issue of affordability. First of all, I would like to commend Chairman Peterson for the work that he has done, certainly increasing transparency and reduces systemic risk for end users. I think it is extremely commendable. I think the legislation goes far in achieving these objectives, however the subject of this hearing focuses on a very narrow area and it is one that we have great concern over and I know that this committee does, and I want to commend you, Mr. Chairman, for having this hearing and calling attention to this issues. We have what I think many of us are very familiar with in which you have two Federal agencies here that could potentially have jurisdiction over an area that is very sensitive, and I would point out to the committee and I think most members of the committee are very aware of the fact that certainly this is a very volatile, sensitive area when you talk about movement of power in this country. And it is extremely important, as this committee has discussed many times that that power move freely, and that it move in a timely fashion, and it move in an affordable way. And in this particular area, I know of no problems that have occurred with regard to the Federal Energy Regulatory Commission in helping bring that about. I am not familiar with any market manipulation issues that have arisen since 2005, and the legislation passed by this committee, and certainly I think that we all are very mindful that it is in all of our best interests, whether we be for-profit or consumer-owned as part of the electric utility industry that we continue to make certain that the power in this country moves in an efficient manner. That is important to consumers and it is certainly important to keep the lights on throughout this nation. So we have become very concerned, Mr. Chairman, in that we have some questions that have arisen here of exactly how we are going to proceed, and this is something that troubles us a great deal. We would strongly suggest, Mr. Chairman, that as we talk about these transactions, both before the transaction takes place and during the period in which the transaction is being carried out that we have one agency that focus on meeting those responsibilities and that be the Federal Energy Regulatory Commission. I would suggest, Mr. Chairman, a very bright line can be painted after the transaction. They should be fair gain for anyone on any wrongdoing, any market manipulation that is detected whether it be the Federal Energy Regulatory Commission or the Commodity Futures Trading Commission Either way we should encourage and hope that they root out any wrongdoing, and they take those steps that are necessary to deal with it but I think it is very important for us to keep in mind, Mr. Chairman, that we need one agency to focus on that very sensitive, critical period of time as to when these transactions are being carried out. And I know the chairman is very sensitive to time in this area as well so I will wind up by simply saying, I hope that you encourage the two Federal agencies to come together, work with us and work with the two committees in Congress into resolving this difficulty so that we don't have any interference taking place in this marketplace. Thank you, Mr. Chairman. [The prepared statement of Mr. English follows:] [GRAPHIC] [TIFF OMITTED] T4855A.036 FOMC20060510meeting--53 51,MR. STOCKTON.," Thank you, Mr. Chairman. I am told that counselors are taught to begin by acknowledging the validity of the fears and anxieties of those whom they are counseling. The strategy then is to deconstruct and examine in greater detail the specific sources of heightened anxiety in order to gain better perspective on the problems at hand. Being a naturally anxious person, I have had moments in the past six weeks when I felt the need to engage in a little “self help” therapy by employing this strategy on myself. So this morning, I thought that I would report the results of my efforts to identify and analyze some of the developments over the intermeeting period that could have made one more uneasy about the outlook for activity and inflation. I’ll admit that there have been a few reasons to be concerned. The growth in real GDP in the first quarter was very strong—even stronger than we had expected in the March Greenbook. And most components of spending surprised us to the upside. Moreover, hard evidence of the anticipated second-quarter slowdown is still sparse. Meanwhile, inflation concerns have been mounting. Oil prices are up another $10 per barrel, and the prices of non-oil commodities are soaring amid signs that the global economy is strengthening. The dollar seems to be sinking on good news and bad. The incoming data on core consumer prices have exceeded our expectations a bit. And measures of expected inflation have moved higher. Clearly, there is plenty to keep one up at night. At other times, I have awoken with the fear that recent developments could provoke us into a familiar trap of overshooting on policy. If policy were to lean against strength in activity and inflation pressure that was largely seen in the rear-view mirror, the risk of tightening too much and for too long would be amplified. In that regard, the evidence has continued to accumulate that housing markets are softening, and last Friday’s employment report at least hinted at some slowing in labor demand. Tightening significantly further when the economy already may have begun to decelerate risks an unwelcome cyclical downturn in the economy. Given our poor track record in predicting recessions, one should not take lightly the risk of overshooting the mark. I’m not embarrassed to admit that I’ve harbored both fears—that of falling behind the curve and that of overshooting—often on the same day and sometimes even in the same conversation with my colleagues. [Laughter] But in the end, I have come to the view that, while you are almost certainly somewhat behind or somewhat ahead of the curve, there are some good reasons to think that you are not too far from the curve. So just how strong is the economy at present, and will it maintain that strength going forward? As you know, we had been expecting a big bump-up in the growth of output in the first quarter, in part as activity rebounded from hurricane-depressed levels. And we surely got it. We are now estimating that the growth of real GDP in the first quarter was 5¼ percent, about ½ percentage point faster than projected in the March Greenbook. That said, it is important not to exaggerate the extent to which that surprise signals greater underlying momentum in the economy. About half of our miss in the first quarter reflected higher-than-expected federal spending. While I’ll admit that “higher-than-expected federal spending” might seem to be an oxymoron, we view the first-quarter miss as largely one of timing, related in part to FEMA outlays. We are expecting the level of federal spending to drop back in the current quarter. Inventory investment outside the motor vehicle sector, after being very subdued in the second half of last year, also has surprised us to the upside of late. Although it is presently providing a lift to activity, we would not expect inventory investment to be a source of ongoing impetus to production. Of course, these were not our only surprises. Household and business spending, too, have come in above our expectations, and we read domestic demand as having somewhat greater momentum than we had earlier thought. As a consequence, we revised up our projection for second-quarter growth in real GDP to 3¾ percent—similar to the above-trend pace that we experienced over the past year. Had everything else remained as it was in March, this greater strength in near-term activity would have led us to mark up our forecast for the remainder of the year as well. But there have been some powerful countervailing forces with which we have had to contend. The steep rise in the price of crude oil has continued to siphon purchasing power from the household sector. The bill for imported oil is now expected to be about $50 billion per year higher than in our March projection. Moreover, gasoline prices have increased even more than oil prices, reflecting a tight inventory situation that has resulted from some refinery shutdowns and from the higher costs associated with the switch in blends of reformulated gasoline. Because the spending propensities of oil company shareholders are likely lower than those of gasoline consumers, the transfer of income between these two groups also is likely to subtract some from consumer spending. In the very near term, we have households dipping into saving to meet their higher energy bills, but we think that some adjustment to overall spending plans probably is under way and that more will be required in coming quarters. Besides the restraining effects of higher oil prices, the recent increase in long-term interest rates is expected to weigh on activity over the remainder of the projection period. To be sure, some of that increase reflects higher expected inflation. But real long-term rates have increased as well, in part as term premiums have widened a bit. Mortgage rates and corporate bond rates are expected to run about 20 to 30 basis points above the levels that in our previous projection we had assumed would prevail. Obviously, those increases have been too recent to have yet affected demand; but we expect that, by the second half of the year, higher rates will be leaving an imprint on housing activity and business investment. As you know from reading the Greenbook, the stronger underlying momentum in the economy is eventually more than offset by the greater drag from higher energy prices and interest rates, leaving the level of output a touch weaker by the end of 2007 than forecast in March. What about inflation concerns? There can be little doubt that price pressures have intensified somewhat over the intermeeting period. As I noted earlier, crude oil prices have risen about $10 per barrel, and participants in futures markets expect those higher prices to persist. Other commodity prices have been soaring as well, especially prices for industrial metals. These increases can be expected to add a bit to core inflation in coming months. Another troubling development in the inflation picture has been the increase in most measures of inflation compensation and inflation expectations. TIPS measures of inflation compensation have increased between 15 and 20 basis points over the intermeeting period. At the same time, the Michigan survey measure of median year-ahead inflation expectations increased to 3.3 percent, and the median measure of inflation expectations five to ten years ahead edged up to 3.1 percent; both are about ¼ percentage point higher than in March. Still, these developments should be placed in perspective. None of these measures has breached the range that has been maintained over the past few years. And there have been several episodes during that period when expectations moved up as much as or more than they have in the past six weeks, only to reverse course on softer news about the economy or inflation. So for now, it is difficult to gauge the extent to which there has been any meaningful deterioration in inflation expectations. Moreover, we have scant evidence that higher price inflation or higher inflation expectations have become embedded in labor costs. As you know, the employment cost index (ECI) rose at an annual rate of just 2½ percent in the first three months of the year, more than 1½ percentage points less than we had projected. In contrast, we currently estimate that compensation per hour in the nonfarm business sector increased at a 5¾ percent annual rate in the first quarter, about 1½ percentage points more than we had projected. Nonetheless, despite their divergent movements last quarter, both measures actually decelerated over the past year. To be sure, because labor compensation tends to lag prices in the overall inflation process, this observation should provide only limited solace. But I do think the incoming information on labor costs makes it more difficult to argue that you have fallen far behind the curve. We continue to expect the growth of hourly labor compensation to pick up going forward in response to tight labor markets, the increases in labor productivity that have occurred in recent years, and the lagged effects of higher price inflation. Nevertheless, with price markups at very high levels, the projected acceleration in hourly labor compensation is expected to result chiefly in some narrowing of profit margins rather than in an increase in price inflation. What about the price data themselves? Both the core consumer price index (CPI) and core personal consumption expenditure (PCE) prices rose 0.3 percent in March, exceeding our expectations. Some of the surprise in both measures was attributable to higher-than- expected increases in apparel prices that may have more to do with imperfectly anticipated seasonal patterns than underlying trends and to a step-up in medical prices related to increased Medicare reimbursements. As a consequence, we attach only a small signal to this upside surprise. All told, the developments over the past six weeksCanother jump in oil prices, some deterioration of inflation expectations, and a slightly higher reading on core inflationCled us to mark up our projection of core consumer price inflation, but just by 0.1 percent in both 2006 and 2007. The pattern of projected inflation remains the same. As higher prices for oil and other commodities are passed through into the prices of final goods and services, core PCE inflation is projected to move up to a 2¼ percent pace this year. With those prices expected to flatten out next year and with the pass-through of the earlier run-ups largely complete, we expect core PCE inflation to ease back down to a 2 percent pace in 2007. Finally, what about the concern that we could be in the process of overshooting the mark on policy tightening? Because policy operates with a lag and because we are so poor at predicting turning points, this risk seems especially relevant after a period of substantial tightening. But given the strength that appears evident in both domestic and foreign economies, my guess is that the expansion is not so fragile that some modest overshoot on policy would result in a cyclical downturn in activity. Moreover, if our baseline assessment of the economy is close to the mark, a higher path for the funds rate might not even be deemed an overshooting. As we noted in a simulation in the Bluebook, greater policy tightening than is built into the baseline might be desired if your objective is to achieve a more rapid and pronounced decline in core price inflation. So, in the end, while we could see a heap of worries in a variety of different directions, we interpreted recent developments as warranting only small changes in our forecast. That forecast remains one in which activity slows to a more sustainable pace and inflation fluctuates around recent levels. Still, I don’t want to be seen as offering false reassurances. Much could happen to change the outlook. My own concerns about potential outcomes that could take us far from the staff baseline projection are centered mainly on asset markets. Asset markets are impressive information-processing machines that, for the most part, deliver very efficient outcomes. But those markets are also subject, from time to time, to abrupt shifts in confidence and psychology that are difficult for forecasters to predict and difficult for policymakers to influence. I see risks on both sides of the ledger here. One of the risks associated with overshooting is that, at some point, higher interest rates could trigger a sharp contraction in house prices and real estate activity. Given the long lags with which we receive reliable information on house prices, such developments might take some time to recognize and thus might prove harder to counteract than implied by our alternative scenarios. Of course, undershooting on policy also presents risks for asset markets. If policy were to trigger a substantial fall in the dollar, inflation pressures and your efforts to deal with those pressures could create some significant challenges for monetary policy and for the economy. Karen will have more to say on the prospects for the dollar in her presentation." FOMC20050202meeting--218 216,MR. POOLE., I support the recommendation and the reasoning. [Laughter] FOMC20080430meeting--196 194,MR. KROSZNER.," Thank you, Mr. Chairman. As many speakers before me have said, this is a pretty close call, and reasonable cases can be made for both alternative B and alternative C. If you look at financial market conditions, you can see your favorite indicator and say whether things have eased or not eased. One indicator that I look at when thinking about the transmission of monetary policy is the LIBOR�OIS spread, which has gone up very significantly. A lot of shortterm borrowing is priced off of that. If we wanted just to keep policy where it was six weeks ago, we would actually have to cut more--not that I'm suggesting that we should. But if you use that spread as the relevant indicator, it would suggest that, if one were to keep the same stance, or potentially the same stance, of monetary policy, you'd have to cut a lot. It doesn't seem as though our liquidity facilities have been effective on this particular dimension. We had been hopeful that they would be, but they don't seem to be. Even with some of the things that we voted on yesterday, we're still going to see very elevated spreads in some of these markets, still making borrowing costs relatively high and so disrupting the traditional monetary transmission mechanism. So that's where I would argue for alternative B. Another argument for alternative B is the potentially protracted slowdown. I agree very much with President Stern. As I've talked about a lot before, this sort of slow burn is related to the housing market. The repair and recovery of those markets is going to take a long time. The spreads are still quite elevated in a number of these markets. So providing more cushion against the downside risk there for those markets and then thinking about how that risk affects the potential for broader downside risks, in which the housing market seems to be a potential trigger point for negative nonlinear dynamics, again suggests that moving down 25 basis points now is prudent. The key, of course, that people have been talking about is inflation pressures going forward--inflation expectations. Here a case can be made on either side with some cogency. One challenge we have right now is that we have a lot of differences in the way to read inflation expectations. Looking at the five-year-ahead versus the five-to-ten-year-ahead, we've seen them spread apart quite a bit and now start to come back together, with the next five years starting to move up but the five-to-ten-year-ahead moving down. We have a number of other measures of expectations, some of which have moved up quite significantly but maybe primarily because of some relative price movements rather than underlying inflation trends. One thing that is comforting for me on the alternative B side is that during the last year to 18 months, when we have had very low--below 5 percent--unemployment rates, we have seen very little evidence of high wage pressure. I find it unlikely that it is going to increase as the unemployment rate goes above 5 percent, and I think, as many people around the table do, that unemployment may sustain itself above 5 percent for quite some time. We also haven't seen some of the real shocks to energy and commodity prices feed through to core. Now, that still could be coming. But we've seen very elevated prices in these areas for quite some time--six to nine months--and the most recent readings from the PCE index suggest that they haven't fed through. Maybe that is still to come, and I think to be worried about that is reasonable. It is also reasonable to be worried about implications for the dollar if we were to go for alternative B rather than alternative C. But the language in alternative B can provide some comfort to the markets that we are unlikely to be pushing much further, given what we see and what we expect, but that we are open to that possibility. We certainly have a very long time between this meeting and the next meeting. We're going to be getting two employment reports, GDP, and a lot of other information, so we may need to revisit some of these issues. But at this point I would come down for alternative B with the language that we have. I think it gives us the appropriate flexibility, and I don't see sufficient evidence of an unhinging of inflation expectations or actual inflationary pressures, at least with respect to core, to say that we need to take a pause now. Thank you, Mr. Chairman. " CHRG-110hhrg46594--33 Mr. Kanjorski," Mr. Chairman, like many industries in America, the automotive sector confronts dire economic conditions. What we have here is a complicated mixture of ineffective management, a lack of innovation, exploding health care and pension costs, a struggling economy, increasing commodity prices, and changing consumer preferences. Regardless of the causes, the current plight demands dramatic reform. The Big Three must either adapt to survive or face extinction. To have a chance at survival, some maintain that the government should underwrite these needed changes to protect American jobs and prevent an impending economic catastrophe. Others counter that government assistance will merely prolong the inevitable failure of American automakers. Some also suggest that $25 billion is not enough to save the industry. Just like we have recently experienced at AIG, the automakers could soon be back at the government's doorstep with a beggar's cup demanding more money in short order. Most of us surely agree that if the Congress chooses to act, and that remains for me a big `if,' any money must come with substantive stipulations. While the draft House bill offers some important conditions, I believe they are insufficient to prevent recipients of taxpayer aid from abusing it. The draft provides no guarantees that these companies protect American jobs. Nothing prevents them from purchasing foreign-made supplies over American-made parts. Moreover, unlike the 1979 Chrysler bailout law that required concessions by many, the proposal before us contains no similar substantive sacrifices by suppliers, dealers, management, and workers. After all, Lee Iacocca symbolically accepted just $1 in annual pay. Why can't today's CEOs at General Motors, Ford, and Chrysler do the same? Furthermore, I am not yet convinced that the Congress must act so rashly. If one of these companies have a specific dollar amount to prevent its insolvency in a matter of weeks, then we should know that so that we can provide a limited bridge loan. We can then take the time to structure a proper deal that does not sell us a pig in a poke to allow yet even more businesses to bathe like pigs at the taxpayers' trough. The American people expect and deserve careful deliberation from this body rather than a blessing of last minute, expedient deals. Only after the Congress carefully and thoughtfully considers its options can it then draft a solution that not only keeps these companies running for months and years to come, but also helps them to thrive in the next generation. Even if we consider this bill, the onus lies with today's witnesses to explain why a direct government loan is a superior option. Many have credibly argued that bankruptcy or a structured receivership remain viable alternatives. The successful Chrysler loan guarantee provided a similar plausible road map this Congress could pursue. Whatever we ultimately decide, we must proceed with caution toward a prudent, long-term solution. In sum, the American public expects us to take the time to get it right, even if we have to stay in Washington to do it. I am committed to getting it right, and look forward to the testimony. " CHRG-111shrg61651--134 PREPARED STATEMENT OF SIMON JOHNSON Ronald Kurtz Professor of Entrepreneurship, MIT Sloan School of Management; and Senior Fellow, Peterson Institute for International Economics; and Cofounder of BaselineScenario.com February 4, 2010A. General Principles \1\--------------------------------------------------------------------------- \1\ This testimony draws on joint work with James Kwak, including ``13 Bankers'' (forthcoming, March 2010) and ``The Quiet Coup'' (The Atlantic, April, 2009), and Peter Boone, particularly ``The Next Financial Crisis: It's Coming and We Just Made It Worse'' (The New Republic, September 8, 2009). Underlined text indicates links to supplementary material; to see this, please access an electronic version of this document, e.g., at http://BaselineScenario.com, where we also provide daily updates and detailed policy assessments for the global economy.--------------------------------------------------------------------------- 1) The broad principles behind the so-called ``Volcker Rules'' are sound. As articulated by President Obama at his press conference on January 21, the priority should be to limit the size of our largest banks and to reduce substantially the risks that can be taken by any financial entity that is backed, implicitly or explicitly, by the Federal Government. 2) Perceptions that certain financial institutions were ``too big to fail'' played a role in encouraging reckless risk-taking in the run-up to the financial crisis that broke in September 2008. Once the crisis broke, the Government took dramatic and unprecedented steps to save individual banks and nonbanks that were large relative to the financial system; at the same time, relatively small banks, hedge funds, and private equity and other investment funds were either intervened by the FDIC (for banks with guaranteed deposits) or just allowed to go out of business (including through bankruptcy). 3) Looking forward, we face a major and undeniable problem with the ``too big to fail'' institutions that became more powerful (in economic and political terms) as a result of the 2008-09 crisis and now dominate our financial system. Implementing the principles behind the Volcker Rules should be a top priority. 4) As a result of the crisis and various Government rescue efforts, the largest 6 banks in our economy now have total assets in excess of 63 percent of GDP (based on the latest available data; details of the calculation and related information are available in ``13 Bankers''). This is a significant increase from even 2006, when the same banks' assets were around 55 percent of GDP, and a complete transformation compared with the situation in the U.S. just 15 years ago--when the 6 largest banks had combined assets of only around 17 percent of GDP. 5) The credit markets are convinced that the biggest banks in the United States are so important to the real economy that, if any individual bank got into trouble, it would be rescued in such a way that creditors would be fully protected. As a result, the implied probability of default on debt issued by these mega-banks is very low--as reflected, for example, in their current credit default swap spreads. 6) The consequent low cost of credit for mega-banks--significantly below what is paid by smaller banks that can fail (i.e., banks that can realistically be taken over through a FDIC intervention)--constitutes a form of unfair subsidy that enables the biggest banks to become even larger. Without a size cap on individual bank size, we will move toward the highly dangerous situation that prevails in some parts of Western Europe--where individual banks hold assets worth more (at least on paper, during a boom) than their home country's GDP. 7) Just to take one example, the Royal Bank of Scotland (RBS) had assets--at their peak--worth roughly 125 percent of U.K. GDP. The mismanagement and effective collapse of RBS poses severe risks to the U.K. economy, and the rescue will cost the taxpayer dearly. Iceland is widely ridiculed for allowing banks to build up assets (and liabilities) worth between 11 and 13 times GDP, but the biggest four banks in the U.K. had bank assets worth over 3 times GDP (and total bank assets were substantially higher, by some estimates as much as 6 times GDP)--and the two largest banks in Switzerland held assets that were worth over 8 times GDP. When there is an implicit Government subsidy to bank size and growing global opportunities to export (subsidized) financial services, market forces do not limit how large banks and nonbank financial institutions can become relative to the domestic economy. In fact, as financial globalization continues, we should expect the largest U.S. banks--left unchecked--to become even bigger in dollar terms and relative to the size of our economy. 8) At the same time, under the current interpretation of our financial rules, a bank such as Goldman Sachs now has full access to the Fed's discount window (as a bank holding company)--yet also retains the ability to make risky investments of all kinds anywhere in the world (as it did when it was an investment bank, before September 2008). In a very real sense, the U.S. Government is now backing the world's largest speculative investment funds--without any effective oversight mechanisms. 9) Under the framework now in place, we are set up for another round of the boom-bailout-bust cycle that the head of financial stability at the Bank of England now terms a ``doom loop.'' The likely consequences range from terrible, in terms of pushing up our net Government debt by another 40 percentage points of GDP (or more), as we struggle again to prevent recession from becoming depression, to catastrophic--if we fail to prevent a Second Great Depression. 10) In this context, reining in the size of our largest banks is not only an appealing proposition, it is also compelling. There is no evidence for economies of scale in banking over $100 billion of total assets (measured in today's dollars). As a result, the growth of our largest banks since the early 1990s has been entirely without social benefits. At the same time, the crisis of 2008-09 manifestly demonstrates the very real social costs: the revised data will likely show more than 8 million net jobs lost since December 2007--due to more than a decade of reckless risk-taking involving large financial institutions. 11) The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 specified a size cap for banks: No single bank may hold more than 10 percent of total retail deposits. This cap was not related to antitrust concerns as 10 percent of a national market is too low to imply pricing power. Rather this was a sensible macroprudential preventive measure--don't put all your eggs in one basket. Unfortunately, since 1994 two limitations of Riegle-Neal have become clear, (1) the growth of big banks was not fueled by retail deposits but rather by various forms of ``wholesale'' financing, and (2) the cap was not enforced by lax regulators, so that Bank of America, JPMorgan Chase, and Wells Fargo all received waivers in recent years. 12) While the U.S. financial system has a long tradition of functioning well with a relatively large number of banks and other intermediaries, in recent years it has become transformed into a highly concentrated system for key products. The big four have half of the market for mortgages and two-thirds of the market for credit cards. Five banks have over 95 percent of the market for over-the-counter derivatives. Three U.S. banks have over 40 percent of the global market for stock underwriting. This degree of market power is dangerous in many ways. 13) These large banks are widely perceived--including by their own management, their creditors, and Government officials--as too big to fail. The executives who run these banks obviously have an obligation to make money for their shareholders. The best way to do this is to take risks that pay off when times are good and that result in bailouts--creating huge costs for taxpayers and all citizens--when times are bad. \2\--------------------------------------------------------------------------- \2\ For more analytical analysis and relevant data on this point, see ``Banking on the State'', by Andrew Haldane and Piergiorgio Alessandri, BIS Review 139/2009.--------------------------------------------------------------------------- 14) This incentive system distorts market outcomes, encourages reckless risk-taking, and will lead to serious trouble. While reducing bank size is not a panacea and should be combined with other key measures that are not yet on the table--including a big increase in capital requirements--finding ways to effectively reduce and then limit the size of our largest banks is a necessary condition for a safer financial system.B. Assessment of Bank Size 1) The counterargument is that big banks provide benefits to the economy that cannot be provided by smaller banks. There are also claims that the global competitiveness of U.S. corporations requires American banks be at least as big as the banks in any other country. Another argument is that large financial institutions enjoy significant economies of scale and scope that make them more efficient, helping the economy as a whole. Finally, it is argued global banks are necessary to provide liquidity to far-flung capital markets, making them more efficient and benefiting companies that raise money in those markets. 2) There is weak or no hard empirical evidence supporting any of these claims. 3) Multinational corporations do have large, global financing needs, but there are currently no banks that can supply those needs alone; instead, corporations rely on syndicates of banks for major offerings of equity or debt. And even if there were a bank large enough to meet all of a large corporation's financial needs, it would not make sense for any nonfinancial corporation to restrict itself to a single source of financial services. It is much preferable to select banks based on their expertise in particular markets or geographies. 4) In addition, U.S. corporations already benefit from competition between U.S. and foreign banks, which can provide identical financial products; there is no reason to believe that the global competitiveness of our nonfinancial sector depends on our having the world's largest banks. 5) There is also very little evidence that large banks gain economies of scale beyond a low size threshold. a. Economies of scale vanish at some point below $10 billion in assets. \3\--------------------------------------------------------------------------- \3\ Dean Amel, Colleen Barnes, Fabio Panetta, and Carmelo Salleo, ``Consolidation and Efficiency in the Financial Sector: A Review of the International Evidence'', Journal of Banking and Finance 28 (2004): 2493-2519. See also Stephen A. Rhoades, ``A Summary of Merger Performance Studies in Banking, 1980-93, and an Assessment of the`'Operating Performance' and 'Event Study' Methodologies'', Federal Reserve Board Staff Studies 167, summarized in Federal Reserve Bulletin July 1994, complete paper available at http://www.federalreserve.gov/Pubs/staffstudies/1990-99/ss167.pdf: ``In general, despite substantial diversity among the nineteen operating performance studies, the findings point strongly to a lack of improvement in efficiency or profitability as a result of bank mergers, and these findings are robust both within and across studies and over time.'' See also Allen N. Berger and David B. Humphrey, ``Bank Scale Economies, Mergers, Concentration, and Efficiency: The U.S. Experience'', Wharton Financial Institutions Center Working Paper 94-24, 1994, available at http://fic.wharton.upenn.edu/fic/papers/94/9425.pdf.--------------------------------------------------------------------------- b. The 2007 Geneva Report on ``International Financial Stability'', coauthored by former Federal Reserve vice chair Roger Ferguson, found that the unprecedented consolidation in the financial sector over the previous decade had led to no significant efficiency gains, no economies of scale beyond a low threshold, and no evident economies of scope. \4\--------------------------------------------------------------------------- \4\ Roger W. Ferguson, Jr., Philipp Hartmann, Fabio Panetta, and Richard Portes, International Financial Stability (London: Centre for Economic Policy Research, 2007), 93-94.--------------------------------------------------------------------------- c. Since large banks exhibit constant returns to scale (they are no more or less efficient as they grow larger), and we know that large banks enjoy a subsidy due to being too big to fail, ``offsetting diseconomies must exist in the operation of large institutions''--that is, without the ``too big to fail'' subsidy, large banks would actually be less efficient than midsize banks. \5\--------------------------------------------------------------------------- \5\ Edward J. Kane, ``Extracting Nontransparent Safety Net Subsidies by Strategically Expanding and Contracting a Financial Institution's Accounting Balance Sheet'', Journal of Financial Services Research 36 (2009): 161-168.--------------------------------------------------------------------------- d. There is evidence for increased productivity in U.S. banking over time, but this is due to improved use of information technology--not increasing size or scope. \6\--------------------------------------------------------------------------- \6\ Kevin J. Stiroh, ``Information Technology and the U.S. Productivity Revival: What Do the Industry Data Say?'' American Economic Review 92 (2002): 1559-1576.--------------------------------------------------------------------------- 6) Large banks do dominate customized (over-the-counter) derivatives. But this is primarily because of the implicit taxpayer subsidy they receive--again, because they are regarded as too big to fail, their cost of funds is lower and this gives them an unfair advantage in the marketplace. There is no sense in which this market share is the outcome of free and fair competition. 7) The fact that ``end-users'' of derivatives share in the implicit Government subsidy should not encourage the continuation of ``too big to fail'' arrangements. This is a huge and dangerous form of support for private interests at the expense of the taxpayer and--because of the apparent downside risks--of everyone who can lose a job or see their wealth evaporate in the face of an economic collapse. 8) There are no proven social benefits to having banks larger than $100 billion in total assets. Vague claims regarding the social value of big banks are not backed up by data or reliable estimates. This should be weighed against the very obvious costs of having banks that are too big to fail.C. Actions Needed 1) While the general principles behind the Volcker Rules make sense and there is no case for keeping our largest banks anywhere near their current size, the specific proposals outlined so far by the Administration are less persuasive. 2) Capping the size of our largest banks at their current level today does not make much sense. It is highly unlikely that, after 30 years of excessive financial deregulation, the worst crisis since the Great Depression, and an extremely generous bailout that we found ourselves with the ``right'' size for big banks. 3) Furthermore, limiting the size of individual banks relative to total nominal liabilities of the financial system does not make sense, as this would not be ``bubble proof''. For example, if housing prices were to increase ten-fold, the nominal assets and liabilities of the financial system would presumably also increase markedly relative to GDP. When the bubble bursts, it is the size of individual banks relative to GDP that is the more robust indicator of the damage caused when that bank fails--hence the degree to which it will be regarded as too big to fail. 4) Also, splitting proprietary trading from integrated investment-commercial banks would do little to reduce their overall size. The ``too big to fail'' banks would find ways to take similar sized risks, in the sense that their upside during a boom would still be big and the downside in a bust would have dramatic negative effects on the economy--and force the Government into some sort of rescue to prevent further damage. 5) The most straightforward and appealing application of the Volcker Principles is: Do not allow financial institutions to be too big to fail; put a size cap on existing large banks relative to GDP, forcing these entities to find sensible ways to break themselves up over a period of 3 years. 6) CIT Group was not too big to fail in summer 2009; it then had around $80 billion in total assets. Goldman Sachs was too big to fail in fall 2008, with assets over $1 trillion. If Goldman Sachs were to break itself up into 10 or more independent companies, this would substantially increase the likelihood that one or more could fail without damaging the financial system. It would also greatly improve the incentives of Goldman management, from a social perspective, encouraging them to be much more careful. 7) Addressing bank size is not a panacea. In addition, capital requirements need to be strengthened dramatically, back to the 20-25 percent level that was common before 1913, i.e., before the creation of the Federal Reserve, when the Government effectively had no ability to bail out major banks. Capital needs to be risk-weighted, but in a broad manner that is not amenable to gaming (i.e., quite different from Basel II and related approaches). 8) Such strengthening and simplifying of capital requirements would go substantially beyond what the Obama administration has proposed and what regulators around the world currently have in mind. In November 2009, Morgan Stanley analysts predicted that new regulations would result in Tier 1 capital ratios of 7-11 percent for large banks--i.e., below the amount of capital that Lehman had immediately before it failed. \7\--------------------------------------------------------------------------- \7\ Research Report, Morgan Stanley, ``Banking--Large and Midcap Banks: Bid for Growth Caps Capital Ask'', November 17, 2009.--------------------------------------------------------------------------- 9) The capital requirements for derivative positions also need to be simplified and strengthened substantially. For this purpose derivative holdings need to be converted according to the ``maximum loss'' principle, i.e., banks should calculate their total exposure as they would for a plain vanilla nonderivative position; they should then hold the same amount of capital as they would for this nonderivative equivalent. For example, if a bank sells protection on a bond as a derivative transaction, the maximum loss is the face value of the bond so insured. The capital requirement should be the same as when the bank simply holds that bond. 10) A strengthened and streamlined bankruptcy procedure for nonbank financial institutions makes sense. This will help wind up smaller entities more efficiently. 11) But improving the functioning of bankruptcy does not make ``too big to fail'' go away. When they are on the brink of failing, ``too big to fail'' banks are ``saved'' from an ordinary bankruptcy procedure because creditors and counterparties would be cut off from their money for months, which is exactly what causes broader economic damage. You can threaten all financial institutions with bankruptcy, but that threat is not credible for the biggest banks and nonbanks in our economy today. And if the Government did decide to make an example of a big bank and push it into bankruptcy, the result would likely be the kind of chaos--and bailouts--that followed the failure of Lehman in September 2008. 12) A resolution authority as sought by the Obama administration could help under some circumstances but is far from a magic bullet in the global world of modern finance. Some of the most severe complications of the Lehman bankruptcy occurred not in the United States, but in other countries, each of which has its own laws for dealing with a failing financial institution. These laws are often mutually inconsistent and no progress is likely toward an integrated global framework for dealing with failing cross-border banks. When a bank with assets in different countries fails, it is in each country's immediate interest to have the strictest rules on freezing assets to pay off domestic creditors (and, in some jurisdictions, to protect local workers). No other G-20 country, for example, is likely to cede to the United States the right to run a resolution process for banking activities that are located outside the U.S. 13) More broadly, solutions that depend on smarter, better regulatory supervision and corrective action ignore the political constraints on regulation and the political power of today's large banks. The idea that we can simply regulate huge banks more effectively assumes that regulators will have the incentive to do so, despite everything we know about regulatory capture and political constraints on regulation. It assumes that regulators will be able to identify the excess risks that banks are taking, overcome the banks' arguments that they have appropriate safety mechanisms in place, resist political pressure (from the Administration and Congress) to leave the banks alone for the sake of the economy, and impose controversial corrective measures that will be too complicated to defend in public. And, of course, it assumes that important regulatory agencies will not fall into the hands of people like Alan Greenspan, who believed that Government regulation was rendered largely unnecessary by the free market. 14) The ``rely on better regulation'' approach also assumes that political officials, up to and including the president, will have the backbone to crack down on large banks in the heat of a crisis, while the banks and the Administration's political opponents make accusations about socialism and the abuse of power. FDIC interventions (i.e., taking over and closing down banks) currently do not face this challenge because the banks involved are small and have little political power; the same cannot be said of JPMorgan Chase or Goldman Sachs. 15) There are no perfect solutions to the problem we now face: a handful of banks and other financial institutions that are too big to fail. The Volcker Principles are sound--we should reduce the size of our largest banks and ensure that banks with implicit (and explicit) Government subsidies are not allowed to engage in risky undercapitalized activities. 16) However, the proposed details in the Volcker Rules do not go far enough. We should put a hard size cap, as a percent of GDP, on our largest banks. A fair heuristic would be to return our biggest banks to where they were, relative to GDP, in the early 1990s--the financial system, while never perfect, functioned fine at that time and our banks were internationally competitive, and there is no evidence that our nonfinancial companies were constrained by lack of external funding. (More details on this proposal are available in ``13 Bankers''.) 17) Much stronger capital requirements will reduce the chance that any individual financial institution fails. But financial failure is a characteristic of modern market economies that cannot be legislated out of existence. When banks and nonbank financial institutions fail, there is far less damage and much less danger if they are small. ______ FOMC20050202meeting--147 145,MR. HOENIG.," Thank you, Mr. Chairman. For the economy, growth currently remains above trend and, as we all know, is likely to remain above trend several quarters forward. As a result, we are systematically approaching long-run potential GDP for the economy. I expect growth will be near 4 percent this year—above trend. There are obvious reasons for this: monetary policy remains accommodative, consumer spending on goods and housing is strong, and business equipment spending is strong. While fourth-quarter growth was below expectations, final sales to domestic purchasers were at a robust 4.3 percent pace. And I think the labor market continues to improve. Evidence from our District is very much in line with this outlook. Most retailers we contacted said that holiday sales were moderately higher than a year ago, and many said that sales were above their plan. In addition, many ski resorts in our region reported sharp increases in hotel occupancy and a near-record volume of ski visits, many from foreigners. Job growth picked up in December. Hiring announcements since the last FOMC meeting exceeded layoff announcements by a margin of two to one, and a substantial fraction of small and midsized manufacturers said that they plan to increase employment in the coming months. District manufacturing continues to expand at a brisk pace; production, new orders, and employment all rose in December, and firms remained upbeat about future activity. Capital spending plans for 2005 are reported strong. We all know where the price indexes are right now but, looking to the future, I would expect to see further increases in core inflation. With the federal funds rate below the lower bound of most estimates for the neutral rate, I remain alert to the greater or increasing risk of inflation. In addition, there are several other reasons to think that this upside risk may be rising. First of all, as others have said here today, we are hearing more about the return to pricing power. Further, a greater pass- through of higher commodity prices seems to be occurring. The possibility of continued dollar depreciation is strong, as is a greater pass-through of higher import prices. And slowing productivity February 1-2, 2005 101 of 177 Evidence from the District supports these observations. For example, the fraction of businesses reporting labor shortages was 53 percent in January, up significantly from last quarter and last year. As a result, wage pressures in the District have also increased. About 26 percent of the employers contacted in January said that they had to boost wages more than normal as compared to 17 percent last quarter and 11 percent a year ago. In addition, our manufacturing survey showed evidence of greater pricing power. For example, among respondents reporting higher input prices, the share who also reported higher output prices has risen markedly, from 40 percent in the fourth quarter of 2003 to 60 percent in the fourth quarter of 2004, the same as before the recession. Similarly, among those who expect to pay higher input prices going forward, those who also expect to charge higher output prices has risen markedly from 41 to 51 percent. In summary, the outlook for the nation and our region is certainly good. Growth is robust, and we are hearing increasingly that there is a lot of money looking for opportunity. I would submit that the risk of higher inflation, therefore, is now large enough that we should at least be thinking about raising rates more aggressively toward neutral than we have in the past. Thank you." FOMC20061025meeting--160 158,MR. KOHN.," Thank you, Mr. Chairman. I support keeping rates unchanged and alternative B. I think that rate, at least for now, seems consistent with growth of the economy just a tad below the growth of its potential and a gradual decline in inflation. Incoming data will tell us if we’re wrong on that, but right now that looks like our best bet to accomplish the objectives I think the Committee ought to be accomplishing. I agree that the pace and the extent of disinflation are great uncertainties here. President Poole has made a valuable contribution here about the loss function relative to the policy path. A failure to reverse the earlier increase in inflation is the main risk to good economic performance that we face. Therefore, we need to see a downward path of inflation. I think our minutes and our speeches have made it pretty clear that that’s what the Committee means by inflation risks remaining. I think the public understands that. President Poole has made a valuable distinction between the loss function and the economic outlook and what that implies for interest rates, but I don’t agree with his conclusion. After all, the Greenbook forecast has essentially a flat federal funds rate and a very, very gradual decline in inflation barely along the path that most Committee members could tolerate. If our loss function is asymmetrical relative to that, it’s more likely that interest rates would have to rise than to fall relative to the Greenbook path. Moreover, many members of the Committee seem to have a stronger path for output, and maybe even inflation going forward, than is embedded in the Greenbook. So the wording about additional firming that may be needed, the asymmetrical wording of a risk assessment, is the appropriate representation of how this Committee is looking at the potential future path of interest rates given both the loss function and the Committee’s outlook for growth and inflation. I do have some comments on the language. In section 2, I like the addition of the forward-looking language and, unlike President Fisher, the use of “moderate.” It seems to me that the word “moderate” is fairly ambiguous, but it does suggest that we don’t expect a great deal of weakness going forward or a great deal of strength. I think that’s about where the Committee is—growth close to, maybe a bit below, the growth of potential, and the word “moderate” conveys the sense that the Committee wasn’t looking for something really weak or something really strong going forward. So I think that was a valuable addition. Like you, President Fisher, I did wonder about the specific reference to the third quarter and how that would play out. Governor Kroszner actually brought this to my attention on Friday. The advantage of the reference to the third quarter is that, by our acknowledging a weak third quarter, the markets might not react as strongly to a print that begins with the number 1 as they would if we didn’t acknowledge that. There are also a couple of disadvantages. The third quarter could come in much closer to 2½ percent. There are a lot of assumptions built into that number. We could be wrong. But even more important, from my perspective, an awful lot of the weakness in the third quarter is in net exports and inventory change. The underlying feel to the third quarter and final demand aren’t really all that different from the second quarter. So emphasizing the weakness in the third quarter in our language may not give a good sense of what we think the underlying situation was. Alternative language might be a more general sentence saying that “economic growth has slowed over the course of the year, partly reflecting a cooling of the housing market.” That more general sentence about “over the course of the year” probably reflects better where the Committee is. I could live with the third-quarter language that’s in there now, but I would have a slight preference for the other one. In section 3, I actually have a slight preference for the wording under alternative A. I’ve always been a little uncomfortable with relating the outlook for inflation to the level of energy prices. The last major increase in energy prices was last spring, and I think they’ve been kind of level since April or May and actually have come down. Some of the commentary after our last announcement pointed out the contradiction in which we have energy prices both pushing up inflation and pulling it down in the future. So my slight preference, again, would be for the wording of alternative A, which says that the high level of resource utilization has the potential to sustain pressures. It doesn’t reference the high level of prices of energy and other commodities. In section 4, the risk assessment, looking at the language that Vincent put on the table yesterday, I think the first sentence of that does a better job of enunciating what the Committee has been thinking about—that the reduction of inflation is what we’re looking at. But I’m hesitant to change the risk assessment language. I think that people do understand what we mean by our risk assessment language now. I am concerned that changing it would provoke a reaction, and I’m not confident that I know what the reaction would be. So my preference, again, is to stick with the current risk assessment language that’s in alternative B. Thank you, Mr. Chairman." FinancialCrisisReport--281 Jason is looking into some adjustments to his [Moody’s] methodology that should be a benefit to you folks.” 1083 In another instance, a difference of opinion arose between Moody’s and UBS over how to rate a UBS transaction known as Lancer II. One senior Moody’s analyst wrote to her colleagues that, given the “time line for closing” the deal, they should side with the investment bank: “I agree that what the [Moody’s rating] committee was asking is reasonable, but given the other modeling related issues and the time line for closing, I propose we let them go with the CDS Cp criteria for this deal.” 1084 S&P made similar concessions while rating three deals for Bear Stearns in 2006. An analyst wrote: “Bear Stearns is currently closing three deals this month which ha[ve] 40 year mortgages (negam) …. There was some discrepancy in that they were giving some more credit to recoveries than we would like to see. … [I]t was agreed that for the deals this month we were OK and they would address this issue for deals going forward.” 1085 While the rating process involved some level of subjective discretion, these electronic communications make it clear that in many cases, close calls were made in favor of the customer. An exception made one time often turned into further exceptions down the road. In August 2006, for example, an investment banker from Morgan Stanley tried to leverage past exceptions into a new one, couching his request in the context of prior deals: “When you went from [model] 2.4 to 3.0, there was a period of time where you would rate on either model. I am asking for a similar ‘dual option’ window for a short period. I do not think this is unreasonable.” A frustrated S&P manager resisted, saying: “You want this to be a commodity relationship and this is EXACTLY what you get.” But even in the midst of his defense, the same S&P manager reminded the banker how often he had granted exceptions in other transactions: “How many times have I accommodated you on tight deals? Neer, Hill, Yoo, Garzia, Nager, May, Miteva, Benson, Erdman all think I am helpful, no?” 1086 1083 2/20/2007 email from Mark DiRienz (Moody’s) to Robert Miller (Chase), PSI-MOODYS-RFN-000031. See also 4/27/2006 email from Karen Ramallo to Wioletta Frankowicz and others, Hearing Exhibit 4/23-18 (“For previous synthetic deals this wasn’t as much of an issue since the ARM % wasn’t as high, and … at this point, I would feel comfortable keeping the previously committed levels since such a large adjustment would be hard to explain to Bear .… So unless anybody objects, Joe and I will tell Bear that the levels stand where they were previously.”). 1084 5/23/2007 email from Yvonne Fu to Arnaud Lasseron, PSI-MOODYS-RFN-000013. 1085 2/23/2006 email from Errol Arne to Martin Kennedy, and others, “Request for prioritization,” PSI-S&P-RFN- 000032. 1086 8/1/2006 email from Elwyn Wong (S&P) to Shawn Stoval (Morgan Stanley) and Belinda Ghetti (S&P), Hearing Exhibit 4/23-13. CHRG-111hhrg74855--8 Mr. Waxman," Thank you very much, Mr. Chairman. Today we are examining whether the derivatives reform legislation reported out of the House Agriculture Committee could disrupt the Federal Energy Regulatory Commission's current regulation of critical regional electricity markets. The pending legislation is intended to bring greater transparency and accountability to derivative markets. I absolutely support that goal however the bill's broad definition of swaps is so inclusive that it threatens to displace comprehensive FERC regulation over regional electricity market products. The bill could be read to assign exclusive and mandatory authority over those products to the Commodities Futures Trading Commission. In 2000 and 2001, California experienced a severe energy crisis. There were blackouts. There was economic chaos. Energy prices in the State skyrocketed. We were being victimized by unscrupulous traders in both power and transmission rights. FERC, at the time, was soundly asleep and unresponsive to the alarms we raised. But in the wake of that California energy crisis, Congress amended and Mr. Markey indicated he was the author, changes in the Federal Power Act to give FERC authority to prevent and punish fraud in market manipulation. We thought FERC had that authority but during that period of time, they claimed they needed clearer statutory authority. Well, if the legislation reported out of the Agriculture Committee is not adjusted to preserve the authority of FERC, it could undermine authorities that Congress gave FERC in the aftermath of that energy crisis to investigate and penalize market manipulation. FERC has strengthened its monitoring and enforcement practices. No one, including the CFTC or sponsors of H.R. 3795, has suggested to us that the current regulatory regime to prevent market manipulation or abuse in FERC's organized regional markets is broken, so we need to ensure that efforts to strengthen derivative regulation don't weaken existing regulation. Before H.R. 3795 is considered on the House floor, members need to understand how it would affect the organized regional markets FERC has created and comprehensively regulated pursuant to detailed tariffs. These markets not only exist because FERC created them, the products traded in these markets are directly linked to the physical limits of the transmission system and are not traded on broad exchanges. We need to make sure that the legislation doesn't unintentionally displace FERC as the regulator of the markets FERC has created. This hearing is an important opportunity for us to find out what impact the proposed legislation may have on these critical markets and what changes to the legislation may be appropriate. I appreciate the expert witnesses here to help us understand its implications. Our committee has a tradition of acting only on the basis of a thorough understanding of the issues before it and I believe we can help to improve H.R. 3795 before it is voted upon. And I believe we are going to need changes in that legislation that is reported out of the Agriculture Committee to make sure that we don't have consequences that would be harmful to what the good job that FERC is doing in this regard and should continue to be able to do. Thank you, Mr. Chairman. " FOMC20080430meeting--243 241,MR. LACKER.," Thank you. This represents a once-in-a-generation opportunity to reengineer our monetary policy operational framework, and I think it's important that we do our best to get it right. I want to start by applauding the staff for taking a very deliberate, very thoughtful approach to this project. I was able to attend the workshop on foreign central banks' operations. I found it very illuminating, instructive, well organized, and well thought out. So far the work has been well organized, and the broad-based involvement has been very good. I want to compliment you on sifting down. The combinatorics must have been mind-boggling given the number of free parameters in the design of one of these schemes. I want to applaud you for boiling it down to a good, representative set that spans everything that I think we'd want to consider. What you produced--with one slight exception that I'll talk about in a bit--is a very thorough and careful analysis. In Richmond, we have thought about the issue of interest on reserves for many, many years--even before the Congress considered it. Toward the end, I'm going to argue that option 4 deserves serious consideration, and I'd like to see you focus on that as well as the other options going forward. Before I do, though, I want to comment briefly on the objectives. You asked for feedback on this. In particular, I think objective 3 needs to be interpreted very carefully. The report often seems to interpret objective 3 as implying that anything that reduces the amount of lending in the fed funds market must reduce financial market efficiency. I just don't think that's right. The prohibition of interest on reserves is obviously a tax on reserve holdings. You have focused on the tax that it implies on reservable liabilities, but the fact that we also don't pay interest on excess reserves is a tax on excess reserve holdings. If we eliminate reserve requirements and we still don't pay interest on reserves, we'll still be taxing reserve holdings. That gives rise to inefficiencies for the same reason that the lack of interest on currency gives rise to inefficiencies, and so in this setting, obviously banks do a lot of things to avoid the reserve tax. Some of the measures involve a lot of monitoring of the reserve account, monitoring of the prospective payment flow, and making sure that they can predict where they're going to be at the end of the day. But some of the measures undoubtedly involve some transactions--such as fed funds loans, purchases of Treasury securities, repo lending, and the like--that are aimed at minimizing their non- interest-earning balances. Such transactions are exactly analogous to the classic shoe-leather costs of inflation. Additional transactions that are induced by the tax on currency are a waste. Reducing the inflation tax results in fewer trips to the bank or to the ATM to get money out, and that reduction is a good thing, not a bad thing. It would be a benefit, and that is exactly what it means to reduce the dead weight burden of inflation. Similarly, I think that paying interest on excess reserves will reduce transaction volumes in the fed funds market, but we should count that as a benefit, not a cost. Put more generally, the effectiveness of a market isn't the same as the quantity of transactions. I bring this up because one of the main objections to option 4, at least in the report--it didn't appear in the slides--is that it could reduce fed funds market lending. I think it should be obvious at this point why that wouldn't necessarily be a bad thing. It's sort of like saying that reducing inflation would be a bad thing because people would make fewer trips to the bank. I don't think you'd say that. Even if we believed that fed funds volume is important, I think a quick look at the numbers would suggest that it's not likely to be that big a problem. The staff estimates that the fed funds market is about $225 billion, on average. So how much by way of reserves will we need to add to ensure a negligible chance that our autonomous reserve factor drains reserves enough to drive the funds rate up? You showed a graph, and there was a flat spot, and you had supply way, way, way out on the curve. But it doesn't need to go out that far. It just needs to go out so that you'd know that you're not going to accidentally go in on the upward part. My reading of your intermeeting report is that reserve misses are typically on the order of $1 billion or $2 billion. I think the average absolute value is about $990 million. Two is pretty rare. It happens every now and then. So it seems as though $5 billion would do plenty. The report says that $35 billion would be how much reserves you'd need to add. I'm a little curious about where that number came from. It's hard for me to believe we'd need that much. But certainly more broadly than that, if you think about the market, is that right now $225 billion in lending is going on. If you do the thought experiments about current equilibriums and you are a bank that just walks into the market and needs some reserves, will it be hard to get reserves? Well, you're going to run into $225 billion worth from banks that are already lending their reserves with interest. So if you're going to get your loan, you're going to have to pay a competitive rate and shake loose some money from one of them. If we are paying interest on $35 billion in reserves, will that change that calculus much? I don't think so. I think that your markets are still going to work the same way. If you want reserves, you're going to have to pay a competitive rate for them. If you're not getting reserves at that rate, you're going to bid up until you get them. So I just don't quite get this concern about the volume of transactions in the funds market. A related objection is the issue of hoarding--the idea that one bank might decide to hold a whole bunch of reserves. The staff cited the example of New Zealand. I thought that was a really interesting discussion at the workshop. One bank accumulated $8 billion or $9 billion in reserves, I think it was, which was large for them, and they had to add a large amount of reserves to accommodate that demand plus the demand of other banks in the system. Now, the problem for the Bank of New Zealand is, as I understand it, that the government doesn't issue debt. When they have to issue deposits, they have to acquire foreign exchange reserves, and that involves a fiscal risk that they're reluctant to take on. My sense of the conversation is that they don't like to accumulate foreign exchange reserves. We seem to be quite willing to expand our balance sheet. Plus, there are plenty of government securities around. So I just don't see why it would be a problem for us if reserve demand was unexpectedly high or some bank decided to hold $50 billion in reserves. I want to talk about one more thing, which is the issue of the rate. The way you have written it up is that what we target now is the average rate of brokered deposits. You said it was $80 billion to $100 billion out of $225 billion, on average--so less than half the market--just the weighted average of trades during the day that go through brokered channels. That doesn't include direct credit funds. The approach you envisioned is that we try to set a remuneration rate so that the effective rate, that average, comes out at the target rate that the Committee sets. A very natural alternative, it seems to me--and I think this is the way the Bank of England does it--is that our policy rate is now the deposit rate. When we issue a press release, we say we're changing the policy rate--I don't know whether or not we would rename it. Now, you folks estimate that the risk premium that would, on average, be the gap between this deposit rate and this effective fed funds rate you measure might be 10 basis points. We now set the funds rate target in � point increments. In theory, we could set our policy rate 10 basis points below � point increments. That seems a little bizarre. I'm not sure that we have such precise confidence in the optimal funds rate that we'd know that it should be on the � point and not 10 basis points below or above. It strikes me that a natural version of option 4 or any of these options would be to set the remuneration rate at � point increments and have that be the policy rate, and just make that the reference point for how we do. Admittedly, econometricians would have to do a lot of work in the future to splice these series together, but I think that's a workable alternative we ought to think about. I think that option 4 has some obvious benefits over the other options. Intuitively, if you were given a limited budget and were asked to peg the price of a commodity--minimize the variance of a commodity price around a given target--your natural inclination would be to stand ready to buy and sell that commodity at the target price. That would be, right out of the box, the first thing every economist would say. Option 4 is the closest practical analogue to that. It's clean. It's simple. I think it's eminently workable. I just don't see the force of the objections. In comparison, option 5, which is the one that comes closest to option 4, involves the monitoring of voluntary targets. You have to monitor these bands. You have to check the balances every night against the bands. It just seems like a lot of superfluous machinery. Option 4 would go furthest toward reducing our dependence on forecasting uncertain autonomous factors. It would also go furthest toward solving the problem that the primary dealer credit facility has given rise to, which has been particularly acute in the last intermeeting period, which is that rates are firm. You've done a pretty good job with the average daily rate, but it crashes at the end of every day. More than half the time you look at the low for the day and it's under 1 percent. It's like � percent. So we have a chronic intraday problem of rates being firm and then crashing because you don't know. Primary dealers come in, that stuff goes on the market, and the rate crashes. I think option 4 would also be the most transparent approach. It would be the easiest to explain to people. It would go furthest toward eliminating the risk of the downside target misses and concerns about stealth easing. Option 4 would also facilitate long-run moves toward lesser lines of daylight central bank credit, and I think that's an important consideration. It shouldn't be the deciding consideration, but it is important. In terms of the timeline, you have yourselves focusing on two options before the results of the public comment come in. To some extent that's prejudging where the public comment is going to come in. So, in short, option 4 strikes me as the most straightforward and practical way to do it, and I'd urge that we direct the group, which has done great work so far, to focus on option 4 and to keep it as a live option. Thank you, Mr. Chairman. " CHRG-111hhrg63105--8 Mr. Peterson," Thank you, Mr. Chairman, Ranking Member, and good morning everybody. Thank you, for holding this hearing today. The Subcommittee and this Committee started looking into excessive speculation in the derivatives market more than 2 years ago before the evidence of the financial crisis actually started to appear. We passed bipartisan legislation to bring greater transparency and accountability to the derivatives market, and many of the Committee-passed provisions were included in the Wall Street Reform and Consumer Protection Act which was signed into law this past summer. There are many important provisions within this law, but the one we are addressing today is the speculative position limits. The law sets a deadline of January 17, 2011, for the CFTC to announce the proposed rule for this provision, but recently many have expressed concerns about the CFTC meeting this deadline. While the CFTC has held seven open meetings to write rules for the law's many provisions, most recently on December 9th, speculative position limits have not yet been addressed, and this leaves little time for the Commission to address this issue. It is important that the CFTC remain on track and implement the Wall Street Reform and Consumer Protection Act in a timely manner and as Congress intended. I understand that there is another meeting being held tomorrow and that the position limits will be addressed at this time. I think that is good news. But I question whether this could have happened earlier. I want to welcome Chairman Gensler and Commissioner Chilton to the Committee today. We appreciate the good working relationship that we have had and look forward to working with you as we go forward. As I say, we have worked closely together and hope that we could help you in implementing this law. So I look forward to hearing your testimony, along with the rest of today's witnesses, and again thank the chair for his leadership on this issue. [The prepared statement of Mr. Peterson follows:] Prepared Statement of Hon. Collin C. Peterson, a Representative in Congress from Minnesota Good morning, and thank you Mr. Boswell for holding today's hearing of the Subcommittee on General Farm Commodities and Risk Management. This Committee started looking into excessive speculation in the derivatives market more than 2 years ago, before evidence of the financial crisis started to appear. We passed bipartisan legislation to bring greater transparency and accountability to the derivatives market and many of the Committee-passed provisions were included in the Wall Street Reform and Consumer Protection Act which was signed into law this past summer. There are many important provisions within this law, but the one we are addressing today is speculative position limits. The law sets a deadline of January 17, 2011 for the CFTC to announce the proposed rule for this provision, but recently many have expressed concerns about the CFTC meeting this deadline. While the CFTC has held seven open meetings to write rules for the law's many provisions, most recently on December 9, speculative position limits have not yet been addressed. This leaves little time for the Commission to address this issue. It is important that the CFTC remain on track and implement the Wall Street Reform and Consumer Protection Act in a timely manner and as Congress intended. I understand there is another meeting being held tomorrow and that speculative position limits will be addressed at this time. This is good news, but I question whether this could have happened earlier. I want to welcome Chairman Gensler and Commissioner Chilton to the Committee today. We have worked closely over the last few years and I look forward to continuing this relationship as you move ahead with implementing this law. I look forward to hearing your testimony, along with the rest of today's witnesses and again thank the Chair for holding this hearing. " FOMC20070628meeting--247 245,MR. POOLE.," Well, I’m sort of asking him to reflect on that. [Laughter]" FOMC20080430meeting--194 192,MR. WARSH.," Thank you, Mr. Chairman. I can support alternative B, but I must admit I can't do it with the conviction that I would prefer to have. I think market participants will look at our decision today and at the data over the next few weeks and try to measure whether we can hold up to the pause language that accompanies alternative B. Taking action with a 25 basis point move today, we have to then be prepared to stomach the continued weakness in the real economy that is in many of our projections. Speaking for myself, I'd say we also have to be prepared when we next meet to hold the line even if we see a retracing of some of the improvements in financial markets. So in my own base case, the judgment when we next meet will be a harder one. The economy might look weak; financial markets might look weaker than they are; and trying to signal to the markets in alternative B that we are serious about holding the line at what would then be 2 percent is putting a pretty hard task on us. I think we're capable of holding the line there, but we have to hold ourselves to that standard. The 25 basis point move, in and of itself, doesn't strike me as that consequential. What strikes me as consequential is the symbolism. Given the uncertainties that Dave and the team have spoken about, it strikes me that the 25 basis points is not nearly as consequential in effect as what might well happen to the transmission mechanism and the efficacy of this change in federal funds rates on the real economy. Put differently, if the financial markets can get back to business, they will be helping the real economy, in effect lowering the cost of capital far more than our actions would today. As I said, I think the symbolism here does matter. By moving 25 basis points today, we're taking some risks with the dollar. I think that the dollar improvement we have seen over the past several days and weeks has occurred because there's an expectation that we are closer to a pause and that this Committee is going to have a tougher decision about whether or not to move than they had anticipated some weeks ago. Even though the language in alternative B is useful in trying to lay the factual predicate for a pause when we next meet, there will be a lot of folks who will be wondering about our convictions there, and when they do, I think we are assuming some dollar risks. We are also assuming incremental risks on the inflation front. Continued easing could well encourage the perception that the FOMC has a greater tolerance for inflation than is prudent, with potential adverse effects on inflation expectations, a further run-up in commodity prices, and a continued decline in the foreign exchange value of the dollar. So this is a tough judgment that we're making, with significant uncertainty. I take comfort in believing that the language in the minutes and the remarks that we all offer between now and the next time we meet will suggest not that this is a cut with a dovish pause but that this is a cut with an expectation of holding after our actions today. We are not barring all events because we can certainly imagine the world turning yet again and we can certainly imagine another let-down, particularly in the global economy. But this is a statement that we want to hold after our action today and that we are prepared to stomach some additional bad news with respect both to the economy and to financial markets. Thank you, Mr. Chairman. " FOMC20080430meeting--182 180,MR. FISHER.," Well, Mr. Chairman, I was listening very carefully to Governor Kohn, as I do the rest of my colleagues. I noted your comment that it doesn't buy us much. I'm worried that it may cost us much. Had I gone first, I would have made arguments similar to those of President Plosser and President Evans. I am in favor of a pause. I think that is pretty clear. I want to stress a couple of things I mentioned yesterday because I think they're important. I am concerned about our costs regarding what I call a different kind of adverse feedback loop, which is the inflation dynamic whereby reductions in the fed funds rate lead to a weaker dollar and upward pressure on global commodity prices, which feed through to higher U.S. inflation and to cutbacks in consumption by consumers and actions by employers to offset the effects of inflation. I quoted a CEO, whom I consider to be very highly regarded, regarding his company's behavioral patterns. This is someone, by the way, who was in the business in the 1970s. He said, ""We're learning to run a business, once again, in an inflationary environment."" That quote bothers me because it shows a behavioral response. This goes beyond the issue, but I thought that comment you made yesterday about relative prices, Mr. Chairman, was very interesting. But it shows a behavioral response, and behaviors eventually become habits, and habits become trends, and I'm worried about that. There was a period when I felt that we were at risk of a repetition of the 1930s. I think the liquidity measures that we have taken--which I have fully supported, and I applaud you, Mr. Chairman, and the New York group for thinking these through with the staff--have provided the bridge that we spoke of yesterday. Don, you mentioned the 1970s. I am no longer worried about the 1930s, although I think there are tripwires out there that are very, very serious. You pointed to them in your intervention. You are right; under Bill Martin these pressures were put in place. But somebody mentioned yesterday--it may have been Vice Chairman Geithner--that he wasn't around in the 1970s. I actually sat by President Carter's side when he got lectures from a leftwing socialist named Helmut Schmidt and by a right winger named Margaret Thatcher. Their points were that you cannot risk appearing to be complacent about inflation. I worry that we risk appearing to be complacent about inflation. I am speaking within the family here, but I sense that we are giving that appearance on the outside. The question really is, Is it worth � point? What is the risk�return tradeoff here? I don't think it's worth cutting � point. I think it is worth staying where we are. I know that the markets anticipate X or Y. We had a conversation about that yesterday. I made my living in the markets. The markets come and go, and I am happy to hear Governor Kohn say that we are not influenced by the markets. I don't think we should be. Their reactions are momentary. But I just don't feel the risk�return tradeoff makes it worthwhile for a � point cut here unless we saw evidence of substantial downside slippage beyond what we are all discounting for housing, which is very negative. I have spoken about a price correction of 35 percent from peak to trough, and we're not there yet. It would have to be more negative than that to convince me to cut rates further. So, Mr. Chairman, I respectfully submit that we should pause, and that's how I plan to vote. Thank you, Mr. Chairman. " fcic_final_report_full--270 Merrill’s then-CFO Jeffrey Edwards indicated that the company’s results would not be hurt by the dislocation in the subprime market, because “revenues from sub- prime mortgage-related activities comprise[d] less than  of our net revenues” over the past five quarters, and because Merrill’s “risk management capabilities are better than ever, and crucial to our success in navigating turbulent markets.” Providing fur- ther assurances, he stated, “We believe the issues in this narrow slice of the market re- main contained and have not negatively impacted other sectors.”  However, Edwards did not disclose the large increase in retained super-senior CDO tranches or the difficulty of selling those tranches, even at a loss—though spe- cific questions on the subject were raised. In July, Merrill followed its strong first-quarter report with another for the second quarter that “enabled the company to achieve record net revenues, net earnings and net earnings per diluted share for the first half of .”  During the conference call announcing the results, the analyst Glenn Schorr of UBS, a large Swiss bank, asked the CFO to provide some “color around myth versus reality” on Merrill’s exposure to retained CDO positions. As he had three months earlier, Edwards stressed Merrill’s risk management and the fact that the CDO business was a small part of Merrill’s overall business. He said that there had been significant reductions in Merrill’s re- tained exposures to lower-rated segments of the market, although he did not disclose that the total amount of Merrill’s retained CDOs had reached . billion by June. Edwards declined to provide details about the company’s exposure to subprime mortgage CDOs and any inventory of mortgage-backed securities to be packaged into CDOs. “We don’t disclose our capital allocations against any specific or even broader group,” Edwards said.  On July , after the super-senior tranches had been accumulating for many months, Merrill executives first officially informed its board about the buildup. At a presentation to the board’s Finance Committee, Dale Lattanzio, co-head of the Amer- ican branch of the Fixed Income, Currencies and Commodities business, reported a “net” exposure of  billion in CDO-related assets, essentially all of them rated triple- A, with exposure to the lower-rated asset class significantly reduced.  This net exposure was the amount of CDO positions left after the subtraction of the hedges— guarantees in one form or another—that Merrill had purchased to pass along its ulti- mate risk to third parties willing to provide that protection and take that risk for a fee. AIG and the small club of monoline insurers were significant suppliers of these guar- antees, commonly done as credit default swaps. In July , Merrill had begun to increase the amount of CDS protection to offset the retained CDO positions. Lattanzio told the committee, “[Management] decided in the beginning of this year to significantly reduce exposure to lower-rated assets in the sub-prime asset class and instead migrate exposure to senior and super senior tranches.”  Edwards did not see any problems. As Kim insisted, “Everyone at the firm and most people in the industry felt that super-senior was super safe.”  FOMC20061212meeting--75 73,MR. POOLE.," Thank you, Mr. Chairman. I have to begin by saying that Janet Yellen, without doubt, has provided the most brilliant exposition of “on the one hand and on the other hand.” [Laughter]" CHRG-111shrg53822--29 Mr. Stern," I am not knowledgeable enough a priori to say that we ought to ban some interconnections or some products. What I would say is if we identified interconnections and exposures and potential vulnerabilities that looked like they would lead to serious problems at a number of institutions--that is, if one institution got into serious difficulty, it would spread in substantial ways to others--then it is an opportunity to do one or both of two things; either to push to reduce those exposures as a regulator and/or to figure out how you are going to deal with the spill-over effect should problems arise. That is, how are you going to contain the problems. So I do think that would be a very valuable, important exercise. That is part of my proposal when I talk about---- Senator Bunning. I complimented you in my opening statement, but I did not get to make it. " Mr. Stern,"----preparing for these kinds of problems. Thank you. Senator Bunning. That is all right. For either of the witnesses, what specifically in the bankruptcy laws is not sufficient for resolving financial institutions? Ms. Bair. Well, I go into that in a little more detail in my testimony. I think there are a couple of things. First, there is the ability to set up a bridge bank. I think continuity of operations, especially for the systemic functions, is important to a resolution mechanism. We have it now with banks. We think that works well. Another key difference is how derivative contracts are treated. In a bankruptcy, the derivatives counterparties have the immediate right to close out their position. With Lehman Brothers, you saw a situation where everyone was doing that, grabbing the collateral, selling it off and going out and re-hedging. Senator Bunning. Can I just interrupt you a second? Ms. Bair. Sure. Senator Bunning. Because we had testimony from the Secretary of the Treasury, past and present, and the head of the Federal Reserve, both present and past, that we should not involve ourselves in overseeing derivatives and credit-default swaps. Ms. Bair. Well, yes. Senator Bunning. I mean, sitting right where you sat---- Ms. Bair. You never heard that from me, Senator. No. And I would say, high on the priority of this body should be to review the Commodity Futures Modernization Act. I think that has shackled the ability of regulators to provide greater oversight of those markets. I do not know what they said, but I feel strongly we need greater oversight of those markets. Senator Bunning. So do I. Ms. Bair. Okay. But our resolution mechanism allows us to accept or reject those contracts. We can require the counterparties to continue to perform in those contracts instead of grabbing the collateral. I think that is another key advantage of our process. Senator Bunning. Mr. Sterns, just hold on just a second, while I have Sheila. When do you expect to end the TLGP, and can all banks survive without it? Ms. Bair. We have been trying to ease out of that program. We have put surcharges on the program, and are putting those surcharges into the Deposit Insurance Fund to try to reduce pressure on the special assessment. Senator Bunning. To other banks. Ms. Bair. Yes, exactly, the smaller institutions. We are working to stabilize the situation. We very much want to end it on October 31st. Senator Bunning. Are you going to be able to do that? Ms. Bair. I am optimistic that we will. We will have to wait and see where we are, but I am optimistic that we will. Mr. Sterns, would you like to say something about bankruptcy? " FOMC20061212meeting--25 23,MR. POOLE., I move approval of the Manager’s report and operations. [Laughter] FOMC20070509meeting--82 80,MR. KOHN.," So here is my reasoning. I thought that the average includes lots of episodes of more or less steady growth in steady state and then other episodes of cyclical adjustments. In my mind, we were in the middle of a kind of mini-cycle, which was an adjustment from greater-than-sustainable growth to growth that we hope is sustainable. We’ve seen that the adjustment had already created some inventory overhangs and some changes in capital spending plans. So I thought that, because we’re not at a steady state, things might be a little more uncertain than usual. But I compensated for that by narrowing my confidence bands in ’08 and ’09 [laughter] when I think we’ll be close to a kind of a steady state. On the skews part, like President Geithner, I had downside skews on output. It wasn’t so much housing because I think that, with the adjustment to demand or activity that’s in the staff forecast and my own adjustment to prices, the risks around that are approximately balanced. Nor was it a spreading of problems in the subprime market to other credit markets; I think we’ve seen enough since the subprime problems started to be pretty sure that the risk is no more than the normal kind. Rather, the risk I saw was from concerns about the financial position and the psychology of the household sector and the interaction of those with housing. So it was a spillover in some sense from housing to consumption. The financial obligations ratio is very high. Households, as President Geithner noted, are highly leveraged. One of the surprises to me in the development of subprime markets was apparently how many borrowers and lenders were counting on the future appreciation in houses just to support the debt service, to say nothing of the consumption that must be going on at the same time. I suspect that this is more widespread than just the subprime market. How many households were expecting price appreciation to continue more as it did before rather than to slow down or even for prices to decline (as I think they will), it’s hard to say. But I suspect there are a lot of these households, and I think we could get some feedback there. The staff has the saving rate actually declining in the second and third quarters, and there might be some technical reasons for that. Even to get modest consumption growth, we see a very gradual uptrend in the saving rate over time. That might be the most likely outcome, but it did suggest to me that there is at least some fatter tail on the possibility that households, seeing what’s happening in the housing market and to their financial obligations, will draw back more quickly from spending. When President Geithner and I were in Basel, the most popular question to us was whether capital spending would really pick up again. A number of central bankers doubted that that could happen as long as consumption wasn’t growing more rapidly. But I’m comfortable with the capital spending pattern so long as the consumption pattern looks something like the pattern in the Greenbook and like the one that I have as my most likely outcome. More generally, as you pointed out at one point last fall, Mr. Chairman, I think we’re in a very unusual situation of below-potential growth for an extended period—a situation that is pretty much unprecedented without breaking out one way or another. Some nonlinearity is going to come up and bite us here, and, as I see it, the nonlinearity is most likely in the household sector. Now, if income proceeds along the expected path, it seems to me that there are upside risks to inflation moving down to 2 percent and staying there in our forecast. I think that overall we’re facing a more difficult inflation environment than we have for the past ten years or so: the high level of resource utilization; rising import prices from the decline in the dollar and the high level of demand relative to potential supply globally, including in the emerging-market economies—one thing we heard in Basel was that increasing numbers of these economies are having trouble sterilizing their reserve accumulation and are running into inflation pressures from that happening—higher prices for energy, food, and other commodities; higher headline inflation; and possibly even slower trend productivity growth. I didn’t see a downside skew to any of these things. But, as I thought about the whole picture with all these things seeming to tilt a bit on one side and their interaction, it seemed to me that there was some upside risk to the possibility that inflation expectations would rise rather than stay where they are as assumed in my most likely outcome. Now, for policy purposes, I would weight the upside risk to inflation more than the downside risk to growth, but we’ll get to that later in the day. Thank you, Mr. Chairman." FOMC20060629meeting--183 181,CHAIRMAN BERNANKE.," Well, let me thank you all very much for your extremely helpful and useful comments. I, too, think that we should raise 25 basis points at this meeting. I think it’s justified by the basic economic situation. The greater risk seems to be from inflation. I think also, following some things that President Lacker said, that a credibility–psychology issue is going on here. Late in April, perhaps because of my testimony, we had a small inflation scare. The TIPS spread widened. The commodity prices, metals prices, essentially went vertical for a while. The minutes, my remarks, the remarks of other Presidents and Governors succeeded in bringing those expectations down significantly, even though we had two upside surprises in the CPI during that period. So obviously some connection exists between our talk and market expectations. Having said that, I think we need to do what we say we’re going to do. Now, conditional on what we know today, I should also add that I think we’re getting very close to where we need to be. We don’t know for sure yet. Obviously we have to look for more information, but in our public utterances going forward we should be somewhat more balanced about the risks and also somewhat more uncertain about where we’re going in the future. The risk- management calculations associated with this move are quite difficult. President Poole has mentioned the risk that if inflation expectations get embedded at a higher level, it would be much more expensive to reduce them later than it is to nip them in the bud, so to speak, at this point. That risk argues for moving earlier rather than waiting to see what happens. That being said, I recognize that there are also some downside risks, some potential nonlinearities in housing markets and financial markets. So where I come out is that I think we should move but try to keep our options open and to move slowly if we do move further. With respect to the statement, I’m the first to agree it’s not a work of art. We have a very difficult balancing act here. First, we have achieved some credibility gains in the past few weeks. We’d like to hold onto those or at least as much of them as possible. However, we want to keep our options open for August, and we don’t want to generate in the market a fear that we are completely focused on inflation with no regard for output, the other part of our mandate. It’s a delicate balancing act to show that we are aware of the inflation situation but that we are not single-mindedly focused on the inflation situation. The statement is designed to show that we are cognizant of the inflation risk. We take note of the elevated readings. We mention that inflation risks remain. We also note, however, that output is moderating and give some reasons for that, and we say in section 4 that the moderation in output will reduce some of the pressure. Obviously there’s disagreement about how flat the Phillips curve is, but all else being equal, that will be a factor. Responding to Governor Bies’ suggestion, I think putting that first sentence of section 4 into the rationale in section 3 is more logical, but the way section 3 is structured, first it says, “Here are the things that are slowing inflation,” and then it says, “But here’s what we’re worried about.” So if we put it there, it will downgrade it somehow; if we put it in section 4, it will say that we are aware of the output risk. There’s also perhaps a subtlety in section 4 that the firming will depend on the evolution of the outlook for both inflation and economic growth. That’s actually an adaptation of a suggestion that President Minehan made, and what it does, I hope, is indicate that we’re looking at both variables as we make our decision. So I’m hopeful that this statement will strike the balance between conveying our vigilance, conveying our concern, maintaining our credibility gains, and removing the notions from the market that we are certain we will move in August or that we will pursue inflation single-mindedly at a rapid rate and independent of whatever happens on the real side of the economy. Again, with respect to some of the suggestions that were made, I think they’re all very interesting. President Poole made a very interesting case. I don’t think there’s a consensus for going to the restrictive language right now. However reasonable it may be in principle to use the first sentence in alternative C, section 4, or to say that readings are unwelcome, I fear it will tip the balance toward a higher probability in August; perhaps this nuance is too fine, but I am concerned about the effect on the markets of perceiving the Fed as too aggressive. There is a new Chairman. They don’t know me. As far as they know, I am an inflation nutter, and I want to make sure that they understand that output is one of our concerns. Those were the main points I wanted to make. Governor Bies suggested striking the last phrase in alternative B, section 4. I don’t feel strongly about that. Does anyone have a view on that? Vice Chairman Geithner." FOMC20081029meeting--248 246,MR. KOHN.," Thank you, Mr. Chairman. A number of the presentations yesterday talked about falling off a cliff in the middle of September. I think we need to remind ourselves that we were sliding downhill pretty fast before we hit that cliff. The third-quarter data, which aren't really affected by what happened in the last two weeks of September, indicate that the economy was weaker than we thought at the time of the last FOMC meeting. I think Dave Stockton or Norm Morin noted that about a third of their downward revision reflected incoming data rather than the credit tightening. That was especially true for consumption, with real consumption spending falling through the summer, responding to lower employment and tighter credit. Private domestic final purchases were revised down to a decline of 3� percent in the third quarter after being flat in the first half. Housing price declines picked up in August, and I think the deteriorating economy and concerns about the economy were reflected in increased nervousness in financial markets over the summer into the first half of September. It was really those worries about what the losses were going to be and how they would spread from mortgages to loan books generally--that deepening pessimism--that doomed the marginal institutions like AIG and Lehman and the GSEs. They just didn't have a chance to recapitalize or stabilize themselves when so many of the other market participants were worried about what their own positions would be. The resulting flight to liquidity and safety, the loss of confidence that followed, the deepening gloom, and the failures and near failures and associated losses triggered a tremendous tightening of financial conditions over the intermeeting period--President Yellen and others discussed this--despite the 50 basis points of easing. Even after the 900 point increase yesterday, equity prices are down about 20 or 22 percent over the intermeeting period. The dollar is up 10 percent. Corporate borrowing rates are up for investment-grade corporations 200 to 250 basis points. Banks tell us that they're tightening across every dimension of their lending; and other lenders, like finance companies, are also cutting back very, very sharply. You can see this in autos clearly, but the stress is much broader than just the auto finance companies. We have good programs in place to deal with many of these problems--the capital, the FDIC guarantees, and the Federal Reserve balance sheet facilities--and they are having some effects relative to the freezing up of markets that we had in mid-September. We can see that interbank spreads and LIBOR have come down some. Commercial paper rose, I guess, on Monday with the introduction of our facility. Declines in money market mutual funds have abated, though they're still there, and there are some signs that maturities are beginning to lengthen in funding markets. As these programs are more fully implemented, we'll see some greater effects--including, I hope, some greater willingness to extend credit. I also assume that the fiscal package is necessary, as in the Greenbook ""fiscal stimulus"" alternative. But we need to remember that the improvement we've seen over the last couple of days is relative to a situation in which funding markets were in effect frozen beyond a very short term, and although a sharp snapback is possible, as President Plosser was noting yesterday, I think further gains are more likely to be gradual. In the past few days, the declines in LIBOR have seemed very grudging and gradual, and LIBOR remains quite high--I think close to 75 basis points higher-- relative to what it was in mid-August, before we even cut rates. This was three-month LIBOR that I looked at this morning. In an environment of economic weakness, spreading credit problems, falling house prices, a number of false dawns in this episode so far, and death and near-death experiences, lenders and investors are going to continue to be very cautious and conserve their liquidity and capital. So despite further improvements, financial conditions will remain quite tight. The effects of lower wealth, higher borrowing costs, the stronger dollar, and tighter nonprice terms of credit will play out over the next few quarters, putting downward pressure on an economy that was already in recession. At the same time, heightened uncertainty and fear of future problems caused a sharp deterioration in attitudes and spending even apart from the effects of credit. Judging from the Conference Board index, regional purchasing manager surveys, and anecdotes--including what we heard around the table yesterday--it feels like a recessionary psychology, as I think Charlie Evans called it. Others talked about pulling back and curtailment of discretionary spending in train, and this is not just caused by credit effects. This is just fear. So we've had a downward shift in aggregate demand as well as a movement along the aggregate demand curve, and this downward shift in aggregate demand will propagate through multiplier�accelerator effects even if attitudes begin to improve some. The global dimensions of the shock are important. As we talked about yesterday, heightened risk aversion has had a pronounced effect on emerging market economies as well as on industrial economies. Net exports cushioned domestic weakness in the first half of the year, but with the dollar strong, if anything we'll be absorbing weakness from abroad, not exporting it, as the rest of the year goes on and we get into next year. Growing credit problems abroad will only add to pressures on many large global lenders who might have thought they were diversified geographically. But a little like our U.S. housing market, they will find that diversification doesn't really work when there's a global recession. The net effect of all of this is a much weaker growth path for the economy. In my forecast, I had a somewhat steeper near-term decline in economic activity and a slightly sharper bounceback than the staff, including my fiscal assumption, but I also have the unemployment rate peaking at over 7 percent, as the Greenbook did. With commodity prices plunging, the added slack maintained through several years, and declines in inflation expectations, inflation will be on a clear downward track. In the Greenbook, this downward track for inflation obtained even with the assumption of some rebound in commodity prices and the resumption of dollar weakness. In my forecast for inflation from next year on, inflation was at or below the 1� to 2 percent rate I would like to see as a steady state consistent with avoiding the zero bound when adverse shocks hit. Critically, the downside risks around activity forecasts are huge and tilted to the downside. I think they're huge because we've never seen a situation like this before, certainly not in my experience dating all the way back to 1970, and have only the vaguest notion of how it will play out in financial markets and spending. I think they're tilted to the downside because I, like the staff, assumed a gradual improvement in financial markets. That could be delayed or even go in the wrong direction for a time, further tightening financial conditions. In addition, the effect on spending of the heightened concerns and tighter credit conditions could be larger and longer lasting than I assumed. For some time an important downside risk to the forecast has been a sharp upward revision to household saving as wealth, job availability, and borrowing capacity eroded. I assumed a moderate increase in the saving rate, but I can definitely see the possibility that adverse developments will galvanize a more thorough rethinking by the household sector of what saving is needed, and that will affect investment as well as consumption. We'll get to the policy implications of all of this in the next round. Thank you, Mr. Chairman. " CHRG-111shrg55479--56 Chairman Reed," Thank you, Senator Bunning. Senator Schumer, please. Senator Schumer. Thank you. I thank all the witnesses. Very informative testimony. I am going to make two comments--one to Professor Verret, one to Professor Coates--to which you can comment in writing, because I do not have much time and I want to ask other questions. To Professor Verret, ``Let the shareholders decide,'' as Ms. Yerger points out, is a tautology. Shareholders do not decide now, so just saying let us leave it up to the shareholders and whatever they decide happens happens, in too many instances they just do not have the ability to decide now. Our rules are supposed to let them decide, and you are sort of proposal, well, whatever they say is what they want--not under these rules. You can respond in writing. [Ed. note: Answer not received by time of publication.] Senator Schumer. To Professor Coates, this idea that financial firms, because they could be bailed out, the shareholders would have a different structure, I would like you to ask the shareholders of Citigroup or AIG, former, if they feel that they have done quite well because they have let risks go too far and they were bailed out. In other words, most companies, by the time they are bailed out, their shares are worth very, very little. And I do not think they would have a different structure, and I would argue that the recent history would undercut your argument even further, and that is, allowing risk--because you are a financial firm and you might be bailed out allows you to take risk, and that is fine for the shareholders? They are going to be very wary of risk over the next 5 years, whether they are bailed out or not, because shares went way down. You can respond in writing to that one, but I just do not think the facts, the recent history bears out that hypothesis. Response: One of the most basic and widely accepted principles of corporate finance is that shareholders--who are entitled to all of the upside if a company does well--would rather that the company take more risks than do the creditors, who are generally entitled only to receive back the principal and preset interest on their loans. See R.A. Brealey and S.C. Myers, Principles of Corporate Finance (5th ed. 1996) at 492 (``stockholders of . . . firms [with debt] gain when business risk increases. Financial managers who act strictly in their shareholders' interests (and against the interests of creditors) will favor risky projects over safe ones. They may even take risky projects with negative [net present expected value]''). Nothing in the recent crisis has affected that general conclusion. Higher risk generally means higher return for shareholders, but for creditors, whose return is fixed, risk-taking by corporate borrowers just increases the odds that they will not get repaid in full. Generally, creditors protect themselves against shareholders pressuring companies to take too much risk by negotiating for explicit restrictions in their contracts. For example, a bank loan may forbid a company from reducing its cash on hand below a set level, or from making large new investments without creditor approval. The U.S. Government, as back-stop creditor of all of the major commercial banks (and, as it turned out, AIG, too, even though AIG was not an insured bank), tries to protect itself against excessive risk-taking by setting capital requirements and imposing other forms of regulation on banks. Existing regulations have not proven effective, and many proposals under consideration would strengthen those regulations, and limit further the risks that banks may take with taxpayer funds. Strengthening the hand of shareholders of major banks may undercut those efforts. You are right that not all risks turn out to be good ones for shareholders, and that there are risks that turn out badly for shareholders as well as creditors, as has been the case in the recent crisis. But when the managers of large financial institutions are making decisions, they do not know how the risks will play out. Imagine a manager can choose between two investments, each to be financed partly with $5 of shareholder money and partly with a $5 loan from the creditor. One investment will pay off $5 100 percent of the time--it has no ``risk'', but it also promises no return to the shareholders, since the whole return will go to creditors. The second investment will pay off $10 90 percent of the time, and will generate a loss of $100 10 percent of the time. The second investment is clearly better for shareholders, since (in expectation) it is worth $5 90 percent of the time ($10 less the $5 loan), and -$5 10 percent of the time (loss of their $5 investment). But the second investment involves a risk to the creditors (e.g., the U.S. taxpayers) since it involves a potential loss and an inability by the company to pay back the loan, and is worse for society as a whole. Suppose the managers nevertheless choose the second investment, and it pays off badly--i.e., it generates a loss. With hindsight, shareholders have lost, too, along with the creditors. But that doesn't mean that the investment was bad for the shareholders. It is only after the loss has appeared that the investment looks bad. If they had to do all over again, most diversified shareholders generally would have the managers choose the second investment. This example is stylized, but it is no different in kind than the investment decisions that financial institution managers make every day. Corporate governance rules are changed rarely--you will be writing legislation not for the next 5 years, but for decades, through recessions and boom markets alike, and will apply to a range of publicly held companies. If the managers are forced by strong corporate governance reforms to follow more closely the directions of shareholders, they will tend, on average, to take more risks than they would if shareholder power were weaker. For most companies, creditors can take care of themselves, through contract, and in principle, as the bank regulators can offset any general increase in risk-taking by managers caused by shareholders, by requiring higher capital ratios or imposing more restrictive regulations. But the tendency of bank regulators has been, unfortunately, to fail to impose strict enough regulations to cope with the pressure of incentive compensation and other techniques for tying managers' interests to shareholder goals. General corporate governance changes of the kind being discussed should be written with that unfortunate fact in mind. Senator Schumer. Ms. Cross, the SEC has proposed ``say-on-pay'' for TARP recipients but not for other public companies. If ``say-on-pay'' is a good idea when the Government is a shareholder, why isn't it a good idea for all shareholders? Ms. Cross. Chairman Schapiro has indicated that she supports ``say-on-pay'' for all public companies, and we do not have authority to require ``say-on-pay'' at public companies beyond the TARP companies. Senator Schumer. But you would be supportive of it. Ms. Cross. I cannot speak for the Commission, and the Commission has not taken a position. Senator Schumer. OK. But Chairman Schapiro is supportive of it. Ms. Cross. Chairman Schapiro has said she supports it, and we stand ready to implement it if Congress enacts it. Senator Schumer. OK, good. Mr. Castellani, you note that some of the proposals--and I think that is significant, and I appreciate that. You note that some of the proposals in the Shareholder Bill of Rights are already being adopted by your member companies and reflect an emerging consensus on best practices in corporate governance. Well, if that is the case, then what are you so afraid of? If this is the trend anyway, if you seem to indicate this is the right thing to do, what is wrong with pushing those--you know, I had a discussion with one of your members, and I will not reveal who it is, but he said, ``Look, I am not''--and then he named his predecessor. ``You do not have to legislate for me.'' I said, ``That is my whole point. We are not legislating for you. You are a good CEO, and whether your shareholders made you be a good CEO or not, you would be. But what about your predecessor?'' So, question: Doesn't the Shareholder Bill of Rights create a competitive advantage for the companies that follow the best practices? And why does the Roundtable, most of whom comply, I think overwhelmingly, with some of our proposals, and many comply with just about all of our proposals, why are they going so far to defend the outlier companies for whom the laws are needed most? " FOMC20060920meeting--131 129,MS. PIANALTO.," Thank you, Mr. Chairman. Since our last meeting, I made a special effort to talk with my directors and business contacts about two topics—developments in housing markets and inflation. My District has been growing at a slower pace than most other parts of the country; consequently, housing prices in the District never appreciated as much as those in the hot markets in the country. Nonetheless, a major Realtor in our region told me that houses in his market, which includes the northern half of Ohio and the western half of Pennsylvania, are taking longer to sell and that the average price of houses sold from January to August is down about 2 percent compared with the same period last year. His view is that nationally the housing market still has a way to go before conditions stabilize. Nevertheless, right now he sees only a limited possibility that the adjustment process will cause serious harm to the U.S. economy. Apparently people are not leaving much to chance. I heard a report yesterday morning that sales at religious stores for statues of St. Joseph have been soaring. [Laughter] It seems as though people who are trying to sell their homes are buying statues of St. Joseph because he’s the patron saint of real estate, and they’re burying him next to the “For Sale” sign. Unfortunately, there is no patron saint for central bankers. [Laughter] Some forecasters, like the Greenbook, are expecting strength in the commercial construction sector to offset much of the weakness in residential building. One of my directors, who represents a large national commercial construction firm, has indicated that commercial building in the past few years has been boosted by the growth of health and education sectors. His entire book of business increased 10 percent in real terms this year compared with last, and he is looking to next year to have the book of business increase 3 to 4 percent. However, he is expecting it to be flat in 2008, and his story squares with what I am hearing from bankers as well—namely, that the flow of commercial loans in the pipeline, although not rapidly falling off, is slowing, and it hasn’t been building as it was. The Greenbook baseline captures very well the pattern that I’ve been describing in its projection for nonresidential investment over the next few years. Now, turning to inflation, the two CPI reports that we received during this intermeeting period have not provided me with enough evidence that inflationary pressures have meaningfully diminished. The reports, however, have encouraged me to think that the forward momentum has been broken, but I’d like to see the next few CPI numbers be at least as good as those for July and August, if not better, to be convinced that that momentum has been broken. I’ve heard some hopeful comments regarding inflation in the past few weeks from several of my directors. Just a few months ago they were indicating that elevated energy prices and material prices had provided them with an opportunity to get more-generalized price increases, and they had wondered whether that was going to be a one-time catch-up opportunity or whether it would be persistent. Now it appears to have been a one-time opportunity, which is passing or has passed. Several of my directors reported last week that they have resorted to unbundling their prices to cope with the rising prices of energy and material costs. On their invoices, they are breaking out the price increases that are due to the increased cost of steel, copper, energy, and shipping in order to pass them on. Apparently, their customers are willing to accept price increases that are due to those increased energy and material costs. But the expectation on the part of both buyers and sellers is that, as energy and material costs dissipate, the ability to pass on price increases will be removed. Several of my directors said that they are not planning any price increases for the next year and that they suspect their commodity costs will be lower than they were this year as well. As others have mentioned, there has been some interest in the elevated unit labor costs in the second-quarter productivity and cost reports. As Dave noted, the compensation growth underlying unit labor costs was boosted when the BLS took on board the first-quarter unemployment insurance tax records. There is some suspicion that the dramatic increase in compensation had a lot to do with stock options and incentive pay, but the underlying data are not available yet, so we don’t know for sure. My staff was able to get some summary figures for Ohio. Compensation has been growing steadily in Ohio over the past several years, but the preliminary figures are flat for the first quarter of 2006. However, there was double-digit growth in three sectors—management of companies, finance and insurance, and utilities. These sectors are often the ones that show substantial growth in the first quarters because they pay out stock options and that’s often when those stock options are realized. So at least in my District there is no evidence of any broad-based acceleration in compensation, and I tend to agree with the staff’s view that it’s too early to incorporate those higher unit labor costs into the inflation outlook. At our last meeting, I expressed the opinion that whatever weakness we would see in GDP was more likely to reflect demand factors than supply factors, and therefore I saw risks to both our objectives. The current Greenbook baseline projection for GDP is even lower than it was at the time of our last meeting because of revisions, as Dave mentioned, to both supply and demand factors. I still think that, if the Greenbook projection comes true, softer demand is likely to be the more dominant explanation. Nevertheless, I would like to see further evidence that inflationary pressures have been checked, if not actually reversed, before I would conclude that the risks to our objectives are evenly balanced. Thank you, Mr. Chairman." FOMC20081029meeting--303 301,CHAIRMAN BERNANKE.," Okay. Thank you. Let me just offer some thoughts that may be somewhat more expansive than usual in response to the questions that have been raised. Some of this is extemporaneous, so you'll have to bear with me. Let me first talk about the strategy we pursued thus far and where we are and then think about where we might go as a country as well as an institution going forward. Without going through all of the familiar discussion about how the crisis began, what the sources of it were, I think that the Federal Reserve's responses are essentially three. First, we were relatively early and aggressive in our monetary policy easing, particularly compared with other countries. Second, we have been creative and expansive in our use of liquidity tools, including a wide variety of lending programs. Third, we have used our available, but not always adequate, tools to try to stabilize systemically critical failing institutions and to try to mitigate systemic risk. Without sounding too defensive, I will try to argue that I think on all three of these we have been more or less in the right direction. First, on the early and aggressive monetary policy easing, obviously there was a lot of concern--a lot expressed abroad that we were going to create a stagflationary 1970s type of situation and that we were going to destroy the dollar and its role as an international currency. Our response essentially was that we thought that the increases in commodity prices were mostly a relative price change induced by changes in real demand for commodities and in the supply of commodities across the globe and that, at some point, those commodity price increases would stabilize, which would lead to a moderation of the inflationary effects and concerns. It took longer than we had expected; but once it began, it was more pronounced than we had expected. Inflation has not become the problem that was anticipated by many early on, and the dollar, of course, is now stronger than it was before we began our cutting of interest rates. So in retrospect, I think our monetary policy, although not perfect certainly--and our communication was not always perfect--broadly speaking was appropriate given what has turned out to be a very severe economic situation. Liquidity expansion also received some criticism early on. There was a view that this was inducing moral hazard. There was also some question of whether this was an effective approach. We were helped in this respect by the fact that the ECB joined us very early in this type of aggressive policy. I don't know the counterfactual. It has obviously not solved all of the problems. But I think there's a strong perception in the markets and in the general public that these actions have been supportive, and they helped mitigate the effects of the crisis on the functioning of the financial system. So I feel comfortable also with that approach. The attempts to stabilize failing systemically critical institutions, beginning with Bear Stearns, have obviously been very controversial. There have been criticisms from the right and from the left. From the right, the initial criticism was that we have no business interfering with the market process. We should let them fail. The market will take care of it. What are we doing? We heard this as recently as Jackson Hole. I never took this seriously. I just don't believe that you can allow systemically critical institutions to fail in the middle of financial crises and expect it to be not a problem. I don't want to get into the issue about the inconsistency. It's true that we treated senior debt differently between Fannie and Freddie and WaMu and Wachovia, but I don't think that that is the reason we are having the financial crisis we're having. I think there was a panic brought about by the underlying concerns about the solvency of our financial institutions. That panic essentially turned into a run. Companies like Wachovia that had adequate Basel capital faced a run on their deposits, which was self-fulfilling. The investment banks essentially faced runs. We did our best to stabilize them, but I think that it was that run, that panic, and then the impact the panic had on these major institutions that was the source of the intensification of financial crisis. So I don't buy the argument that we should stay out of the business of protecting the financial system, and I think that the major factor was, in fact, the panic that was generated by the underlying uncertainties and the effect that had on critical institutions. Also more recently we have heard more of a critique from the left, which is, What in the heck were you guys doing letting Lehman fail? This is interesting given that the critique had been the other one for quite a while. I think that critique is unfair at a narrow level in that, first, Lehman was a symptom as well as a cause of the recent crisis and, second, the Fed and the Treasury simply had no tools to address both Lehman and the other companies that were under stress at that time. I think that criticism is appropriate, though, as directed toward the United States as a whole. We did not have--as the Europeans have or as we have FDICIA for banks--a system that was set up to allow a reasonable and responsible orderly resolution of nonbank systemically critical institutions. I think we now have made a lot of progress there. The TARP will provide a good interim solution. It is very important that in the future we address the too-big-to-fail problem that we have, that we find ways to reduce that problem, and that we find ways to deal systematically with firms that are in crisis. So given the fog of war--which has, of course, been intense going back for more than a year--I would defend what we've done in terms of the general direction, acknowledging that execution is not always perfect and that communication is not always perfect. Now, what about the future? History suggests that, whenever a financial crisis becomes sufficiently severe, ultimately the only solution is a fiscal solution, and we will have a fiscal solution. There are two possibilities. One is that the financial system will muddle through, in which case the fiscal solution will be of the sort we've already seen: injections of capital, support for critical firms, support for the credit markets in general; Keynesian-style demand support. That's one possibility. I hope that's where we're going to be. In my own testimony, I argued that we should try to focus whatever stimulus we have in solving the underlying problems rather than simply handing out money and that we could do that, again, by addressing credit markets. I would add, foreclosure, homeownership, and some of those issues as well. So I hope that's where the fiscal policy will be. I hope that will take the lead from us going forward. Obviously, we'll have to continue to play a supporting role in a lot of different ways. The other possibility, of course, is that things get much worse and that we are in the same situation as Sweden or Japan, in which case a massive recapitalization of the banking system will be necessary. That will eventually happen, but I just note that, in all of these fiscal dynamics, there is a political economy overlay. You have to get to the point that it is not only the right policy to induce fiscal support but also that it is politically possible. That's one reason that I think the TARP was not possible before the most recent period. In fact, it was barely possible recently. So, again, I believe that fiscal policy will have to be a critical part of the solution going forward. Another part that we should not forget about is the international response, which is now just beginning really to become serious. The responses after the G7 weekend on banks and bank guarantees were important and suggested a commitment by other countries to stabilize the system. That's very important. I think we will see aggressive monetary policy going forward, and I think we'll see increasingly aggressive fiscal policy in other countries because they recognize that the decoupling is no longer a realistic story. So that's going to be important as well. With respect to the Federal Reserve, just generally speaking--and I'll come back to the specific recommendation for today--again, I think that our liquidity provision has been constructive. It has allowed the use of our balance sheet to help push in the deleveraging process that's been going on now for more than a year. My guess is it will probably expand some more, but I don't see it expanding a lot more, if for no other reason than we are reaching the limits of our operational capacity as well as balance sheet capacity. I think we have been reasonably successful in staying on the side of liquidity provision and not straying into credit or taking credit risk. I want to stay on that side of the line both for legal reasons and because that's the way monetary policy and lender-of-last-resort policy are supposed to work. Again, I hope that the fiscal interventions will now be able to take away some of these responsibilities from us, but we'll have to see how they play out. I confess that I hear President Plosser's concerns about reversing these programs. I recognize that it's something we'll have to do carefully. But I just don't see it as being something that will be a huge problem if the economy begins to recover and credit markets begin to function more normally. I think we'll be able to do it. Japan was able to get out the quantitative easing without too much difficulty. But I acknowledge the point that it is something we're going to have to plan for and think about. On monetary policy, I think it is important for us to be responsive. Even if we stipulate for the moment that the interest rate changes we might make today have a minimal effect on the cost of capital--and I don't necessarily agree with that, but let me stipulate it--there is still the importance of the signaling and what we're trying to tell the markets about what we plan to do in the future. Frankly, I don't think that we should try to signal that we are going to stand pat, that we are reluctant or refuse to move lower. We have to be prepared to move as low as makes sense. By that I mean in part that there are institutional factors that affect the efficacy of monetary policy at very low interest rates. We're all aware of that. I asked yesterday, and I'll ask again, for the staff to go back to the 2003 work, to update it, and to think it through and help us understand what I would call the effective zero. What is the real zero? Is it zero? Is it 50 basis points? Is it 75 basis points? We have to recognize that if we do go to literal zero, it would have very substantial effects on a number of financial markets, and we would have to ask ourselves whether the benefits from that are worth the dislocations. The Japanese thought they were, and for example, they did shut down the interbank market for a long time. Maybe doing it is worth that. Those are decisions that we need to make before the next meeting, and we will have opportunities to talk about this together and in public as well. But I do think that monetary policy needs to be proactive and to continue to be part of the solution here going forward. What about today's action? I essentially accept the general change in outlook as proposed by the Greenbook. Since our last meeting there has been an effective tightening in financial conditions, which has overwhelmed the 50 basis point cut that we did with the other central banks. The outlook has become much worse. So it is important for us to act aggressively and to signal essentially that we're willing to do whatever is necessary to support the recovery of this economy. There has been a lot of talk about confidence. I think the best thing we can do for confidence is to say that we're going to do whatever it takes, even if it involves extraordinary actions, to get this economy back onto a path where it can begin to grow in a reasonable way again. Signaling coyness, being cute, is not a safe strategy right now. We just need to be straightforward and say that we're going to do what it takes. In my view, just to be specific, 50 basis points is the right step today. Now, a number of concerns and objections have been raised. Let me address just a few of them. One is President Bullard's very interesting presentation on the inflation trap, and intuitively it's clear that, for a given real interest rate, you can have an equilibrium at which you have a high nominal rate and a high expected inflation rate or you can have a low nominal rate and deflation. Both of those things are possible. That was the trap that Japan got into. We obviously want to avoid the deflation trap. The question is, How do you avoid it? As far as I can see--obviously we can get further into this--the best two ways to avoid it are, first, as President Lacker suggested, reaffirm our commitment to price stability defined as 1� to 2 percent or whatever our Committee's general view is. We're going to try to do that with our projections and potentially with the trial projection that we're doing, and I think we can continue to strengthen our commitment to maintaining a positive inflation rate. The other thing, in terms of the dynamics, is to be aggressive in trying to avoid getting to a deflationary situation, where those expectations move in that direction. I don't think deflation expectations will arise spontaneously because we're cutting interest rates. I think they'll arise because the economy is expected to be extremely weak, and anything we can do to eliminate that expectation in my view would be helpful. The second objection I've heard is the question of whether or not these actions are effective. I think they are effective. Maybe they're not as effective as under normal circumstances, but let me put it to you this way. If we cut 50 basis points today and the LIBOR�OIS spread rises 50 basis points tomorrow, I will accept that there's a problem. But if the LIBOR spread doesn't move much and the overall LIBOR drops 50 basis points, then I think that we're having an effect. If you look at LIBOR over the past year, you'll see a dramatic decline even though the spreads have widened. I don't think you can argue that we're not having any effect. To the extent that we're having a muted effect, you can just as well argue that we should be more aggressive because you need to do more to get the same impact. So I understand those concerns, and I reiterate, responding to Governor Duke and others, that as we get very low, there are side effects on certain institutions and financial markets. We need to understand those, and that's part of our decision process. But I don't think it's the case that monetary policy has zero impact. The third argument I've heard is the ""keep the power dry"" argument. Unless you think that movements in the rate are entirely psychological in their effect, I don't think that that's a strong argument in this particular circumstance. Again, we analyzed this quite a bit in the 2003 episode, and the general outcome from the literature and from simulations done by our own staff--Dave Reifschneider, John Williams, and others have published research on this--is that the best way to avoid the zero bound is to be more aggressive than normal to try to avoid the accumulation of weakness and try to avoid getting into that trap. So more-preemptive strategies are, in fact, consistent with what we've done for the last year. My recommendation for today is 50 basis points and the language in alternative A. I do think that it will be at least moderately beneficial both in terms of psychology and in terms of reducing the cost of funding and giving some additional support to funding markets. I hope that in these remarks, which again are somewhat extemporaneous, I have addressed to some extent the future steps. We ought, again, to think very hard in the next six weeks about what the real zero is and what the implications are of going below, say, 75 basis points. Then we ought to make a determination, and it may be that we can sit still in December. It may be that things improve quite a bit in the markets, for example. It's possible. One advantage of doing 50 today is that we almost certainly will not have to do anything intermeeting because we will have done this significant step today. So in December we'll be able to look at the situation. We may be able to do little or nothing--it is possible. But if we decide that further action is needed, at that point we should be prepared to decide what the regime is going to be, how far we're going to go, and what the effective zero is, and I think that we shouldn't hesitate to do that if that's what the situation calls for. So I think there is a way forward. I understand the need to withdraw all these policy actions at an appropriate time. But I don't think that focusing on the near term for the moment is at all inconsistent with the fact that at some point these things will have to be reversed. So, any further questions or comments? President Fisher. " FOMC20060629meeting--124 122,MR. POOLE.," Thank you, Mr. Chairman. I’ll start by saying that I support 25 basis points today. Many of us, including especially the Chairman, helped to shape market expectations that we’re going to do that today, and I think not to carry through, given that we shaped market expectations, would be very unfortunate. Before I get to the statement, I want to try to state as clearly as I can what my position is on the substance of what we ought to do, thinking about the clarity in the formulation of the statement as having to precede the discussion of it with the public. I was struck in our discussion yesterday by the differences around the table in the degree of optimism about the real economy. The Greenbook outlook is perhaps on the low side of the range around the table, and some of those who support that view give some weight to the possibility of a weaker outcome than the Greenbook outcome. Others are more optimistic than the Greenbook, and they put some weight on a stronger outcome than even their point estimate. So that produces a range of views about the real economy, but I believe that the range is well within the normal bounds of professional disagreement and well within the normal forecast errors. Now, how would we characterize our policy stance coming out of this meeting, assuming that we raise 25 basis points? I think that the right way to characterize the stance, and this is what I was trying to say in the memo that I distributed earlier, is that a fed funds rate of 5.25 percent would be a stance of mild restraint. Let me give you just a short list of some of the things that lead me to believe that. This list is in no particular order, although I suppose it’s not an accident that I’m going to put money growth at the top of the list. We have slow and, indeed, slowing growth of MZM (Money Zero Maturity) and M2, particularly in recent weeks; I don’t put a lot of weight on the short-run information that we get, but what we see is consistent with the view that policy has mild restraint. We’ve had some persistent increase in real rates of interest this year, particularly, as Jeff Lacker noted, since our last meeting. We’ve had some modest declines in U.S. equity markets—that is consistent with mild restraint. We’ve had some dollar appreciation since the May FOMC meeting. We’ve observed pretty clearly some reduced activity in sectors of the economy that are interest sensitive, particularly housing, and interest sensitivity may have something to do with automobiles as well. There have been some modest declines in commodity prices in recent weeks—again, not very much, just a bit if you look at the chart against the context of what has happened. Perhaps there are some other things that you would want to add to the list, but I don’t see anything out there that would be a clear indication on the other side that would say that it is a glaring exception to the list of things that I’ve given. So I think we have a stance of modest restraint. It could well be that we will need additional restraint in the future, but we should not have a clear presumption that we will be raising the funds rate in the future. The decision in August should depend on all the information that we get between now and August, and we should not try to build in a particular assumption on the policy decision. In fact, if I were to be as neutral as I can be on this, I would say something like 50 percent odds that we would hold steady in August and 50 percent odds of another 25 basis point raise. You could take the mean of that and say, “Well, let’s just be done with it today and raise the funds rate an additional 12½ basis points.” [Laughter] But I think that would be pretty silly. The message we ought to give to the market is that we have mild restraint in place, and we don’t know whether or not that will be enough to do the job. But if we get some unfortunate additional news about the current inflation readings, which I think we could easily get, I don’t want to be in a position in which I have to prove my manhood, so to speak, by proposing that we have more draconian increases in rates. If we believe that we already have mild restraint in place and over time it is going to be enough to do the job, then we don’t want to position ourselves that in response to market expectations we have to act more. Now, I don’t know that we have enough in place, but I don’t want to have a presumption that what’s in place is inadequate at this point. I think that the inflation we have, including the energy situation, is predominantly from worldwide demand; we’re making a mistake if we ascribe very much of it to supply shocks. We’ve had a very strong worldwide expansion. We know that China is soaking up energy like crazy—that’s part of the very strong worldwide demand situation. Of course, some of the Chinese success comes back to produce demand in the United States: They’ve ordered a lot of aircraft from Boeing, for example. Now I’m going to get to the statement itself. All the alternatives help to create a presumption about the August meeting. I understand from the paper this morning that the market has now bid into it a probability of a move in August of more like 85 percent rather than 70. That obviously fluctuates from day to day. But we shouldn’t produce a presumption. The way to avoid creating a presumption but at the same time to emphasize our concern about inflation is to say, as I suggested in the memorandum I distributed, that we believe that we have mild restraint in place, assuming that that view is accepted around the table (which it may well not be), and that we will act in August on the basis of the incoming information, which may change the outlook that we get. So that’s where I come out on this. Thank you." FOMC20070628meeting--115 113,MS. MINEHAN.," Thank you, Mr. Chairman. The pace of growth in New England, at least as measured by employment, remains below that of the nation. Indeed, since the trough of the last recession, New England’s jobs have grown at less than half the pace of the nation as a whole. Some of this is the traditionally slower pace of job formation in the region, and some is undoubtedly the result of the kind of industries— telecommunications and technology more generally—that were hardest hit in the 2001 recession and have yet to recover fully. But some of it also revolves around issues of supply. Almost every firm, large or small, comments on the difficulty of finding skilled labor. There is also reason to believe that, at least relative to the rest of the nation, the supply versus demand imbalance may be a particular issue in the region. This comes from the Conference Board’s online job-posting measure, which for some time has shown New England as having the highest number of advertised job openings relative to the size of the labor force. Contacts report that they are willing to offer—and do offer— higher pay to get the skills they need, but finding the workers is harder to do and takes longer than earlier in the cycle. Another issue that came up again in our round of contacts is the pervasive rise in the cost of almost any metal, but especially copper and aluminum. Contacts at one very large diversified company speculated about China’s stockpiling valuable metals. Whatever the cause, worldwide demand is strong, and prices are rising for all types of metal inputs. Some firms report progress in passing on those price increases. Indeed, larger manufacturing companies appear to be buoyed, if not driven, by strength in foreign markets. One firm reported that their booming aircraft business required such long hours and continued stress on skilled workers to figure out ways to meet demand that employee turnover had tripled. Not surprisingly, year-over-year manufactured exports for the region rose in the first quarter. Elsewhere, news in the region has been fairly positive, with business confidence rising and commercial real estate markets good and improving throughout. Residential real estate markets remain slow. Regardless of what measure is used, the region’s home prices appear to have slowed more than the nation’s. However, although we had led the nation—this is not something in which you want to lead the nation—in the rate of rising foreclosure initiations, especially for those related to subprime mortgages, the pace of this growth has subsided. Indeed, initiations of subprime foreclosures went down in the region most recently. Moreover, in the most recent data on home sales, the Northeast was a bright spot. I have speculated before that the New England residential real estate market could be bottoming out. Such thoughts may remain in the category more of a hope than a certainty, but perhaps the pace of decline is slowing. Finally, while consumer confidence has been bouncy recently, probably from concerns about gasoline prices, demand seems reasonably strong as gauged by local retailers. Software and IT firms are showing considerable strength, and at least in our region, so is temporary help. Coincident indicators of regional health also show solid growth for all six states. In sum, the region appears to be doing fairly well; and except for residential real estate, there are perhaps growing signs of price and resource pressures, in that regard not unlike the nation as a whole. Turning to the nation, I was pleased to see that incoming data validated the substantial pickup in second-quarter growth that we, along with the Greenbook, had forecasted. Indeed, outside of residential investment, incoming data have depicted an economy that is growing at a relatively healthy pace. Data on shipments and orders of capital goods have improved, consumer demand seems relatively well maintained despite high gas and soft home prices, and payroll data show little sign of dwindling labor demand. Markets have at last decided to adopt the Committee’s more positive outlook on economic prospects, and credit was repriced as a result. I view this event as healthy. It has tempered our GDP forecast slightly, but the continued ebullience of equity markets is an important offset. As I noted at our last meeting, we find ourselves a bit more optimistic than the Greenbook about trends in residential real estate, based on new housing starts and data on new home sales most recently, and we have moderated the pace of decline of residential investment for the second quarter just a bit relative to our May forecast. The April value of nonresidential construction put in place was a clear positive as well. The health of the rest of the world continues to surprise, and we, like the Greenbook, expect little drag from net exports over the forecast period. Turning to projections for 2008 and 2009, the factors shaping our outlook haven’t changed much. We continue to see output accelerating mildly as the housing situation moderates and more of the underlying strength of the economy shows through. This is tempered a bit both by rising long-term interest rates and by our expectations that consumers will mend their ways a bit—consume less and save more. This hasn’t shown signs of happening yet. By the end of 2009, GDP is about at potential, unemployment has ticked up a bit but remains below 5 percent, and core inflation moves down gradually to 2 percent—again, not much change and certainly within the central tendency of members’ forecasts. One obvious risk to this forecast lies in housing, as everybody has said. But as I noted at our last meeting, the longer there are no obvious spinoffs from the subprime problem to the wider economy, the more that particular risk seems to ebb. Indeed, as we have yet to see the saving rate pick up with the moderation in consumption over what would be expected by the fundamentals, there may be some upside to growth. Pressures from abroad—worldwide expansion of somewhat larger size than we expected—do raise some upside issues, both for growth and for inflation. On the inflation side, it is true that the April and May core data were encouraging. However, those numbers were dominated by temporary rather than permanent effects, at least in our view. So we haven’t moderated our forecast of core inflation, as have the Greenbook authors, albeit they moderated it only in a very minor way, and I remain concerned about upside risks. Headline CPI inflation has been strong. The unemployment rate and widening concerns about input costs suggest that pressures to raise prices might have grown, and strong growth worldwide affects not only input prices but the value of the dollar as well. If anything, since our last meeting, I think that risks related to growth have abated and have become more balanced and risks regarding inflation have grown. Thus, as we look over the next two and a half years, our forecast sees policy staying somewhat restrictive given the inflation risks and then easing a bit in late 2008 or 2009 to a level closer to its equilibrium rate. Finally, continuing some thoughts I began to articulate at our last meeting, as we think about policy, we also need to be concerned about financial stability. This is particularly true given what we’ve seen in the markets for credit derivatives. We’ve talked before about how high levels of liquidity and low interest rates worldwide cause much reaching for risk, much reaching for return, and related risk-taking. While the Bear Stearns hedge fund issue may well not have legs, the concerns regarding valuation of the underlying instruments do give one pause. Can markets adequately arrive at prices for some of the more exotic CDO tranches? What happens when the bottom falls out and positions thought to be at least somewhat liquid become illiquid? Is there a potential for this to spread and become a systemic problem? Maybe not, and I am not advocating our taking any action as a central bank. But I do think the size of the credit derivatives market, its lack of transparency, and its activities related to subprime debt could be a gathering cloud in the background of policy. Thank you." CHRG-111shrg51395--272 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM ROBERT PICKELQ.1. Do you all agree with Federal Reserve Board Chairman Bernanke's remarks today about the four key elements that should guide regulatory reform? First, we must address the problem of financial institutions that are deemed too big--or perhaps too interconnected--to fail. Second, we must strengthen what I will call the financial infrastructure--the systems, rules, and conventions that govern trading, payment, clearing, and settlement in financial markets--to ensure that it will perform well under stress. Third, we should review regulatory policies and accounting rules to ensure that they do not induce excessive procyclicality--that is, do not overly magnify the ups and downs in the financial system and the economy. Finally, we should consider whether the creation of an authority specifically charged with monitoring and addressing systemic risks would help protect the system from financial crises like the one we are currently experiencing. Would a merger or rationalization of the roles of the SEC-and CFTC be a valuable reform, and how should that be accomplished? How is it that AIG was able to take such large positions that it became a threat to the entire financial system? Was it a failure of regulation, a failure of a product, a failure of risk management, or some combination? How should we update our rules and guidelines to address the potential failure of a systematically critical firm?A.1. ISDA supports legislative efforts to create a governmental authority to monitor, assess and take action to address potential systemic risk within the financial system. This systemic risk regulator should have the authority to: monitor large exposures across firms and markets; assess potential deficiencies in risk management practices; analyze the exposures of highly connected firms; identify regulatory gaps; and have the ability to promulgate rules necessary to carry out its authorities. The powers of the systemic risk regulator should be focused on markets as a whole, and not limited to narrow categories of products or participants. The systemic risk regulator should work cooperatively with other regulators globally to help promote internationally consistent standards. Merger of the SEC and CFTC is a complicated issue which presents many issues extending beyond the OTC derivatives industry. The framework of regulation created by the Commodity Futures Modernization Act of 2000, which provides elements of oversight of OTC derivatives activity by both agencies, has been very successful in promoting the growth of the business in the United States. AIG's ability to take large positions appears to stem primarily from a failure of AIG to follow widely used, generally accepted best practices with respect to collateralization. It appears that a failure of prudent risk management as well as lax oversight contributed to AIG's downfall. The U.S. Bankruptcy Code and Federal Deposit Insurance Corporation Act provide mechanisms for the orderly wind down of qualified financial contracts; these provisions appear to have functioned well during the failures of both banks and non-banks (such as Lehman Bros.). ------ FOMC20080130meeting--253 251,MR. POOLE.," Yes. I am older than Governor Kohn, so I can answer. [Laughter] " FOMC20060510meeting--97 95,CHAIRMAN BERNANKE., I’m still trying to understand that comment about the schizophrenia. [Laughter] President Poole. FOMC20080318meeting--90 88,MR. KROSZNER.," Thanks. I've talked many times before about the slow burn from the financial markets that is spreading out elsewhere. Unfortunately, I think the fire is a bit hotter than I had expected in my earlier discussions, and it comes particularly through capital pressures in the financial institutions. What we're seeing now is the simultaneity of stress in the housing market and stress in the financial markets, and they will be cured together. I think they are joined at the hip. Whether we have tools to address those directly is something we continue to discuss, but I think it is this direct connection that potentially leads to the negative feedback loop that we have discussed quite a bit. For housing, of course, there are the direct negative wealth effects but also the lingering uncertainty of what's going to happen, as many people have mentioned. Part of this comes from just a change in behavior. People are acting very differently during this housing cycle from in the past, so it is very difficult to predict the evolution of foreclosures even given a particular macroeconomic outcome. There's still the uncertainty of the macroeconomic outcome, but people are going delinquent much earlier--they are going delinquent on their houses before they go delinquent on their credit cards--and so it is really a different model of consumer behavior, which makes valuing the securities particularly problematic. This is, of course, in addition to uncharted territory in terms of real and nominal price declines. We'll see exactly how people will respond to these things. Obviously the markets are closed, and the banks have to keep these on their books, with higher cost and more difficulty financing. Some of the changes that came in with the stimulus package to raise the conforming limits for Freddie Mac and Fannie Mae have done little to bring down the spreads because they have significantly increased the cost of the guarantees given this new environment. It's not unreasonable to do that, but the potential benefit from the changes is lower than we might otherwise have hoped for. This is all having consequences for credit cards. Even though at first it was the mortgages, now we're starting to see a significant uptick in delinquencies on credit cards and spending, and a number of people--President Rosengren, President Yellen, and First Vice President Sapenaro-- have mentioned some of these things. I just want to report a bit from my conversations with some of the major credit card companies, which have kind of a window into real-time consumer spending. They are seeing a continuing flattening but not a falloff of growth. There's no collapse but certainly a continued downtrend, as I've been reporting over the past few months--a continuing slowing of payments and a continuing increase in delinquencies. Their so-called roll rates of people moving from 30 days behind to 60 days behind to 90 days behind continue to go up. They are still going up, although not significantly. They are concerned about that, but it is not spiking up. They are mainly concerned about when the roll rate gets into 90 to 180 days. They're not getting their money back. Personal bankruptcies are going up. The cure rates are much lower, and the recovery rates are much lower. So there seems to be a group of people who are getting into extreme financial difficulty. All the series that I've quoted are general averages. The contacts said that in areas of particular housing stress basically all of the numbers are three times as high. It is significantly more stressful there, showing a very clear link between stress in the housing market and these other stresses. Have they been responding? Well, because of very strong pressures that may be coming directly from us and certainly from Capitol Hill, the credit card companies don't respond by changing interest rates. They respond by reducing the amount of credit available, and that's exactly what they've been doing. So they've been cutting credit lines of a lot of people. Also, as I think President Yellen or a number of people mentioned, they're also cutting back on the HELOCs because they have been concerned that people are taking money out when no equity is there, and so they really want to pull back on that. These overall tightening credit conditions are reflecting the continued stress on the balance sheets of banks and financial institutions more generally; as you see with the Bear Stearns example, it's not just the depository institutions but a broader set of institutions that are creating pressures both on the asset side and on the funding side. We have had a lot of the SIVs and a lot of the other assets coming on board. Unplanned asset expansions may continue, particularly if the economy does go down. What now seem to be very good credits in the leveraged lending market may no longer be good credits. So the anecdotal evidence that you've been mentioning around the table could turn into further unplanned asset expansions if these things start to go south. Consumer write-offs, obviously, are another thing that is putting on funding pressure. Also as I think President Evans mentioned, interestingly there have been few actual losses that have occurred on many of these securities in terms of the inability to make the payments, although the losses in the value in the markets have been quite spectacular in some cases. Some of this has to do with the broad evaluation uncertainty. Some of it has to do with liquidity. I think this is where we have the direct link between liquidity and macro stability because the uncertainties in part are coming from the macro uncertainty about how housing markets will evolve. Obviously I have said this before. There are other factors that come in, but that's a big one. So doing something to provide some insurance against that or to help provide comfort that these markets can come back is important because there's a very close link between liquidity issues that we have been seeing, the unwillingness to finance, and the capital issues that have been coming from an incompleteness of markets. The markets just aren't there for people to be trading in. They are valuing things off an index. The index can't be arbitraged against the underlying markets because the underlying markets aren't there. So the index is doing something else. It's the only somewhat liquid market that's providing some hedging. It's driving that down, and people don't want to buy the underlying security because they'll have to take the mark against this index rather than the true value. If they have to take the mark against something that they think is going to be pushed down artificially, they're not going to buy the security in the first place. These kinds of continuing stress make me feel a little less optimistic about the bounce-back in '09 that's in the Greenbook, although I don't think it's ruled out. Just turning quickly to inflation, we have a bit of a paradox in what has gone on recently as everyone has said--significantly slowing growth over the past four to five months but no evidence of slowing in the pressure on commodity, energy, and agriculture prices. That's despite some slowing elsewhere in the world and expectations of slower growth. The PPI numbers that came out today raised some concerns that some of the good parts of the CPI will not be flowing through to PCE. Also, over the last year or two, when we've had the unemployment rate below 5 percent or 4� percent, whatever your favorite number is, where there would be pressure on wages, we haven't seen much pressure on wages. So I'm not sure that, if the unemployment rate goes significantly above 5 percent, we'll see much on the other side that will take pressure off wages to bring things down. So I do remain concerned there. But I think there's a final risk that, if commodity, energy, and agriculture prices do significantly move down, it could have a major effect on some of the emerging markets and some of our other trading partners. So there's a bit of a paradox here that, if there are some potential benefits of the slowdown to reduce these prices, that could actually also reduce export demand, which--as a number of people pointed out--is very important in the forecast for keeping this a shallow recession. So I remain concerned on both the growth front and the inflation front, but I do think that macro stability is probably the primary thing that we need to be thinking about right now. Thank you, Mr. Chairman. " CHRG-111shrg54589--15 Mr. Gensler," Chairman Reed, Ranking Member Bunning, other Members of the Subcommittee, thank you for inviting me here to talk to you today about the over-the-counter derivatives market. I would like my full testimony to be entered into the record, if that is all right. I, too, am speaking on behalf of the full Commission. I believe we must urgently move to bring the over-the-counter derivatives marketplace under regulation, and there are four key objectives in accomplishing this goal. One is to lower systemic risk. Two, we need to provide the transparency and efficiency to these markets that we believe we have in our securities and futures and options markets. Three, we need to ensure integrity in these markets, preventing fraud, manipulation, and other abuses. And, four, we need to protect the retail public in these markets as we do in other markets we oversee. Meeting these objectives will also require close coordination between the CFTC, SEC, and other Federal regulators. Senators, I believe that we must establish a regulatory regime that governs the entire over-the-counter marketplace, no matter who is trading them, what type of derivative is traded, whether it is standardized, tailored, or highly customized. I think this should include interest rate product, currency product, commodity product, equities product, credit default swaps, and those swaps that we have not yet thought of that are just a blip on the horizon. As the Administration laid out in its May 13th letter, I believe this can best be accomplished with two complementary regimes: one to regulate the derivative dealers, or the actors, so to speak; and another regime to regulate the big market functions, or the stages upon which the actors perform their duties. For the dealers in this marketplace--the large financial institutions--we should set capital standards and margin requirements to help lower the risk in the system. We should set business conduct standards to make sure that the market is free from fraud, manipulation, and other abuses. And, third, we should set record keeping and reporting, with audit trails, so that we have transparency. So lower risk, promote market integrity, and enhance transparency. But I think this dealer regime will not really be enough. It is important, and it gets all the markets customized and standardized. We can further lower risk by having central clearing on standardized products, and also bringing the standardized products onto regulated trading venues, whether they be full exchanges or electronic platforms. This will lower risk and further enhance transparency. To fully achieve these objectives, we must enact both of these complementary regimes. Regulating both the traders and the trades will ensure that we cover both the actors and the stages upon which they create the significant risks. I am fortunate to have a partner in this effort in SEC Chair Mary Schapiro. She brings invaluable expertise that gives me great confidence that we will be able to work together on what is bound to be many challenges moving forward. We will also work together to advise Congress and the rest of the Administration on how we can best harmonize some of the rules between the securities and futures world and cover gaps in our regulatory oversight. President Obama has called for action to strengthen market integrity, lower risk, and protect investors, and I look forward to working with Members of this Committee and others in Congress to accomplish this goal. I thank you again for the opportunity to testify, and I look forward to answering any of your questions. " fcic_final_report_full--269 MERRILL LYNCH: “DAWNING AWARENESS OVER THE COURSE OF THE SUMMER” On October , Merrill Lynch stunned investors when it announced that third- quarter earnings would include a . billion loss on CDOs and  billion on sub- prime mortgages—. billion in total, the largest Wall Street write-down to that point, and nearly twice the . billion loss that the company had warned investors to expect just three weeks earlier. Six days later, the embattled CEO Stanley O’Neal, a -year Merrill veteran, resigned. Much of this write-down came from the firm’s holdings of the super-senior tranches of mortgage-related CDOs that Merrill had previously thought to be ex- tremely safe. As late as fall , its management had been “bullish on growth” and “bullish on [the subprime] asset class.”  But later that year, the signs of trouble were becoming difficult even for Merrill to ignore. Two mortgage originators to which the firm had extended credit lines failed: Ownit, in which Merrill also had a small equity stake, and Mortgage Lenders Network. Merrill seized the collateral backing those loans: . billion from Mortgage Lenders, . billion from Ownit. Merrill, like many of its competitors, started to ramp up its sales efforts, packag- ing its inventory of mortgage loans and securities into CDOs with new vigor. Its goal was to reduce the firm’s risk by getting those loans and securities off its balance sheet. Yet it found that it could not sell the super-senior tranches of those CDOs at accept- able prices; it therefore had to “take down senior tranches into inventory in order to execute deals”  —leading to the accumulation of tens of billions of dollars of those tranches on Merrill’s books. Dow Kim, then the co-president of Merrill’s investment banking segment, told FCIC staff that the buildup of the retained super-senior tranches in the CDO positions was actually part of a strategy begun in late  to reduce the firm’s inventory of subprime and Alt-A mortgages. Sell the lower-rated CDO tranches, retain the super-senior tranches: those had been his instructions to his managers at the end of , Kim recalled. He believed that this strategy would reduce overall credit risk. After all, the super-senior tranches were theoretically the safest pieces of those investments.  To some degree, however, the strategy was invol- untary: his people were having trouble selling these investments, and some were even sold at a loss.  Initially, the strategy seemed to work. By May, the amount of mortgage loans and securities to be packaged into CDOs had declined to . billion from . billion in March.  According to a September  internal Merrill presentation, the net amount in retained super-senior CDO tranches had increased from . billion in September  to . billion by March  and . billion by May.  But as the mortgage market came under increasing pressure and as the market value of even su- per-senior tranches crumbled, the strategy would come back to haunt the firm. Merrill’s first-quarter earnings for —net revenues of . billion—were its second-highest quarterly results ever, including a record for the Fixed Income, Cur- rencies and Commodities business, which housed the retained CDO positions. These results were announced during a conference call with analysts—an event that in- vestors and analysts rely on to obtain important information about the company and that, like other public statements, is subject to federal securities laws. CHRG-111hhrg52397--39 Chairman Kanjorski," Thank you very much, Mr. Murphy. And next we will hear from Mr. Don Thompson, managing director and associate general counsel of JPMorgan Chase & Co. Mr. Thompson? STATEMENT OF DON THOMPSON, MANAGING DIRECTOR AND ASSOCIATE GENERAL COUNSEL, JPMORGAN CHASE & CO. Mr. Don Thompson. Mr. Chairman, Ranking Member Garrett, and members of the committee, my name is Don Thompson, and I am a managing director and associate general counsel at JPMorgan Chase & Co. Thank you for inviting me to testify at today's hearing. For the past 30 years, American companies have used OTC derivatives to manage interest rate currency and commodity risk. Increasingly, many companies incur risks outside their core operations that if left unmanaged would negatively affect their financial performance and possibly even their viability. In response to marketplace demand, risk management products, such as futures contracts and OTC derivatives, were developed to enable companies to manage risks. OTC derivatives have become a vital part of our economy. According to the most recent data, over 90 percent of the largest American companies and over 50 percent of mid-size companies use OTC products to hedge risk. JPMorgan's role in the OTC derivatives market is to act as a financial intermediary. In much the same way that financial institutions act as a go-between with investors seeking return and borrowers seeking capital, we work with companies looking to manage their risks and entities looking to take on those risks. A number of mainstream American companies have expressed great concern about the unintended consequences of recent policy proposals, particularly at a time when our economy remains fragile. In our view, the effect of forcing such companies to face an exchange or a clearinghouse will limit their ability to manage the risk they incur in operating their businesses and have negative financial consequences for them because of increased collateral posting. These unintended consequences have the potential to harm economic recovery. Let me first touch on some of the benefits of OTC derivatives. Companies today demand customized solutions for risk management and the OTC market provides them. Keep in mind that customization does not necessarily mean complexity. Rather, it means the ability to hand tailor every aspect of a risk management product to the company's needs to ensure that the company is able to offset its risks exactly. For example, a typical OTC derivative transaction might involve a company that is borrowing at a floating interest rate. To protect itself against the risk that interest rates will rise, the company would enter into an interest rate swap. These transactions generally enable the company to pay an amount tied to a fixed interest rate and the dealer counterparty will pay an amount tied to the floating rate of the loan. This protects the company against rising interest rates and allows them to focus on their core operations. In addition, the company is often able to qualify for hedge accounting and thus avoid seeing volatility in its financial reporting that would obscure the true value of its business. OTC derivatives are used in a similar manner by a wide variety of companies seeking to manage volatile commodity prices, foreign exchange rates, and other market exposures. In addition to customization, the other main benefit of OTC derivatives is flexibility with respect to the collateral that supports a derivative transaction. In the interest rate swap example I went through before, the dealer counterparty may ask the company to provide credit support to mitigate the credit risk that it faces in entering into the transaction. Most often, that credit support comes in the same form as the collateral provided for in the extensions of credits by that dealer counterparty to the customer. Thus, if the loan is agreement is secured by property, equipment or accounts receivable, that same high-quality collateral would be used to secure the interest rate swap. As a result, the company does not have to incur additional costs in obtaining and administering collateral for the interest rate swap. It is important to note that although derivatives are currently offered on U.S. exchanges, few companies use these exchange traded contracts for two main reasons: First, exchange-traded products are by necessity highly standardized and not customized. As a result, companies are unable to match the products that are offered on exchanges to their unique portfolio of risks. Second, clearinghouse collateral requirements are by design onerous and inflexible. Clearinghouses require that participants pledge only highly liquid collateral, such as cash or short-term government securities to support their positions. However, companies need their most liquid assets for their working capital and investment purposes. Thus, in the example I gave, if the company had actually hit its hedge on an exchange, it would have had to post cash or readily marketable collateral up front and twice daily thereafter. By transacting in the OTC market, the company is able to use the same collateral that it has already pledged to secure its loan with no additional liquidity demands or administrative burdens. This collateral is high quality, given that it is the basis for the extension of credit in the loan but posting it does not affect the company's operations or liquidity. The flexibility to use various forms of credit support significantly benefits companies because without it, many companies will choose not to hedge risks because they cannot afford to do so. While we believe that exchanges play a valuable role in risk management, not all companies can or want to trade on exchange. Currently, companies have the choice of entering into hedging transactions on exchange or in the OTC markets, and we believe that companies should be allowed to have the choice to continue to use those competing products. The discussion of the benefits of OTC derivatives is not to deny that there have been problems with their use and it is essential that policymakers carefully examine the causes of the financial crisis to ensure that it does not repeat it. We have noted recent press reports indicating that banks are engaged in the concerted effort to avoid regulation. This is absolutely not true. For the past 4 years, major derivatives dealers, working in conjunction with regulators, have been engaged in an extensive effort to improve practices and controls in the OTC derivatives market. The letter referred to is just the latest quarterly submission outlining our efforts to enhance market practices, and we are committed to reforming the regulatory system and increasing confidence in the markets. To that end, we propose the following, which is consistent with the Administration's position, and CFDC Chairman Gensler's recent remarks on the issue: First, financial regulation should be considered on the basis of function, not form; second, a systemic risk regulator should oversee all systemically significant financial institutions and their activities; third, standardized OTC derivative transactions between major market participants should be cleared through regulated clearinghouses; and, finally, enhanced reporting requirements should apply to all OTC derivatives transactions, whether cleared or not. JPMorgan is committed to working with Congress, regulators, and other industry participants to ensure that an appropriate regulatory framework for OTC derivatives is implemented. I appreciate the opportunity to testify and look forward to taking your questions. [The prepared statement of Mr. Don Thompson can be found on page 189 of the appendix.] " FOMC20071031meeting--200 198,MR. WARSH.," Thank you, Mr. Chairman. Let me be the most recent but, I guess, not the last to say that this is a close call. I suppose I take more comfort in that than some around the table because I am pleased at the progress though it is not perfect and we’re not even back to an honest view of normal in the financial markets. That it’s a close call suggests to me that the data in the financial markets are normalizing. I guess the alternative of a close call would have been to have this be an easy call, and I suspect that the only way this would have been an easy call would be if we continued to have bad data and bad sentiment in the market. So I think we’re in the realm of a close call and we shouldn’t completely rue that situation. Again, that’s probably a function of the resilience of the economy, the resilience in the markets, some time and patience, and maybe even a little good monetary policy. So I’m okay with that, I think. The judgment that we make on moving or not moving ¼ percentage point today matters, but it strikes me as being considerably less important than what the future path of policy is expected to be in the capital markets. So I think that the most important judgment we make is in the fourth paragraph rather than the first paragraph. Let me spend a moment on what the financial markets are telling us with a degree of certainty which, speaking for myself, is quite surprising. Again, I think they have responded to real data over the past couple of weeks. They haven’t changed their probabilities based on utterances from the Chairman or from any of us, and I take some comfort in that. I might disagree with what they’re saying, but I don’t think that they’re just giving us a mirror image of our own views. So I take what they’re saying and the certainty with which they have taken on board that we’re going to move today. It’s not determinative. It’s not dispositive, nor should it be, but the debt capital markets, at least, think that the economy is worse—worse than the Greenbook and worse than many of us feel. Again, I would say that I have to take that on board without giving it too much predictive capability. I think that Brian is right—given the fragility in the financial markets and given the surprise that we had for them last time, I wouldn’t want our judgments today to add to that volatility, which I think would be quite possible. In sum, I would say that I support alternative A as written on this revised page. I think that, absent having strong language in alternative A, section 4, it would look to some as though the markets dictated this outcome. I think A-4 and robust balance of risk language is important so that the markets don’t believe incorrectly that we succumb to what their wants are. I think that previously, including at our last meeting, when we spoke about uncertainty, they seemed to understand what that was—that it wasn’t that we’re just calling it uncertainty but we really have cuts ahead. For better or for worse, they’ve now learned a lesson. Uncertainty with even pretty good data led us to cut this time, if we end up adopting alternative A. So if we use that same uncertainty language, I don’t think it would have the effect that it had last time of letting folks be on both sides of the bet on whether we would have continued actions. So I’m comfortable with alternative A, paragraph 4. It is a way of addressing market expectations and addressing our uncertainties by insurance, but being very clear to the markets that they ought not prejudge nor have we prejudged the outcome next time. The references to inflation risks there and in alternative A, paragraph 3, are useful to address some of the broader concerns we have about commodities and the foreign exchange value of the dollar. So with that, I think that alternative A is the right thing to do and that it does preserve for us plenty of ability to call it as we see it when we meet next. Thank you, Mr. Chairman." CHRG-111hhrg63105--11 Mr. Lucas," Thank you, Mr. Chairman, for calling this hearing today. I am not sure that I should call this the last in a long series of hearings this Committee has had on the regulation of derivatives in this Congress, or, perhaps better described, as the first in a long series of intensive oversight hearings I promise this Committee will engage in through the next several months. One thing I am sure of, and I have to echo the comments of my colleague, our good friend from Kansas, who is going to the other side of the building--I didn't say to the other side of the world--he will be missed indeed in this body. I can't use that other phrase, Jerry, I am sorry, I just can't say that word that some people now describe you within the public in the future, but your efforts on behalf of Kansas agriculture and this Committee have been and are much appreciated. One of the many legislative battles that you and I fought was the integrity of our domestic futures markets. We have long been focused on making sure the markets provide our farmers, ranchers, and commercial end-users the ability to manage their risk and discover market-driven prices. Those efforts and the efforts of everyone on this Committee resulted in legislation that ultimately became Title VII of the Dodd-Frank Act. Although there are so many issues and authorities contained in Title VII, the imposition of position limits probably received the most attention by this Committee. The imposition of position limits in various forms and fashions played huge parts in my and Mr. Peterson's legislative initiatives, and Mr. Goodlatte's before that. We have always known the balance between liquid vibrant markets and transparent price discovery markets were, and are, imperative. In the end, the position limits regime in the Dodd-Frank isn't what I would have written, but it is a cautious approach that provides the Commission with the appropriate discretion to address what I believe is a political problem and not necessarily a problem driven by artificial volatility or distorted supply and demand. The Dodd-Frank Act committed a new level of authority and discretion to use that authority to the Commodity Futures Trading Commission. I have heard from several of the regulated community, and have seen myself, how consumed the Commission and the staff is with implementation. I do not envy you in the least. It is a huge task, perhaps too big to be done in the timelines provided. As this fragile economy attempts to get back on its feet, we ought not to be throwing regulatory hurdles in its way, costing even more jobs and higher prices. I fear that is what will happen if the most sweeping reform of the nation's derivative markets is done hastily and without all due deliberation. I am not pressing for a perfect rule, but we have to have a good rule. I stand willing to consider easing of statutory deadlines to ensure rules don't end up further distorting markets and costing American jobs. I certainly look forward to hearing from our witnesses today, and I am prepared for that informed decision as they work their way through the implementation of position limits. And I would note, if the Chairman indulges me for one moment, this may well be the last hearing where my first Agriculture Committee Chairman continues to look down over our shoulder, Mr. de la Garza, in the way pictures are handled. I look forward to having Mr. Goodlatte looking over my shoulder, and having what will inevitably be the awesome portrait of Mr. Peterson to admire at the other end of the room. Such is the nature of the way these bodies move forward. Again, Mr. Chairman, thank you for calling this hearing. " FOMC20081029meeting--209 207,MR. EVANS.," Thank you, Mr. Chairman. In spite of the fact that I am going to validate what President Fisher said in terms of content, I am reminded of what candidate Ronald Reagan said in 1980 against George Bush. To paraphrase, ""I paid for the plane ticket down here. I'm going to tell you what I learned."" [Laughter] Pessimism is running deep, and no one I spoke with this round was immune to the current economic and financial turmoil. Even contacts who have sworn for months that their prudent financial management had insulated them from funding difficulties now report being stressed. The speed of the turnaround in sentiment has been breathtaking. Some of these new reports about changes in financing conditions came from large manufacturing firms that had been doing well this cycle. For example, John Deere noted that its financing subsidiary was having difficulty rolling medium-term notes that fund their customer leases. This seems symptomatic of financial stress because the subsidiary has a large capital cushion with high-value collateral backing the leases. Caterpillar did have better luck getting such funding but only because it went to the market during a very brief window when lenders were actively seeking customers with high credit quality. I also heard numerous reports of businesses having difficulty renewing longstanding lending arrangements with their banks; and for those who were able to get new loans, the terms were typically viewed as unattractive--at least they felt so. Several Chicago directors indicated that businesses were successfully tapping existing loan commitments and revolving credit, much along the lines that President Yellen just mentioned. However, this was not greeted enthusiastically by their bankers. In fact, I heard a very interesting story about a major New York bank CEO who spent some time in Chicago a couple of years ago. He was calling a large customer to assure him that their credit lines were good and that they didn't need to be taken down preemptively. The customer, who is our chairman, listened politely and then tapped the line anyway. [Laughter] No wonder banks are worried about their liquidity position. With regard to nonfinancial developments, reports on both current and expected real activity have turned uniformly more negative. An abrupt change occurred in September. People are spooked--sorry--[laughter] and it is showing through to spending. Retail sales are weak. I have grown accustomed to the inherent pessimism of one of my retail contacts. He has often said that business has never been weaker in 40 years, but this time he said never in 46 years. I also heard many reports about how the slowing in demand is worldwide. In my District, the sharp slowdown is evident in the Chicago purchasing managers' index. In October, it plunged nearly 20 points, to 37.8, the lowest level since the last recession in May 2001. This index will be publicly released on Friday. Businesses appear to be responding to the drop in demand by doing anything and everything they can to cut back spending. Labor demand is way off. My Manpower contact indicated that even companies that are doing well had turned cautious about hiring and are trying to squeeze out more productivity. He thought that the drop in sentiment could have some extra impact, given that it was occurring during the annual planning cycle for corporations. The idea was that a lot of harder-to-sell structural adjustments were being implemented anyway and that CEOs wanted to get these moves done quickly and have them behind them by early 2009. This is consistent with a range of reports we have heard that new capital spending is dead in the water or that planned expansions are being canceled. On a positive note, I think we are seeing the benefits of the structural improvement and inventory management that has occurred over the last 25 years. My contacts are reporting some increases in inventories, but they think that so far they have kept stocks under relatively good control. With prompt production cuts, we may not get the additional downside of a big inventory swing later in the cycle, perhaps when it is more painful. Turning to the national outlook, our forecast envisions a full-blown recession, roughly on the scale of the Greenbook. But like everyone else, I have a great deal of uncertainty about this projection. Things could turn out a lot worse. In contemplating the transmission from recent financial events to the real economy, there seem to be at least two channels to note. First, there is the dramatically reduced availability and higher cost of credit. Second, a recessionary psychology has emerged strongly in households and businesses. With regard to the psychology, I haven't spoken with anyone this round who thought there was a good reason to undertake any kind of discretionary expenditure. Clearly, the self-reinforcing dynamics implied by these and other reports could generate a deeper downturn than I have written down in my forecast. That's a big risk. With regard to the credit channel, the hit to the nonfinancial sector has intensified a good bit. We clearly are sailing in uncharted waters when it comes to quantifying these effects. The factors identified in the Greenbook highlight the unprecedented nature of the financial impulses to the economy. Looking ahead, I expect that the improvement in financial conditions will be somewhat faster than in the Greenbook. That is my cautious optimism. Still, in our forecast, financial headwinds weigh substantially on growth throughout 2009 and continue, to a degree, into 2010. Accordingly, substantial resource gaps remain open throughout the projection period. Also, I expect inflation expectations to decline in this depressed environment. With greater slack, lower inflation expectations, the reduction in energy and other commodity prices, and the higher value of the dollar, we are projecting core inflation to move under 2 percent by 2010. And I won't be shocked if the Greenbook projection for this to happen in 2009 actually happens. So, on balance, I think that inflationary risks are low but the downside risks to the economy are very high. Much as President Fisher indicated, it is much in line with the reports so far. Thank you, Mr. Chairman. " FOMC20081216meeting--240 238,CHAIRMAN BERNANKE.," Why don't we reconvene, have a brief summary of our goround, and then I will make just a few additional comments. The participants noted that the economic downturn has intensified sharply recently with significant downside risks to the outlook. Recessionary dynamics have set in, with interplays among real and financial variables. The economy is likely to contract through early next year, with considerable uncertainty about subsequent developments. Consumption, employment, and production indicators have weakened further. Financial conditions remain very strained, with improvement in some areas, but many the same or worse. The global economy has also slowed markedly. Looking more specifically at different sectors, credit conditions continue to tighten, with credit lines not being renewed and banks, including smaller banks, hunkering down. Securitization markets are still largely dysfunctional. The overall deleveraging process continues to be a powerful drag on activity. Delinquencies are increasing, implying greater credit losses for banks and other lenders, with small businesses being among the borrowers facing tighter conditions. Banks continue to face intense balance sheet pressures and are reluctant to lend or make markets, and feedback effects from worsening credit quality to the balance sheets of financial institutions are evident. Regarding the consumer, spending continues to contract, as households face ongoing pressures with respect to wealth, income, credit availability, and job security. Psychology is very negative, and luxury and discretionary expenditures are being cut back. Labor market developments have been negative as well, with accelerating job losses and participation finally declining after remaining high for a period of time. The latest housing numbers suggest a continued contraction in that sector. The fall in mortgage rates has sparked some refinancing and purchase mortgage applications, but the longer-term impact on housing demand is not yet evident. Nonresidential construction is projected to fall significantly, reflecting poor fundamentals and tight credit. Federal fiscal policy will likely provide aid to states, including funds for infrastructure, but the size and the timing of the economic impact of that policy remain uncertain. Manufacturing production continues to slow, along with new orders, capital spending, and business expectations; mining and drilling activities have been reacting to the decline in commodity prices, as has agricultural activity to some extent. Export demand has weakened with the sharp slowing in the global economy of recent months and the strengthening of the dollar since the summer. The sharp global slowdown, including emerging markets, will make recovery more difficult. Manufacturing surveys show that firms expect considerable near-term weakness and declining pricing power. Finally, inflation looks set to decline significantly, reflecting falling commodity prices, rising slack, limited pricing power, and falling inflation expectations. Participants cited the risk that inflation could fall below desired levels. That is just a very quick summary. Any comments? Let me make just a few additional comments, but I won't add, I think, a great deal of insight to our discussion. I will just note for the record here that the NBER has finally recognized that a recession began in December 2007. I said in the Christmas tree lighting ceremony that they also recognized that Christmas was on December 25 last year. [Laughter] The Committee was a little more forward-thinking. We began cutting rates, of course, in September 2007 and did 100 basis points of cuts in January 2008. Despite our efforts, this recession, in terms of duration and depth, is likely to be equal to or greater than the two largest previous postwar recessions, those in 1974-75 and 1981-82. There are a number of reasons that may be the case, and some of them were already discussed by the staff. The financial conditions are the most obvious difference between this recession and the earlier ones. A number of previous recessions have had financial headwinds of one type or another. For example, the current financial crisis and housing correction bear some family relationship to the stock market decline and the capital overhang in the 2001 recession. But overall, the financial aspects of this episode are, I think, much more serious than in previous cases. To cite two aspects: One, as Governor Warsh noted, there has been a big impact on household wealth. The flow of funds accounts show a decline in nominal wealth of about 11 percent in the last year or, as he said, a decline in real wealth of about 15 percent. This is going to lead to an increase in saving, which would be desirable in the longer term but in the short term is going to create dislocation. Two, this financial crisis has affected the intermediation of credit far more severely than any other episode since the 1930s. We have already seen a big impact on intermediary capital and bank activity. The deleveraging process is continuing. It is very intense. Again, reduced risk-taking, deleveraging, all of those things are not necessarily bad, but the adjustment process is a very difficult one. A second reason that this recession could well be more severe than the previous ones has to do with the cyclical position of monetary policy, a fact also noted by the staff. The 1974-75 and 1981-82 recessions were basically generated by a tightening of monetary policy, and when the Federal Reserve decided to let up, essentially conditions began to rebound. Obviously, in this case, other factors have driven the downturn. Monetary policy was proactive in trying to promote recovery. But given where we are today, at the zero lower bound, we are unable to ease policy in the way that we saw in those previous episodes. This suggests, as others have noted, the need for additional policy actions, either on our part or by the fiscal authorities, to get the economy moving again. Finally, a third reason that I think this episode is particularly severe is the global nature of the downturn, which a number of people have also noted. It has always been said that, if the United States sneezes, the rest of the world catches cold. So there has always been a certain amount of coherence or synchronicity between U.S. downturns and those around the world. But the extent of the global downturn this time is really quite exceptional. It is striking that global growth over the past few years has been between 4 and 5 percent, and now the Greenbook is looking at a 1.6 percent decline for global activity in the fourth quarter and a decline of about 0.6 percent in the first quarter. That is quite a big difference between what we might think of as potential and actual growth. So, as I said, there are a number of reasons to think that this is going to be a very severe episode and that we are far from being at the turning point. I won't go through the sectors. We have all discussed consumption, employment, housing, commercial real estate, and financial markets. These are all aspects of the downturn that continue to be exceptional and very worrisome as we look forward. I will make just a couple of comments about inflation or disinflation. The forecast is for significant disinflation--perhaps not deflation, although deflation is easily within the standard errors of the forecast. A number of factors may affect this forecast or create risks on both sides. Stephanie talked about structural unemployment perhaps being a factor that might make the effect of slack less than otherwise. On the other hand, there may be some evidence that the Phillips curve is steeper when unemployment is high--that is, recessions tend to have a greater impact on inflation than do small changes in growth. That only goes to say that there is a lot of uncertainty about exactly how far the inflation rate will fall. Although we might reach a technical deflation, I guess it is worth pointing out here that there is nothing special about zero. That is, from this point on, any further disinflation will have the effects of making a given nominal interest rate a higher real interest rate. It is making monetary policy de facto tighter and perhaps having debt deflation effects as the real value of debts and debt payments becomes greater as inflation falls. Because we are already at the zero lower bound, obviously that constraint is already in play. So I think we shouldn't focus too much or focus the public too much on the deflation line, on that zero number. It is not all that consequential. Rather, the disinflation process--and a very low rate of inflation--is a source of concern. Just to summarize, I don't think my outlook differs very significantly from what I have heard around the table. I think the issues are what we do about it, and in that spirit, we should turn now to the policy round. So let me turn to Brian to introduce the monetary policy alternatives. " FOMC20080916meeting--122 120,MR. BULLARD.," Thank you, Mr. Chairman. I am going to start with the national economy in the interest of brevity here. Concerning the national outlook, it is difficult and probably unwise to try to assess growth and inflation prospects in the immediate aftermath of an event like the Lehman bankruptcy. I expect to see more failures among financial firms, and I expect those failures to continue to contribute to market volatility. This is part of an ongoing shakeout among financial market firms, following some of the worst risk management in a generation. I expect sluggish growth in the second half of 2008, in part due to labor markets that are somewhat weaker than expected. Financial market turmoil is certainly a key concern, but the U.S. economy still outperformed expectations in the first half of 2008, despite the demise of Bear Stearns--an event not too different in some respects from the current episode. My sense is that three large uncertainties looming over the economy have now been resolved--the GSEs and the fates of Lehman and Merrill Lynch. Of these, the resolution of GSE uncertainty seems to be the most pivotal, even though it is not the one leading the news today. Normally, the elimination of key uncertainties is a plus for the economy. As is typical in this type of situation, safe interest rates have fallen dramatically across the board. A second macroeconomic shock stemming from the dramatic rise in oil and other commodities prices has been an unwelcome development during the past six months. The retreat of West Texas intermediate prices to $94 a barrel, and today down to $92 a barrel, should improve second-half growth prospects. Meanwhile, an inflation problem is brewing. The headline CPI inflation rate, the one consumers actually face, is about 6� percent year-to-date. That does not include today's report. This is against the federal funds target of 2 percent. While it makes sense to focus on financial markets for the time being, it is essential that we keep in position to put downward pressure on inflation going forward. The financial crisis threatens to roll on for such a long time and to demand so much attention that the private sector may rationally conclude that we have lost all sight of our inflation objective. In such a case of unmoored expectations, outcomes could be far more severe than those envisioned in the Greenbook. My policy preference is to maintain the federal funds rate target at the current level and to wait for some time to assess the impact of the Lehman bankruptcy filing, if any, on the national economy. In uncertain circumstances like these, I think it would be unwise to react too hastily to a fluid situation. Any immediate effects may not be the ones that are intended, and further down the line--that is, once more data have accumulated--a hasty action may leave the Committee out of position relative to the incoming data. By denying funding to Lehman suitors, the Fed has begun to reestablish the idea that markets should not expect help at each difficult juncture. Changing rates today would confuse that important signal and take out much of the positive part out of the previous decision. In addition, a rate move would be poorly targeted toward mitigation of difficulties at particular financial firms. The FOMC has already done a great deal to create a low interest rate environment in order to shepherd the economy through a substantial shock to the financial and housing sectors. The Committee now needs to allow the financial sector shakeout to occur using liquidity facilities to the extent possible to help navigate the resulting turbulence. Thank you. " fcic_final_report_full--60 A sset - Ba ck ed Se cu r i t i es Ou tstand i ng In the 1990s, many kinds of loans were packaged into asset-backed securities. IN BILLIONS OF DOLLARS $1 , 000 Other 800 Student l oans 600 M anufactured hous i ng 4 00 200 0 Eq u i pment H ome e q u i ty and other res i dent i a l Cred i t card A utomob il e ’ 85 ’ 86 ’ 88 ’ 89 ’ 91 ’ 92 ’ 93 ’ 95 ’ 9 7 ’ 99 NO TE: Res i dent i a l l oans do not i nc l ude l oans secur i t iz ed by government - sponsored enterpr i ses . SOURC E: Secur i t i es I ndustry and Fi nanc i a l M arkets A ssoc i at i on Figure . these instruments became increasingly complex, regulators increasingly relied on the banks to police their own risks. “It was all tied up in the hubris of financial engineers, but the greater hubris let markets take care of themselves,” Volcker said.  Vincent Reinhart, a former director of the Fed’s Division of Monetary Affairs, told the Com- mission that he and other regulators failed to appreciate the complexity of the new fi- nancial instruments and the difficulties that complexity posed in assessing risk.  Securitization “was diversifying the risk,” said Lindsey, the former Fed governor. “But it wasn’t reducing the risk. . . . You as an individual can diversify your risk. The sys- tem as a whole, though, cannot reduce the risk. And that’s where the confusion lies.”  THE GROWTH OF DERIVATIVES: “BY FAR THE MOST SIGNIFICANT EVENT IN FINANCE DURING THE PAST DECADE ” During the financial crisis, leverage and complexity became closely identified with one element of the story: derivatives. Derivatives are financial contracts whose prices are determined by, or “derived” from, the value of some underlying asset, rate, index, or event. They are not used for capital formation or investment, as are securities; rather, they are instruments for hedging business risk or for speculating on changes in prices, interest rates, and the like. Derivatives come in many forms; the most com- mon are over-the-counter-swaps and exchange-traded futures and options.  They may be based on commodities (including agricultural products, metals, and energy products), interest rates, currency rates, stocks and indexes, and credit risk. They can even be tied to events such as hurricanes or announcements of government figures. Many financial and commercial firms use such derivatives. A firm may hedge its price risk by entering into a derivatives contract that offsets the effect of price move- ments. Losses suffered because of price movements can be recouped through gains on the derivatives contract. Institutional investors that are risk-averse sometimes use interest rate swaps to reduce the risk to their investment portfolios of inflation and rising interest rates by trading fixed interest payments for floating payments with risk-taking entities, such as hedge funds. Hedge funds may use these swaps for the purpose of speculating, in hopes of profiting on the rise or fall of a price or interest rate. FOMC20060131meeting--62 60,MR. SHEETS.," Your first international exhibit focuses on the dollar. As indicated by the red line in the top-left panel, despite widening U.S. external imbalances, the dollar rose strongly against the major currencies through much of 2005. As seen on the top right, against the euro and the yen, the dollar has recorded net gains of more than 10 percent over the past year, even after tailing off some during the last two months. The dollar’s rise against these currencies occurred as interest rate differentials (shown on the bottom left) moved strongly in favor of dollar assets, and market commentary has pointed to this as a key factor supporting the dollar. Against the Canadian dollar, however, the greenback has moved down since mid-2005, and—as displayed on the bottom right—the dollar has also fallen against an array of emerging-market currencies, as market confidence in these countries has climbed. On balance, the broad nominal dollar has strengthened about 1¾ percent over the past year. As shown in the top panels of exhibit 10, the dollar’s resilience last year came in the context of a shift in the composition of reported U.S. financial inflows, away from official financing and toward private financing. In 2005, foreign official inflows (line 1 on the left) were down sharply from their 2004 pace. A plunge in official inflows from the G-10 countries (line 2) led this decline, as the Japanese authorities ceased intervening in foreign exchange markets. In contrast, inflows from emerging Asia (line 3) continued to move up, reflecting massive reserve accumulation by China. Purchases of U.S. securities by private foreigners (the top right panel) surged last year to more than $700 billion. All major categories of instruments saw increased foreign purchases, with particularly large gains in Treasury securities (line 2) and corporate bonds (line 4). The positive sentiment toward the emerging market economies, which was seen in foreign exchange markets, has also been manifest in global debt markets. As shown on the bottom left, the EMBI+ spread—which had hovered above the U.S. double-B corporate spread in recent years—cut below the double-B spread in mid-2005 and has now sunk to historical lows of just above 200 basis points. These favorable conditions, however, have not triggered a rise in external borrowing. As shown on the bottom right, net issuance of international debt securities by the emerging Asian economies has remained stable over the last year or two, and the Latin American countries have been paying down debt on net. Moreover, a sizable fraction of these economies continue to run current account surpluses. Your next exhibit focuses on the outlook for activity abroad, which in our view is quite favorable. As shown in line 1 of the top left panel, we estimate that total foreign growth in the second half of last year climbed to 4.1 percent, as growth in the emerging market economies (line 6) exceeded 6 percent. Going forward, we expect the foreign economies on average to expand at a strong pace of 3½ percent. Recent data have pointed to renewed signs of life in the euro-area economy (line 3), particularly in Germany, as strengthening in the export sector appears to have jump- started investment. We expect this impetus eventually to feed through to increased employment and consumer spending. Accordingly, we have marked up our forecast for the euro area and now expect growth there to remain near the 2 percent pace posted in the second half of 2005. Our forecast for Japan (line 4) calls for the expansion to broaden and for growth to remain above our estimate of potential. As shown in the middle left panel, over the past decade, Japanese corporations have dramatically reduced their debt burdens (the blue line). As balance sheets have strengthened, business investment (the black line) has risen and labor market conditions (the red line) have improved. More recently, as shown on the right, urban land prices—after many years of sharp contraction—appear to have stopped falling, and bank credit seems to be following a similar pattern. These developments suggest that conditions in the Japanese financial sector may finally be normalizing. The bottom panels focus on China. Over the intermeeting period, the Chinese authorities reported that GDP in 2004 was $280 billion (or 17 percent) larger than they had previously realized. Given these revisions, China’s GDP last year now appears to have exceeded that of France and the United Kingdom, making China the world’s fourth-largest economy. Other recent data indicate that China’s trade surplus (displayed on the right) jumped to $100 billion in 2005, as import growth declined sharply. Returning to the top left panel, this deceleration in imports did not reflect a slowing in the overall pace of Chinese activity last year, as GDP growth (line 8) remained near 10 percent. We see growth there notching down to around 7¾ percent in 2006, as the authorities are expected to implement administrative measures to restrain investment. As displayed in the top right panel, average foreign inflation is projected to remain well contained, cycling near 2½ percent through the forecast period. Inflation rates in the foreign industrial countries are seen to step down in mid-2006, as the run- up in oil prices plays through. For the emerging market economies, oil price increases typically pass through into consumer prices more slowly, as a number of these countries have price controls or subsidies in place that temporarily cushion the upward pressure on prices. As such, the rise in oil prices should continue to push up consumer price inflation through the next few quarters, but these pressures should abate in 2007. The top panels of exhibit 12 focus on trade prices. As shown on the left, the spot price of West Texas intermediate (the black line) has surged about $20 per barrel over the past year and now trades above $65 per barrel. Oil prices have been driven up both by strong global demand and by concerns about the reliability and adequacy of global supplies. Recent developments in Iran, Iraq, and Nigeria have further intensified these concerns. Tracking futures markets, our forecast calls for the price of WTI to remain elevated through the end of 2007. Nonfuel commodity prices (the red line) have also risen sharply over the past year, as metals prices have surged in response to strong global demand. In sync with futures markets, our forecast calls for commodity prices to flatten out near current levels, as supply responses help cap further price rises. The center panel displays our projection for the broad real dollar. After rising somewhat on balance last year, the dollar is projected to depreciate slightly, at an annual rate of about 1⅓ percent, through the forecast period. We see the expanding current account deficit and associated financing concerns—as well as monetary tightening by some foreign central banks—as likely to be sources of downward pressure on the dollar. Core import prices (the right panel) spiked in the fourth quarter, driven largely by a surge in natural gas prices following the hurricanes. Given that natural gas prices have already retreated, the run-up in core import price inflation should quickly unwind. Smoothing through these fluctuations, we see core import price inflation moving down to around 1 percent by early next year, consistent with flat commodity prices and only modest dollar depreciation. Recent data on U.S. nominal trade (the bottom left panel) indicate that the trade deficit has widened further. In October and November, exports of goods and services (line 2) increased $17 billion, led by a rise in capital goods exports (line 3), owing in part to a rebound in aircraft exports following the Boeing strike in September. Notably, exports of industrial supplies in October and November (line 4) were down relative to the third quarter. A large share of U.S. firms that produce these goods are located in hurricane-affected areas, and their production has been temporarily impaired. As shown on the right, this circumstance is highlighted by a sharp drop in real exports from several industries that were particularly affected by the hurricanes. Nominal imports of goods and services (line 6 on the table) rose a hefty $80 billion in October and November, notwithstanding soft growth in consumer goods (line 7) and capital goods (line 8). The recent rise in imports primarily reflected large increases in industrial supplies (line 9) and oil (line 10). These gains were due both to higher import prices, particularly for oil and natural gas, and to rising import quantities (which have substituted for impaired domestic production). Notably, as seen on the right, real imports have risen sharply in some of the same hurricane-affected industries in which exports have been particularly weak. As shown in the top left panel of your final international exhibit, we estimate that the growth of U.S. real exports of goods and services (the blue bars) dipped during the second half of 2005, as the hurricanes contributed to softness in goods exports and as last year’s dollar appreciation reduced the stimulus to services exports. Imports (the red bars), in contrast, expanded at a solid rate in the second half of last year, with a boost from the hurricanes. This pattern is expected to reverse in the first half of 2006, with exports recovering from the effects of the hurricanes and imports of oil and industrial supplies moderating. Thereafter, imports and exports are projected to grow at comparable paces, in line with solid U.S. and foreign growth and with the dollar projected to depreciate only mildly. As shown by the black line in the top right panel, the contribution of net exports to U.S. GDP growth in the second half of last year is estimated to have been around negative 0.6 percentage point, but it is projected to swing slightly positive in the first half of this year. Subsequently, the subtraction due to net exports should run at roughly ⅓ percentage point; imports and exports grow at comparable rates, but with imports more than 50 percent larger than exports, a sizable subtraction from growth results. As shown in the middle left panel, the U.S. current account deficit widened from about $150 billion in 1997 to $780 billion in the third quarter of last year. Over the forecast period, we see the deficit increasing further, to over $1 trillion, or about 7½ percent of GDP. The bottom panel provides some additional perspective on the widening of the current account deficit. As shown in the first column, from 1997:Q1 to 2001:Q4—a period of dollar appreciation—the current account balance fell $217 billion, which was more than accounted for by a decline in the non-oil trade balance. Over the next four years (the second column), the current account balance dropped another $421 billion, largely because of a continued decline in the non-oil trade balance (despite a net depreciation of the dollar) and a sharp rise in oil imports. As shown in the last column, we expect the current account deficit to widen nearly $300 billion over the forecast period, with all four major components contributing to the decline. Notably, net investment income is expected to fall sharply, as growing U.S. indebtedness and rising short-term interest rates push up our payments to foreigners. The middle right panel shows that our current account projections for 2006 and 2007 are markedly gloomier than those of other forecasters. Thus, there is a distinct possibility that investors will be surprised by the extent that the current account deficit widens. We see this as representing an important downside risk for the dollar." FOMC20061025meeting--185 183,MS. MINEHAN.," As I noted yesterday, I’ve become somewhat less worried about the downside risk to the baseline outlook. So to some degree, that factor has changed a little since the last time. In fact, I think the baseline isn’t bad at all. Indeed, it’s a testament, again, to the resilience of the U.S. economy if we can actually pull off, as we seem to be doing, a gradual slowing of the powerful U.S. housing markets against the background of considerable geopolitical and energy market uncertainty and price pressures, not to mention the potential for both strong consumer retrenchment and financial market volatility. So we seem to be threading the line through a lot of risks on both sides of this baseline, and we seem to be doing it successfully in negotiating that soft landing. I think we should take some pride in that so far so good and that monetary policy has played a key role in this unwinding process. In that regard, I continue to believe that the cost to the central bank of being wrong on inflation risks is greater than being wrong on the side of growth at this time. If growth wanes more than is now expected, we can ease policy fairly quickly. Getting behind the curve on inflation could be a good deal more costly. Thus, I am pretty comfortable with the current stance of policy, which I see as slightly restrictive. At least for the time being, I think it balances the risk of being wrong on inflation with the risk of slower growth and is appropriate given the brighter tone of much of the incoming data, with the possible exception of residential investment. A risk-management argument could be made for raising rates, and certainly those less comfortable with the current and prospective levels of core inflation might find such an action attractive. I don’t, as I continue to worry some about downside risks to growth, and I am more or less comfortable with our forecast that, with no change in policy in the near term, inflation will gradually fall to just over 2 percent as measured by the core PCE in the next eighteen months or so. That projection, at least at this time, seems right. So I come down on the side of keeping the fed funds rate at 5¼. So that’s the policy choice. The next issue is what to say about it. I think it’s important to continue to emphasize some concern regarding inflation rather than to move to more of a balance of risks. Financial markets remain quite accommodative, and I really see no reason to encourage them to be more so, thinking that policy easing might occur sooner than they do now. I think that would be the outcome of alternative A. So I’d prefer alternative B. The next question is, which alternative B? We now seem to have B-, B+, and B. Let me just comment a bit on the variety of alternatives that have been raised. You know, I have a lot of regard for Governor Kohn, and I take his point—and Governor Kroszner’s point—about section 2. However, when reading through it myself, I did think that the reference to the third quarter might help the markets react better if, in fact, the Greenbook forecast is accurate about the number that we’re going to see on Friday, which is considerably less than what a lot of people in the market think we’re going to see. I thought that the reference to the third quarter was helpful there. But, again, I have a great deal of regard for the cumulative wisdom on the other side of that. With regard to section 3, I, too, believe that there is some benefit to making the change that’s suggested in the Bluebook of using the alternative A wording for section 3. The shorter wording does reflect the moderation that has occurred in energy and commodity prices, and it puts the level of resource utilization more front and center as an inflation risk. I also find that it’s somewhat shorter, which, in general, I think is desirable. In section 4, I found the B+ wording attractive because it suggests a concern regarding inflation that I heard around the table yesterday and somewhat of a diminution of deep concern about the downside risks. In a way, I think there is a benefit at the margin to getting away from stock phrases. But I take Governor Kohn’s point very seriously that one does that recognizing that there’s a potential for unknowable consequences. So while I am marginally in favor of B+, I am more than happy to go with alternative B, either as it’s presented, with the switch of section 3, or the new language for section 2. I’m easy, you might say. [Laughter]" FOMC20080916meeting--89 87,MR. STOCKTON.," Thank you, Mr. Chairman. In response to your request for some economy in our remarks this morning, I'm going to set aside my prepared remarks and just hit some of the highlights here. We did receive a great deal of macroeconomic data since we closed the Greenbook last Wednesday. We didn't seem to get any of it right, but it all netted out to just about nothing. [Laughter] Retail sales came in considerably weaker than we had anticipated, enough by themselves to have knocked about � percentage point off third-quarter GDP growth. But some of that was offset in higher retail inventories, and the rest was offset by a stronger-than-expected merchandise trade report for July. It all left us still feeling very comfortable with our forecast because it looks to us as though economic growth is going to drop below 1 percent on average in the second half of the year. In terms of the things that really have stood out over the intermeeting period, at least to my mind, one has been the weakness in consumption. As I indicated, the retail sales report was weak; and now with that report in hand, we'd probably mark down our current-quarter consumption forecast to a decline of 1� percent at an annual rate. What I think is really remarkable about that is that this weakness is occurring even though we still think spending is probably receiving some boost from the rebates. So excluding that effect, we'd be looking at something even weaker. Now, as you know, we've been head-faked a number of times by the retail sales data, which are subject to some pretty substantial revisions. So I wouldn't necessarily take that report at face value. But the drop we've seen in motor vehicle purchases pretty much mirrors in size and timing the kind of falloff that we've seen in overall consumption spending. So it looks like a very weak picture for consumption. The other notable development over the intermeeting period has been the weakness in the labor markets--now not principally in the payroll employment figures. Private payroll employment has been falling pretty sharply but not any faster than we would have thought. But the rise in the unemployment rate is remarkable. Now, some of the 0.4 percentage point increase in the unemployment rate last month could be statistical noise. It wouldn't be entirely surprising to see it fall back some. But the more than 1 percentage point rise that we've had since April is not going to be statistical noise. Some of that increase probably reflects a bigger response to the emergency unemployment compensation program than we previously thought, and we've upped our estimates for that to a little less than 0.3 percentage point on the level of the unemployment rate. But even putting that aside, we have experienced a more significant rise in the unemployment rate, and I think that's consistent with other things that we're seeing in terms of the labor market data. We've seen another appreciable jump in initial claims. Announced job cuts are up. Job openings are down. Survey hiring plans have softened. Now, this sharp rise in the unemployment rate is a bit difficult to square with a GDP figure that looks as though it was running above 3 percent in the second quarter and even 2 percent if you want to average the first and second quarters together. There are occasionally large errors in Okun's law, as I think I've noted in the past. It seems as though Okun's law gets obeyed about as frequently as the 55 mile an hour speed limit on I-95. [Laughter] But still, one of the things that we should probably be considering is that perhaps the economy has not been as strong as suggested by the real GDP figures. Real gross domestic income, which is output measured on the income side of the accounts, has risen about 2 percentage points less than GDP over the past year. And if we look at industrial production and compare that with the components of GDP that are, in essence, goods production, there's about a 1 percentage point discrepancy there, with industrial production suggesting weaker figures than GDP. We see no reason to discount the rise in the unemployment rate as suggesting that we're entering the second half with more labor market slack than we had previously thought. Furthermore, on net, we've revised down our projected growth in GDP over the next two years--admittedly just a bit--and that was in response to two pretty strong crosscurrents. One was the significantly lower oil prices that we have in this forecast. We do think they're going to provide some support to underlying disposable income and spending. But the positive effect of that on our forecast going forward was more than offset by a significant marking down in our forecast for net exports--which Nathan will be discussing--in response to an appreciation of the dollar and a further downward revision to our outlook for foreign activity. On net, that left us with a little lower growth rate and carrying forward a noticeably higher unemployment rate over the forecast period. Now, those were pretty small adjustments. I don't think we've seen a significant change in the basic outlook, and certainly the story behind our forecast is very similar to the one that we had last time, which is that we're still expecting a very gradual pickup in GDP growth over the next year and a little more rapid pickup in 2010. The three things that are absolutely central to producing that outcome are our projection that we're going to get a stabilization in housing in 2009--and early in 2009; that there will be some diminishment of the drag on growth from the financial turbulence; and that oil prices flatten out. Of those three, to my mind, the component that probably is most central and most important would be seeing some stabilization in the housing market, not only because this has been a big drag on growth and will also have consequences for household wealth but also because if there's going to be some clarity and reassurance to financial market participants, it seems as though some end to the housing debacle has to be in sight. We think we are seeing a few glimmers of hope there--however, we thought that on occasion in the past and have been proven wrong. But sales of existing homes have been flat since the turn of the year. Sales of new homes have been flat for several months now. We've had a drop in mortgage interest rates that followed the takeover of Fannie and Freddie. Starts have fallen so much now that, in fact, builders are making significant progress in working down the inventory of unsold new homes and even months' supply has tipped down of late. So we think that some things are looking a little better for us there. As a consequence, we're expecting to see some bottoming-out near the end of this year or the beginning of next year--but not a sharp recovery. Overall residential investment actually is still a negative for 2009 but less of a negative than it has been this year. As you know from the Greenbook, our estimates suggest that the financial restraints on overall activity--actually on the level of GDP--will increase between 2008 and 2009, but their effects on the growth rate of GDP are diminishing somewhat. Finally, with regard to oil prices, by our assessment the rise in crude oil prices since the beginning of 2006 is probably knocking about � percentage point off growth in 2008; and with a flattening out of oil prices, we expect that to be more of a neutral factor over the next two years. That's providing some impetus. A lot of what's going on in our forecast is bad things not worsening any more quickly next year than they did this year, rather than things actually getting better. I guess it's a sad comment that we're relying on second derivatives turning positive to be the main force generating some upward impetus to economic growth. But we are projecting a gradual pickup. Now, on the inflation side, this morning's CPI report for August actually came in a little better than we were expecting. The CPI in August fell 0.1 percent. We had been expecting an increase of 0.1 percent. That surprise was all in the energy component, but we at least did see some moderation in the retail food price side that we were looking for, and the change in core CPI fell back to 0.2 percent after a string of 0.3 percent increases. I don't think these data will do much to change our basic forecast, which is for total PCE prices to be up somewhere in the neighborhood of a 5 percent rate in the third quarter, and core prices up 3 percent. Still, if one looks back at the last few CPIs and PCEs, things have come in a little higher on the core side. The projected 3 percent increase is up about � percentage point from where we were in our August forecast, and our interpretation of this is that we're probably seeing more upward impetus and passthrough from the higher energy prices, other commodity prices, and imports than we had previously expected. That certainly squares with what we're hearing from our business contacts. It also squares with what we saw last week in the PPI, which was another very sharp increase in prices of intermediate materials. At least going forward, for the first time since this process got under way, we are seeing more than just a futures price forecast flattening out. Some easing in the prices of both oil and other commodities and the appreciation of the dollar are giving us at least a little more confidence that some of these cost pressures are going to abate going forward and that we will get the disinflation that we have been forecasting. We continue to see reasonably encouraging signs on inflation expectations. The medium-term and long-term inflation expectations in the preliminary Michigan report last week dropped 0.3 percentage point, to 2.9 percent. TIPS haven't really done very much, and hourly labor compensation continues to come in below our expectations. So based on our assessment, once these cost pressures work their way through the system--and we still think that the process will take place over the second half--we think that we'll get some receding of core inflation from the 2.4 percent that we're projecting for this year to 2.1 percent next year and 1.9 percent in 2010. Just a couple of final remarks on current events. Hurricanes Gustav and Ike obviously created an enormous amount of devastation for a whole lot of people, but they don't really appear to us to have significant macroeconomic consequences. There will be some temporary disruption to oil and gas extraction and refining, but it looks as though the basic infrastructure has largely been spared. I'll be interested to hear President Fisher's report. Retail gasoline prices have jumped in the last few days, but wholesale prices for delivery in October are actually lower than they were before the storms were on the horizon. I think that suggests that this is not going to be a major negative event. Undoubtedly, industrial production is going to fall like a stone in September, reflecting these two hurricanes as well as the Boeing strike, but we're expecting that to bounce right back again. I don't really have anything useful to say about the economic consequences of the financial developments of the past few days. I must say I'm not feeling very well about it at the present, but I'm not sure whether that reflects rational economic analysis or the fact that I've had too many meals out of the vending machines downstairs in the last few days. [Laughter] But in any event, we're obviously going to need to wait a bit to see how the dust settles here, but I think the sign would be obviously in a bad direction. I'll turn over the floor to Nathan. " CHRG-110shrg50418--328 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM PETER MORICIQ.1. Dr. Morici, industry analysts have indicated that each firm has too many brands, car models, dealerships, factories, and workers for its market share. In other words, as currently constituted, the firms' size are not aligned with economic reality. How much of each of the brands, models, dealerships, factories, and workforce need to be reduced to align with the present economic situation?A.1. For January through November 2008, market shares for the Big Six were as follows: GM (excluding Saab)--21.9 percent; Ford (excluding Volvo)--14.3; Chrysler--11.0; Toyota--16.8; Honda--10.9; Nissan--7.2 GM (excluding Saab) has six brands and Toyota four. It is clear that GM has more brands than it needs. Moreover, Toyota brands have much clear identities. Toyota is the commodity brand, Lexus the luxury brand and Scion the youth brand. GM lacks such clarity for cars, other than Cadillac. Regarding trucks, it is not clear why GM should sell both Chevy and GMAC trucks. One truck brand should be adequate. GMAC trucks could be sold by Chevy dealers. Ford (excluding Volvo) has three brands of cars. I don't know that it needs more than two. Mercury adds little extra value. Ford's real problem, though, is that Lincoln is not differentiated enough from Ford and Mercury offerings. Chrysler has two brands of cars, sells trucks under its Dodge brand, and has Jeep. As Jeep has particular value that brand should stay. The real question is does Chrysler need both Dodge and Chrysler cars and minivans? Moreover is Chrysler viable as a stand alone company or should another company purchase its Jeep and Minivan franchises? The fate of Chrysler (or even Jeep and Minivan franchises) is not easy. Ford does not want either Chrysler or Jeep/Minivan, and GM is already too big. Once the issue of brands is resolved, all three companies could be slimmed down-production workers, dealerships, etc. However, I would not include engineering in that. I don't have estimates for what their employee, factory and dealership numbers should be.Q.2. Dr. Morici, the world looks to the U.S. on how to conduct economic policy. The actions we take set precedents that other countries follow to when they are devising their own economic policies. When the U.S. is unwilling to take the tough steps necessary to ensure sustainable, long-term economic growth, we should not be surprised if other countries follow our example and resist our calls for economic reform. If other countries follow the U.S. and begin to actively bail-out their own domestic industries, what impact would it have on the competitiveness in the global economy and on long-term global growth?A.2. We certainly want to make sure our businesses and workers compete on a level playing field with foreign entities, and make appropriate trade and industrial polices to that end. Each industry and bailout is different and should be judged on its own merits. In the case of automobiles, the industry has and continues to inflict harm on itself. The government should make any assistance to the industry contingent on reforms in management and labor agreements to ensure that taxpayer money is not wasted." CHRG-111shrg54589--6 STATEMENT OF SENATOR MIKE CRAPO Senator Crapo. First of all, Mr. Chairman, let me thank you for holding this hearing. I believe that although there is a breadth of derivative action in our economy, I believe that a significant amount, if not the significant majority of the amount of those transactions falls under the jurisdiction of this Committee, and I appreciate your attention to that fact. I also agree with the comments that both the Chairman and Ranking Member have made. Recent events in the credit markets have highlighted the need for greater attention to risk management practices, and counterparty risk in particular; and although I agree with the need to focus on where we can standardize and the types of risk reduction and better practices that we need to address, I also want in my remarks to just focus very quickly on one specific part of it, and that is, not letting the pendulum swing too far to the other side to where we cause damage to an efficient economy. The creation of clearinghouses and increased information to trade information warehouses are positive steps to strengthen the infrastructure for clearing and settling credit default swaps. While central counterparty clearing and the exchange trading of simple standardized contracts has the potential to reduce risk and increase market efficiency, market participants must be permitted to continue to negotiate customized bilateral contracts in over-the-counter markets. Many businesses use over-the-counter derivatives to minimize the impact of commodity price, interest rate, and exchange rate volatility in order to maintain stability in earnings and predictability in their operations. If Congress overreaches or bans or generates significant uncertainty with regard to the legitimacy of decisions to customize individual OTC derivatives transactions, I believe there could be very significant negative implications on how companies manage risk. In the contemplation of this hearing and this issue, Mr. Chairman, I actually requested that a number of the end users of these types of transactions respond to a question about what increased flexibility or reduction of flexibility would do, and at this time, I would like to just share three or four examples of the responses that I received. David Dines, the President of Cargill Risk Management, indicates, ``While margining and other credit support mechanisms are in place and utilized every day in the OTC markets, there is flexibility in the credit terms, the credit thresholds and types of collateral that can be applied. This flexibility is a significant benefit for end users of OTC derivatives such as Cargill in managing working capital. Losing this flexibility is particularly concerning because mandatory margining will divert working capital from investments that can grow our business and idle it in margin accounts. While it depends on market conditions, the diversion of working capital from Cargill for margining could be in excess of $1 billion. Multiply this across all companies in the United States and the ramifications are enormous, especially at a time when credit is critically tight.'' Kevin Colgan, the Corporate Treasurer of Caterpillar: ``Our understanding of currently pending regulation in this area is that it would require a clearing function which would standardized terms like `duration' and `amount.' Any standardization of this type would prohibit us from matching exactly the terms and underlying exposure we are attempting to hedge. Thus, in turn it would expose us to uncovered risk and introduce needless volatility into our financial crisis.'' I have a number of other examples which I will insert for the record, Mr. Chairman. " CHRG-111hhrg49968--7 Mr. Bernanke," Thank you, Mr. Chairman. Chairman Spratt, Ranking Member Ryan, and other members of the committee, I am pleased to have this opportunity to offer my views on current economic and financial conditions and on issues pertaining to the Federal budget. The U.S. economy has contracted sharply since last fall, with real gross domestic product having dropped at an average annual rate of about 6 percent during the fourth quarter of 2008 and the first quarter of this year. Among the enormous cost of the downturn is the loss of nearly 6 million jobs since the beginning of 2008. The most recent information on the labor market, the number of new and continuing claims for unemployment insurance through late May, suggests that sizeable job losses and further increases in unemployment are likely over the next few months. However, the recent data also suggests that the pace of economic contraction may be slowing. Notably, consumer spending, which dropped sharply in the second half of last year, has been roughly flat since the turn of the year, and consumer sentiment has improved. In coming months, household spending power will be boosted by the fiscal stimulus program. Nonetheless, a number of factors are likely to continue to weigh on consumer spending, among them the weak labor market, the declines in equity and housing wealth that households have experienced over the past 2 years, and the still-tight credit conditions. Activity in the housing market, after a long period of decline, has also shown some signs of bottoming. Sales of existing homes have been fairly stable since late last year, and sales of new homes seem to have flattened out in the past couple of monthly readings, though they remain at depressed levels. Meanwhile, construction of new homes has been sufficiently restrained to allow the backlog of unsold new homes to decline, a precondition for any recovery in homebuilding. Businesses remain very cautious and continue to reduce their workforces and their capital investments. On a more positive note, firms are making progress in shedding the unwanted inventories that they accumulated following last fall's sharp downturn in sales. The Commerce Department estimates that the pace of inventory liquidation quickened in the first quarter, accounting for a sizeable portion of the reported decline in real GDP during that period. As inventory stocks move into better alignment with sales, firms should become more willing to increase production. We continue to expect overall economic activity to bottom out and then to turn up later this year. Our assessments that consumer spending and housing demand will stabilize and that the pace of inventory liquidation will slow are key building blocks of that forecast. Final demand should also be supported by fiscal and monetary stimulus, and U.S. exports may benefit if recent signs of stabilization in foreign economic activity prove accurate. An important caveat is that our forecast also assumes continuing gradual repair of the financial system and an associated improvement in credit conditions. A relapse in the financial sector will be a significant drag on economic activity and could cause the incipient recovery to stall. I will provide a brief update on financial markets in a moment. Even after recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum, and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, and the unemployment rate is likely to rise for a time, even after economic growth resumes. In this environment, we anticipate that inflation will remain low. The slack in resource utilization remains sizeable. And notwithstanding recent increases in the prices of oil and other commodities, cost pressures generally remain subdued. As a consequence, inflation is likely to move down some over the next year relative to its pace in 2008. That said, improving economic conditions and stable inflation expectations should limit further declines in inflation. Conditions at a number of financial markets have improved since earlier this year, likely reflecting both policy actions taken by the Federal Reserve and other agencies, as well as a somewhat better economic outlook. Nevertheless, financial markets and financial institutions remain under stress, and low asset prices and tight credit conditions continue to restrain economic activity. Among the markets where functioning has improved recently are those for short-term funding, including the interbank lending markets and the commercial paper market. Risk spreads in those markets appear to have moderated, and more lending is taking place at longer maturities. The better performance of short-term funding markets in part reflects the support afforded by Federal Reserve lending programs. It is encouraging that the private sector's reliance on the Fed's programs has declined as market stresses have eased, an outcome that was one of our key objectives when we designed these interventions. The issuance of asset-backed securities, backed by credit card, auto, and student loans, has also picked up this spring, and ABS funding rates have declined--developments supported by the availability of the Federal Reserve's Term Asset-Backed Securities Loan Facility, or TALF, as a market backstop. In markets for longer-term credit, bond issuance by nonfinancial firms has been relatively strong recently. And spreads between Treasury yields and rates paid by corporate borrowers have narrowed some, though they remain wide. Mortgage rates and spreads have also been reduced by the Federal Reserve's program of purchasing agency debt and agency mortgage-backed securities. However, in recent weeks, yields on longer-term Treasury securities and fixed-rate mortgages have risen. These increases appear to reflect concerns about large Federal deficits but also other causes, including greater optimism about the economic outlook, a reversal of flight to quality flows, and technical factors relating to the hedging of mortgage holdings. As you know, last month, the Federal bank regulatory agencies released the results of the Supervisory Capital Assessment Program. The purpose of the exercise was to determine for each of the 19 U.S.-owned bank holding companies with assets exceeding $100 billion a capital buffer sufficient for them to remain strongly capitalized and able to lend to creditworthy borrowers, even if economic conditions over the next 2 years turn out to be worse than we currently expect. According to the findings of the SCAP exercise, under the more adverse economic outlook losses of the 19 bank holding companies would total an estimated $600 billion during 2009 and 2010. After taking account of potential resources to absorb those losses, including expected revenues, reserves, and existing capital cushions, we determined that 10 of the 19 institutions should raise, collectively, additional common equity of $75 billion. Each of the 10 bank holding companies requiring an additional buffer has committed to raise this capital by November 9th. We are in discussions with these firms on their capital plans, which are due by June 8th. Even in advance of those plans being approved, the 10 firms have among them already raised more than $36 billion of new common equity, with a number of their offerings of common shares being oversubscribed. In addition, these firms have announced actions that would generate up to an additional $12 billion of common equity. We expect further announcements shortly, as their capital plans are finalized and submitted to supervisors. The substantial progress these firms have made in meeting their required capital buffers and their success in raising private capital suggests that investors are gaining greater confidence in the banking system. Let me turn now to fiscal matters. As you are well aware, in February of this year, Congress passed the American Recovery and Reinvestment Act, or ARRA, a major fiscal package aimed at strengthening near-term economic activity. The package included personal tax cuts, increases in transfer payments intended to stimulate household spending, incentives for business investment, increases in Federal purchases, and Federal grants for State and local governments. Predicting the effects of these fiscal actions on economic activity is difficult, especially in light of the unusual economic circumstances that we face. For example, households confronted with declining incomes and limited access to credit might be expected to spend most of their tax cuts. But then again, heightened economic uncertainties and a desire to increase precautionary saving or pay down debt might reduce households' propensity to spend. Likewise, it is difficult to judge how quickly funds dedicated to infrastructure needs and other longer-term projects will be spent and how large any follow-on effects will be. The CBO has constructed a range of estimates of the effects of the stimulus package on real GDP and employment that appropriately reflects these uncertainties. According to the CBO's estimates, by the end of 2010, the stimulus package could boost the level of real GDP between about 1 percent and a little more than 3 percent and the level of employment by between roughly 1 million and 3.5 million jobs. The increases in spending and reductions in taxes associated with the fiscal package and the financial stabilization program, along with the losses in revenues and increases in income support payments associated with the weak economy, will widen the Federal budget deficit substantially this year. The administration recently submitted a proposed budget that projects the Federal deficit to reach about $1.8 trillion this fiscal year before declining to $1.3 trillion in 2010 and roughly $900 billion in 2011. As a consequence of this elevated level of borrowing, the ratio of Federal debt held by the public, to nominal GDP is likely to move up from about 40 percent before the onset of the financial crisis, to about 70 percent in 2011. These developments would leave the debt-to-GDP ratio at its highest level since the early 1950s, the years following the massive debt buildup during World War II. Certainly our economy and financial markets face extraordinary near-term challenges, and strong and timely actions to respond to these challenges are necessary and appropriate. Nevertheless, even as we take steps to address the recession and threats to financial stability, maintaining the confidence of the financial markets require that we, as a Nation, begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby boom generation and continued increases in medical costs. The recent projections from the Social Security and Medicare trustees show that, in the absence of programmatic changes, Social Security and Medicare outlays will together increase from about 8.5 percent of GDP today to 10 percent by 2020 and 12.5 percent by 2030. With the ratio of debt to GDP already elevated, we will not be able to continue borrowing indefinitely to meet these demands. Addressing the country's fiscal problems will require a willingness to make difficult choices. In the end, the fundamental decision that the Congress, the administration, and the American people must confront is how large a share of the Nation's economic resources to devote to Federal Government programs, including entitlement programs. Crucially, whatever size of government is chosen, tax rates must ultimately be set at a level sufficient to achieve an appropriate balance of spending and revenues in the long run. In particular, over the longer term, achieving fiscal sustainability--defined, for example, as a situation to which the ratios of government debt and interest payments to GDP are stable or declining, and tax rates are not so high as to impede economic growth--requires that spending and budget deficits be well-controlled. Clearly, the Congress and the administration face formidable near-term challenges that must be addressed, but those near-term challenges must not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances. Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth. And let me close briefly with an update on the Federal Reserve's initiatives to enhance the transparency of our credit and liquidity programs. As I noted last month in my testimony before the JEC, I have asked Vice Chairman Kohn to lead a review of our disclosure policies, with the goal of increasing the range of information that we make available to the public. That group has made significant progress, and we expect to begin publishing soon a monthly report on the Fed's balance sheet and lending programs that will summarize and discuss recent developments and provide considerable new information concerning the number of borrowers at our various facilities, the concentration of borrowing, and the collateral pledged. In addition, the reports will provide quarterly updates of key elements of the Federal Reserve's annual financial statements, including information regarding the system open market account portfolio, our loan programs, and the special-purpose vehicles that are consolidated on the balance sheet of the Federal Reserve Bank of New York. We hope that this information will be helpful to the Congress and others with an interest in the Federal Reserve's actions to address the financial crisis and the economic downturn. We will continue to look for opportunities to broaden the scope of the information and supporting analysis that we provide to the public. Thank you, Mr. Chairman. [The statement of Ben Bernanke follows:] Prepared Statement of Hon. Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System Chairman Spratt, Ranking Member Ryan, and other members of the Committee, I am pleased to have this opportunity to offer my views on current economic and financial conditions and on issues pertaining to the federal budget. economic developments and outlook The U.S. economy has contracted sharply since last fall, with real gross domestic product (GDP) having dropped at an average annual rate of about 6 percent during the fourth quarter of 2008 and the first quarter of this year. Among the enormous costs of the downturn is the loss of nearly 6 million jobs since the beginning of 2008. The most recent information on the labor market--the number of new and continuing claims for unemployment insurance through late May--suggests that sizable job losses and further increases in unemployment are likely over the next few months. However, the recent data also suggest that the pace of economic contraction may be slowing. Notably, consumer spending, which dropped sharply in the second half of last year, has been roughly flat since the turn of the year, and consumer sentiment has improved. In coming months, households' spending power will be boosted by the fiscal stimulus program. Nonetheless, a number of factors are likely to continue to weigh on consumer spending, among them the weak labor market, the declines in equity and housing wealth that households have experienced over the past two years, and still-tight credit conditions. Activity in the housing market, after a long period of decline, has also shown some signs of bottoming. Sales of existing homes have been fairly stable since late last year, and sales of new homes seem to have flattened out in the past couple of monthly readings, though both remain at depressed levels. Meanwhile, construction of new homes has been sufficiently restrained to allow the backlog of unsold new homes to decline--a precondition for any recovery in homebuilding. Businesses remain very cautious and continue to reduce their workforces and capital investments. On a more positive note, firms are making progress in shedding the unwanted inventories that they accumulated following last fall's sharp downturn in sales. The Commerce Department estimates that the pace of inventory liquidation quickened in the first quarter, accounting for a sizable portion of the reported decline in real GDP in that period. As inventory stocks move into better alignment with sales, firms should become more willing to increase production. We continue to expect overall economic activity to bottom out, and then to turn up later this year. Our assessments that consumer spending and housing demand will stabilize and that the pace of inventory liquidation will slow are key building blocks of that forecast. Final demand should also be supported by fiscal and monetary stimulus, and U.S. exports may benefit if recent signs of stabilization in foreign economic activity prove accurate. An important caveat is that our forecast also assumes continuing gradual repair of the financial system and an associated improvement in credit conditions; a relapse in the financial sector would be a significant drag on economic activity and could cause the incipient recovery to stall. I will provide a brief update on financial markets in a moment. Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, and the unemployment rate is likely to rise for a time, even after economic growth resumes. In this environment, we anticipate that inflation will remain low. The slack in resource utilization remains sizable, and, notwithstanding recent increases in the prices of oil and other commodities, cost pressures generally remain subdued. As a consequence, inflation is likely to move down some over the next year relative to its pace in 2008. That said, improving economic conditions and stable inflation expectations should limit further declines in inflation. conditions in financial markets Conditions in a number of financial markets have improved since earlier this year, likely reflecting both policy actions taken by the Federal Reserve and other agencies as well as the somewhat better economic outlook. Nevertheless, financial markets and financial institutions remain under stress, and low asset prices and tight credit conditions continue to restrain economic activity. Among the markets where functioning has improved recently are those for short-term funding, including the interbank lending markets and the commercial paper market. Risk spreads in those markets appear to have moderated, and more lending is taking place at longer maturities. The better performance of short-term funding markets in part reflects the support afforded by Federal Reserve lending programs. It is encouraging that the private sector's reliance on the Fed's programs has declined as market stresses have eased, an outcome that was one of our key objectives when we designed our interventions. The issuance of asset-backed securities (ABS) backed by credit card, auto, and student loans has also picked up this spring, and ABS funding rates have declined, developments supported by the availability of the Federal Reserve's Term Asset-Backed Securities Loan Facility as a market backstop. In markets for longer-term credit, bond issuance by nonfinancial firms has been relatively strong recently, and spreads between Treasury yields and rates paid by corporate borrowers have narrowed some, though they remain wide. Mortgage rates and spreads have also been reduced by the Federal Reserve's program of purchasing agency debt and agency mortgage-backed securities. However, in recent weeks, yields on longer-term Treasury securities and fixed-rate mortgages have risen. These increases appear to reflect concerns about large federal deficits but also other causes, including greater optimism about the economic outlook, a reversal of flight-toquality flows, and technical factors related to the hedging of mortgage holdings. As you know, last month, the federal bank regulatory agencies released the results of the Supervisory Capital Assessment Program (SCAP). The purpose of the exercise was to determine, for each of the 19 U.S.-owned bank holding companies with assets exceeding $100 billion, a capital buffer sufficient for them to remain strongly capitalized and able to lend to creditworthy borrowers even if economic conditions over the next two years turn out to be worse than we currently expect. According to the findings of the SCAP exercise, under the more adverse economic outlook, losses at the 19 bank holding companies would total an estimated $600 billion during 2009 and 2010. After taking account of potential resources to absorb those losses, including expected revenues, reserves, and existing capital cushions, we determined that 10 of the 19 institutions should raise, collectively, additional common equity of $75 billion. Each of the 10 bank holding companies requiring an additional buffer has committed to raise this capital by November 9. We are in discussions with these firms on their capital plans, which are due by June 8. Even in advance of those plans being approved, the 10 firms have among them already raised more than $36 billion of new common equity, with a number of their offerings of common shares being over-subscribed. In addition, these firms have announced actions that would generate up to an additional $12 billon of common equity. We expect further announcements shortly as their capital plans are finalized and submitted to supervisors. The substantial progress these firms have made in meeting their required capital buffers, and their success in raising private capital, suggests that investors are gaining greater confidence in the banking system. fiscal policy in the current economic and financial environment Let me now turn to fiscal matters. As you are well aware, in February of this year, the Congress passed the American Recovery and Reinvestment Act, or ARRA, a major fiscal package aimed at strengthening near-term economic activity. The package included personal tax cuts and increases in transfer payments intended to stimulate household spending, incentives for business investment, increases in federal purchases, and federal grants for state and local governments. Predicting the effects of these fiscal actions on economic activity is difficult, especially in light of the unusual economic circumstances that we face. For example, households confronted with declining incomes and limited access to credit might be expected to spend most of their tax cuts; then again, heightened economic uncertainties and the desire to increase precautionary saving or pay down debt might reduce households' propensity to spend. Likewise, it is difficult to judge how quickly funds dedicated to infrastructure needs and other longer-term projects will be spent and how large any follow-on effects will be. The Congressional Budget Office (CBO) has constructed a range of estimates of the effects of the stimulus package on real GDP and employment that appropriately reflects these uncertainties. According to the CBO's estimates, by the end of 2010, the stimulus package could boost the level of real GDP between about 1 percent and a little more than 3 percent and the level of employment by between roughly 1 million and 3\1/2\ million jobs. The increases in spending and reductions in taxes associated with the fiscal package and the financial stabilization program, along with the losses in revenues and increases in income-support payments associated with the weak economy, will widen the federal budget deficit substantially this year. The Administration recently submitted a proposed budget that projects the federal deficit to reach about $1.8 trillion this fiscal year before declining to $1.3 trillion in 2010 and roughly $900 billion in 2011. As a consequence of this elevated level of borrowing, the ratio of federal debt held by the public to nominal GDP is likely to move up from about 40 percent before the onset of the financial crisis to about 70 percent in 2011. These developments would leave the debt-to-GDP ratio at its highest level since the early 1950s, the years following the massive debt buildup during World War II. Certainly, our economy and financial markets face extraordinary near-term challenges, and strong and timely actions to respond to those challenges are necessary and appropriate. Nevertheless, even as we take steps to address the recession and threats to financial stability, maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and continued increases in medical costs. The recent projections from the Social Security and Medicare trustees show that, in the absence of programmatic changes, Social Security and Medicare outlays will together increase from about 8\1/2\ percent of GDP today to 10 percent by 2020 and 12\1/2\ percent by 2030. With the ratio of debt to GDP already elevated, we will not be able to continue borrowing indefinitely to meet these demands. Addressing the country's fiscal problems will require a willingness to make difficult choices. In the end, the fundamental decision that the Congress, the Administration, and the American people must confront is how large a share of the nation's economic resources to devote to federal government programs, including entitlement programs. Crucially, whatever size of government is chosen, tax rates must ultimately be set at a level sufficient to achieve an appropriate balance of spending and revenues in the long run. In particular, over the longer term, achieving fiscal sustainability--defined, for example, as a situation in which the ratios of government debt and interest payments to GDP are stable or declining, and tax rates are not so high as to impede economic growth--requires that spending and budget deficits be well controlled. Clearly, the Congress and the Administration face formidable near-term challenges that must be addressed. But those near-term challenges must not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances. Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth. federal reserve transparency Let me close today with an update on the Federal Reserve's initiatives to enhance the transparency of our credit and liquidity programs. As I noted last month in my testimony before the Joint Economic Committee, I asked Vice Chairman Kohn to lead a review of our disclosure policies, with the goal of increasing the range of information that we make available to the public.\1\ That group has made significant progress, and we expect to begin publishing soon a monthly report on the Fed's balance sheet and lending programs that will summarize and discuss recent developments and provide considerable new information concerning the number of borrowers at our various facilities, the concentration of borrowing, and the collateral pledged. In addition, the reports will provide quarterly updates of key elements of the Federal Reserve's annual financial statements, including information regarding the System Open Market Account portfolio, our loan programs, and the special purpose vehicles that are consolidated on the balance sheet of the Federal Reserve Bank of New York. We hope that this information will be helpful to the Congress and others with an interest in the Federal Reserve's actions to address the financial crisis and the economic downturn. We will continue to look for opportunities to broaden the scope of the information and supporting analysis that we provide to the public.--------------------------------------------------------------------------- \1\ Ben S. Bernanke (2009), ``The Economic Outlook,'' statement before the Joint Economic Committee, U.S. Congress, May 5, www.federalreserve.gov/newsevents/testimony/bernanke20090505a.htm. " fcic_final_report_full--160 CDOs created by Goldman Sachs.  Because of such deals, when the housing bubble burst, billions of dollars changed hands. Although Goldman executives agreed that synthetic CDOs were “bets” that mag- nified overall risk, they also maintained that their creation had “social utility” be- cause it added liquidity to the market and enabled investors to customize the exposures they wanted in their portfolios.  In testimony before the Commission, Goldman’s President and Chief Operating Officer Gary Cohn argued: “This is no dif- ferent than the tens of thousands of swaps written every day on the U.S. dollar versus another currency. Or, more importantly, on U.S. Treasuries . . . This is the way that the financial markets work.”  Others, however, criticized these deals. Patrick Parkinson, the current director of the Division of Banking Supervision and Regulation at the Federal Reserve Board, noted that synthetic CDOs “multiplied the effects of the collapse in subprime.”  Other observers were even harsher in their assessment. “I don’t think they have social value,” Michael Greenberger, a professor at the University of Maryland School of Law and former director of the Division of Trading and Markets at the Commodity Fu- tures Trading Commission, told the FCIC. He characterized the credit default swap market as a “casino.” And he testified that “the concept of lawful betting of billions of dollars on the question of whether a homeowner would default on a mortgage that was not owned by either party, has had a profound effect on the American public and taxpayers.”  MOODY ’S: “ACHIEVED THROUGH SOME ALCHEMY ” The machine churning out CDOs would not have worked without the stamp of ap- proval given to these deals by the three leading rating agencies: Moody’s, S&P, and Fitch. Investors often relied on the rating agencies’ views rather than conduct their own credit analysis. Moody’s was paid according to the size of each deal, with caps set at a half-million dollars for a “standard” CDO in  and  and as much as , for a “complex” CDO.  In rating both synthetic and cash CDOs, Moody’s faced two key challenges: first, estimating the probability of default for the mortgage-backed securities purchased by the CDO (or its synthetic equivalent) and, second, gauging the correlation between those defaults—that is, the likelihood that the securities would default at the same time.  Imagine flipping a coin to see how many times it comes up heads. Each flip is unrelated to the others; that is, the flips are uncorrelated. Now, imagine a loaf of sliced bread. When there is one moldy slice, there are likely other moldy slices. The freshness of each slice is highly correlated with that of the other slices. As investors now understand, the mortgage-backed securities in CDOs were less like coins than like slices of bread. To estimate the probability of default, Moody’s relied almost exclusively on its own ratings of the mortgage-backed securities purchased by the CDOs.  At no time did the agencies “look through” the securities to the underlying subprime mortgages. “We took the rating that had already been assigned by the [mortgage-backed securi- ties] group,” Gary Witt, formerly one of Moody’s team managing directors for the CDO unit, told the FCIC. This approach would lead to problems for Moody’s—and for investors. Witt testified that the underlying collateral “just completely disinte- grated below us and we didn’t react and we should have. . . . We had to be looking for a problem. And we weren’t looking.”  FOMC20070509meeting--51 49,MR. MOSKOW.," Thank you, Mr. Chairman. Conditions in the Seventh District have improved modestly since my last report. The overall pace of business activity is still rather restrained, but we have seen some pickup in our manufacturing sector. The key issues regarding the national outlook are the same as the ones the last time we met. How will the residential investment puzzle settle out, and can we explain this puzzling weakness in business fixed investment? Based on the data that we’ve received since March and my contact calls this round, I’ve become somewhat more optimistic about investment and somewhat more pessimistic about housing. At the same time, higher gasoline prices have the potential to weigh on consumer spending. So on balance our growth projection for ’07 and ’08 is a bit lower than it was in March. We now think that growth will average moderately short of potential over the remainder of ’07 and then run close to potential in 2008. However, our GDP numbers are a bit higher than the Greenbook’s, reflecting both a smaller shortfall from potential this year and a somewhat higher assumption about the rate of potential output growth. Indeed, there has been some good news regarding the near-term outlook. First, the international outlook continues to improve. Many of our contacts noted exceptionally strong demand from abroad, particularly for capital goods. Second, although we’ve been actively looking for spillovers from the problems with subprime mortgages, we have not yet seen major effects on pricing or the supply of credit in other markets. That is not to say that we have not heard of any effects. One of our directors, the CFO of a major national homebuilder, noted that tighter underwriting standards are reducing housing demand somewhat outside the subprime sector. Consumers still appear to have ample access to financing. For example, the head of GM noted that banks were making more auto loans with six- or seven-year maturities in order to lower monthly payments for liquidity-strapped consumers. Finally, as I noted earlier, we feel a bit more confident in our assumption that the weakness in BFI will turn out to be relatively transitory. I don’t want to make too much out of one month’s noisy data, but the latest readings on capital good orders and the PMI (purchasing managers’ index) were encouraging, and most of the comments from my business contacts have been positive in this regard. The impression I have from these discussions is that the pause in investment spending is showing early signs of ending; but this is very early, and we clearly need to keep monitoring developments carefully. Beyond the near-term cyclical developments, the changes in structural productivity in the Greenbook highlight an important source of risk to the longer-run outlook for sustainable non- inflationary growth, as Janet just discussed. There is a lot of uncertainty about the components of structural productivity. In our view, we haven’t seen enough evidence yet to mark down structural productivity as much as the Greenbook has. Consequently, our estimate of potential output growth is a bit higher than that of the Greenbook. With regard to inflation, the incoming information has caused the forecasts from our indicator models to come down a bit. They now project that core PCE prices will rise 2¼ percent this year and 2.1 percent in ’08. But we do not see any progress beyond that. If we carry our models out to ’09, they have inflation staying at 2.1 percent, higher than my preferred range. Furthermore, I see some upside risks to this forecast. Neither our GDP projection nor the Greenbook’s generates any meaningful resource slack over the projection period, and then there are the higher costs for energy and other commodities and increases in import prices. So we will be relying heavily on stable expectations to keep inflation in check. I believe we are currently achieving some implicit tightening of policy by keeping rates on hold during this period of sluggish activity, but this restraint will wane if the real economy returns to potential by early next year as we expect. So I continue to think that the risks to price stability dominate the risks to sustainable growth." CHRG-110hhrg44901--3 Mr. Bachus," I thank the chairman. Chairman Frank, I am going to follow your lead and restrict my remarks to the real economy, which is the purpose of this hearing, and not some of the recent developments in the past week or two. Chairman Bernanke, looking at the economy, we had an overextension of credit. We had too easy of credit, it wasn't properly underwritten, and the risks were not taken into account. As a result of that, we have had, I think, massive debt accumulation in this country, and we are going through what is inevitable when people borrow more than they can repay. I think a second factor, and it may be in your remarks or questions, you can address this, but a tremendous amount of leverage and risk-taking and other risky and speculative investment practices and a lot of fortunes were made on the way up, but there is pain on the way down. As I see it, it is not an easy thing to go through, but it is a part of a market cycle. The third factor, and this is a factor that I think is the most important, is the high commodity prices, and particularly energy prices that have been a particular hardship on importing nations, and we are obviously an importing Nation. It has been a financial windfall to exporting countries. I have been to Abu Dhabi and Dubai, and the fabulous wealth that has been created out of really a desert society there in the past 40 years is just almost beyond belief. I think T. Boone Pickens, he is running a commercial right now, and he calls this, I think rightly so, the largest transfer of wealth in the history of the world. That, to me, and the effect it is having on Americans day-to-day, is our biggest problem. I believe it is the largest source of instability in our financial markets. I think that the consumers are stressed, they are paying high gas prices, high diesel prices, and they can't pay their other bills. They are even having trouble putting food on their tables. Finally, while we require the American people to live within their budget, we had deficit spending here, and have for some time, and there is a tremendous lack, I think, in Washington of financial discipline. The Federal Government has more obligations than it can fund today, but it continues to obligate itself, it continues to expand and create new programs, and it continues to assume responsibility for funding services that were traditionally in the province of local or State governments or families themselves. Obviously, all of these problems, the problem of tremendous mushrooming of extension of credit and debt accumulation, of overleveraging and risk-taking, of high energy costs, high food costs, high gas prices, and then a Federal Government that spent beyond its means, obviously there is no single approach we can take to getting ourselves out of this. I think the banks have repriced for risk. There has been a lot of--they have raised capital. I will state right here that I know there is a debate in this country on the overall financial stability of our financial system, but I, for one, think that we are well on our way to recovery in the financial system. I think the present stock prices of our banks don't accurately reflect the value of those banks. I think the stock prices are too low. The banks are sound, they are solid. I think the stock prices, right now you may have--I think there is a real--it is just a confidence factor. Anyway, we have had a retrenching and a correction, and I do worry about some attempts that we are doing to short-circuit the correction and the period of adjustment. I think long term they can deepen the damage. But, in contrast, there is something that I think we should do, and we can do now, and that is to address high energy prices. High energy prices mean higher production and transportation costs. Those increases are passed on to the consumers, and we saw that this morning, causing inflationary pressures. Particularly hard hit are those Americans, a million-and-a-half Americans, whose adjustable-rate mortgages are adjusting. Those families are facing a double whammy. To sum up, what I believe is needed now is a concerted bipartisan effort by Congress and the Administration to develop and implement a comprehensive energy and conservation initiative. It needs to be done now. It should have been last year or the year before that. I believe until we get a handle on our dependency on foreign oil, we are going to continue to have real severe problems. Thank you. " CHRG-111shrg51395--33 Mr. Silvers," Good morning, Chairman Dodd and Ranking Member Shelby. Thank you for inviting me here today. Before I begin, I would like to note that in addition to my role as Associate General Counsel of the AFL-CIO, I am the Deputy Chair of the Congressional Oversight Panel created by the Emergency Economic Stabilization Act of 2008 to oversee the TARP. While I will describe in my testimony aspects of the Congressional Oversight Panel's report on regulatory reform, my testimony reflects my views alone and the views of the AFL-CIO unless otherwise noted and is not on behalf of the panel, its staff, or its chair. The vast majority of American investors participate in the markets as a means to secure a comfortable retirement and to send their children to college, as you noted, Mr. Chairman, in your opening remarks. While the spectacular frauds like the Madoff Ponzi scheme have generated a great deal of publicity, the bigger question is what changes must be made to make our financial system a more reasonable place to invest the hard-earned savings of America's working families. Today, I will address this larger question at three levels: Regulatory architecture, regulating the shadow markets and the challenge of jurisdiction, and certain specific steps Congress and regulators should take to address holes in the investor protection scheme. First, with respect to regulatory architecture, the Congressional Oversight Panel in its special report on regulatory reform observed that addressing issues of systemic risk cannot be a substitute for a robust, comprehensive system of routine financial regulation. Investor protection within this system should be the focus of a single agency within the broader regulatory framework. That agency needs to have the stature and independence to protect the principles of full disclosure by market participants and compliance with fiduciary duties among market intermediaries. This has been noted by several of the panelists prior to me. This mission is in natural tension with bank regulators' mission of safeguarding the safety and soundness of the banks they regulate, and that natural tension would apply to a Systemic Risk Regulator that was looking more broadly at safety and soundness issues. Because of these dynamics, effective investor protection requires that any solution to the problem of systemic risk prevention should involve the agency charged with investor protection and not supercede it. I have a more detailed document on issues associated with creating a Systemic Risk Regulator that I will provide the Committee following the hearing. I should just note that in relation to this, it is my belief that more of a group approach to systemic risk regulation rather than designating the Fed as the sole regulator would be preferable. Among the reasons for this are the issues of information sharing and coordination that other panelists raised, but most importantly, the fact that the Federal Reserve in its regulatory role fundamentally works through the regional Fed banks, which are fundamentally self-regulatory in nature. Several of the prior witnesses have mentioned some of the problems with self-regulation on critical issues. Furthermore, a Systemic Risk Regulator, as we have learned through the TARP experience, is likely to have to expend public dollars in extreme circumstances. It is completely inappropriate for that function to be vested in a body that is at all self-regulatory. While the Fed could be changed, its governance could be changed to make it fully a public agency, that would have implications, I believe, for the Fed's independence in its monetary policy role. Now, we have already in the Securities and Exchange Commission a regulator focused on investor protection. Although the Commission has suffered in recent years from diminished jurisdiction and leadership failure, the Commission remains an extraordinary government agency whose human capital and market expertise needs to be built upon as part of a comprehensive strategy for effective re-regulation of the capital markets. This point flows right into the issue of jurisdiction and the shadow markets. The financial crisis we are currently experiencing is directly connected to the degeneration of the New Deal system of comprehensive financial regulation into a Swiss cheese regulatory system where the holes, the shadow markets, grew to dominate the regulated markets. The Congressional Oversight Panel specifically observed that we need to regulate financial products and institutions, in the words of President Obama, ``for what they do and not what they are.'' The Congressional Oversight Panel's report further stated that shadow institutions should be regulated by the same regulators that currently have jurisdiction over their regulated counterparts. So, for example, the SEC should have jurisdiction over derivatives that are written using public debt or equity securities as their underlying asset. At a minimum, the panel stated, hedge funds should also be regulated by the SEC in their role as money managers. There is a larger point here, though. Financial re-regulation will be utterly ineffective if it turns into a series of rifle shots at the particular mechanisms used to evade regulatory structures in earlier boom and bust cycles. What is needed is a return to the jurisdictional philosophy that was embodied in the founding statutes of Federal securities regulation: Very broad, flexible jurisdiction that allowed the Commission to follow changing financial market practices. If you follow this principle, the SEC should have jurisdiction over anyone over a certain size who manages public securities and over any contract written that references publicly traded securities. Applying this principle would require at least shifting the CFTC's jurisdiction over financial futures to the SEC, if not merging the two agencies under the SEC's leadership, as I gather some of my fellow panelists believe is necessary. Moving on to substantive reforms, beyond regulating the shadow markets, the Congress and the Securities and Exchange Commission need to act to shape a corporate governance and investor protection regime that is favorable to long-term investors and to the channeling of capital to productive purposes. First, strong boards of publicly traded companies that the public invests in--having strong boards requires meaningful accountability to long-term investors. The AFL-CIO urges Congress to work with the SEC to ensure that long-term investors can nominate and elect psychologically independent directors to company boards through access to the corporate proxy. Second, effective investor protection requires comprehensive executive pay reform involving both disclosure governance and tax policy around two concepts. Equity-linked pay should be held significantly beyond retirement. And two, pay packages as a whole should reflect a rough equality of exposure to downside risk as well as to upside gain. Part of this agenda must be a mechanism for long-term shareholders to advise companies on their executive pay packages in the form of an advisory vote. Finally, Congress needs to address the glaring hole in the fabric of investor protection created by the Central Bank of Denver and Stoneridge cases. These cases effectively granted immunity from civil liability to investors for parties such as investment banks and law firms that are actual co-conspirators in securities frauds. Now, to address very briefly the international context, the Bush administration fundamentally saw the internationalization of financial markets as a pretext for weakening U.S. investor protections. That needs to be replaced by a commitment on the part of the Obama administration, the Congress, and the regulators to building a strong global regulatory floor in coordination with the world's other major economies. However, Congress should not allow the need for global coordination to be an impediment or a prerequisite to vigorous action to re-regulate U.S. financial markets and institutions. Obviously, this testimony simply sketches the outline of an approach and notes some key substantive steps for Congress and the administration to take. While I do not speak for the Oversight Panel, I think I am safe in saying that the Panel is honored to have been asked to assist Congress in this effort and is prepared to assist this Committee in any manner the Committee finds useful. I can certainly make that offer on behalf of the AFL-CIO. Thank you. " FOMC20060131meeting--116 114,MR. KOHN.," Thank you, Mr. Chairman. The projections I submitted for this meeting reflected expectations of an economy that probably is operating in level terms somewhere in the neighborhood of its long-run, sustainable potential and will continue to do so over the next two years with growth broadly in line with the growth of potential and inflation basically stable. My forecasts for 2006 are very close to those I submitted last January and June. That’s partly a product of innate stubbornness. [Laughter] But it also reflects the fact that 2005 came in largely as expected—after allowance for hurricanes and an energy shock last year that elevated core inflation and damped growth somewhat compared with our forecasts last January. This is encouraging in that it suggests that we are not looking at major unexplained and unanticipated forces acting on the economy. At this point, our focus appropriately is on keeping inflation contained. I see several reasons for optimism in this regard. One is the performance of core consumer prices and price measures, which continue to suggest that the pass-through of higher energy prices will be limited. Core inflation was roughly stable last year. It picked up a bit in the fourth quarter, but that was from unusually low readings in the third quarter. Declining consumer inflation expectations in the most recent Michigan survey, along with the failure of market-based inflation compensation readings to respond significantly to the substantial run-up in oil prices and higher core readings over the intermeeting period, just reinforce my assessment that any pass-through should be small and limited in duration. As we noted at the last meeting, perhaps the greater threat to sustained good inflation performance comes from possible increases in pressures on resources. The critical question is whether growth in output close to trend is a reasonable expectation with only modest further policy firming, given the low level of long-term rates, reduced drag from energy prices, and a boost from rebuilding. I thought it was a reasonable expectation, for a number of reasons. First, after smoothing through the fluctuations caused by auto incentives and hurricanes, private domestic final demand already showed signs of moderation last year. Growth in private domestic final sales slowed from 4¼ percent in the first half of the year to 3 percent in the second half of the year, with every element—consumption, business fixed investment, residential housing investment— moderating. The staff estimates that about 0.3 of this was due to hurricane effects, but that still leaves underlying private demand slowing to an annual rate of about 3¼ or 3½ percent. This moderation did not reflect the full effects of our policy tightening, especially on the housing market. Even well-anticipated increases in the short-term rates seem to be having a significant effect on housing markets, which have become more dependent on adjustable rate mortgages to maintain affordability. We are just beginning to see the anticipated slowdown in this sector. With growth in consumption and sales constrained by a leveling-out of housing wealth, businesses are unlikely to see the need to step up the pace at which they are adding to their capital stock. As a consequence, investment growth could slow, at least slightly, over the next few years, reflecting reduced impetus from the accelerator. Finally, although foreign economies are strengthening some, foreign investment and consumption remain subdued relative to income. And given our continuing outsized appetite for imports, net exports are unlikely to be putting added impetus to demands on domestic production. I think there are several upside and downside risks around this picture of growth near potential, as a number of you pointed out. I agree that the housing market is the most likely source of a shortfall in demand. I don’t think we can have much confidence about how the dynamics of this market will play out now that it has begun to soften. My suspicion is that, as little bubbles in the froth are popped, the risks are tilted more toward quite a sharp cooling off than toward a very gradual ebbing of price increases and building activity. On the other side, it seems to me global demand would be a major upside risk to growth and to price stability. The extraordinarily rapid rise in commodity prices and upward movement in global equity prices may indicate a very fundamental turnaround in foreign demand and attitudes beyond just a stepwise strengthening of growth. For now, these remain risks that we’ll need to monitor. In making my forecast, I assumed we would tighten at this meeting, and likely at the next as well, to gain greater assurance that inflation will remain contained over time, consistent with my forecast of a 1¾ percent increase in core prices in 2007. However, I do see action in March as dependent on the readings we get in coming months. There is, as usual, considerable uncertainty about the precise nature and magnitude of the risk to the outlook, but we’re dealing with an economic picture that overall is remarkably good and expected to remain that way for the foreseeable future. Reflecting on this situation, among many, many aspects of the past, I end my remarks as I began them: Thank you, Mr. Chairman." FOMC20060629meeting--57 55,MS. JOHNSON.," Why don’t I give an overview? Then Steve can speak a bit about where we think we are. The topic has obviously become of great interest. It’s cropping up in any number of places, including the BIS. When we think about it, the first problem we confront is that we were never able in the simpler world of ten years ago or so to get Phillips curves that were the least bit acceptable for almost any foreign industrial country you could name. There was always great tension in international meetings, in research efforts, in conversations that we would have with central bank staff in some of these countries, and so forth to reconcile the way we thought about inflation and the forces driving inflation because they didn’t think in terms of slack and price pressures. If you go back far enough, obviously they had a lot of faith, somehow, in money growth or medium-term things. The OECD has tried often—indeed, people on my staff have tried often— to identify roles for gaps, in many of the European countries anyway. These things we call speed effects—which indicate that what matters is how fast you’re changing (not whether you have a lot of slack in resources but how quickly are you closing that gap)—always seemed to loom large in certain countries, and effects of gaps were very hard to find. For example, the whole period of Japanese deflation defies explanation in terms of a Phillips curve that has any kind of reasonable properties, or the deflation would have gotten worse and worse and worse over a long period of time, and it did not. So you’re starting from a world in which the links between capacity as we normally think about it and inflation were never strong and never commonly shared across a range of countries. Now we add a level of complexity in that we have a more-globalized economy. We have had what amounts to a big, positive supply shock of labor, at the very least via the China-India- former Soviet Union line of reasoning, and suddenly people are now making arguments and estimating equations in which a global capacity measure is behaving better than I could ever find individual capacity measures to apply in these countries. It leaves me in a bit of a quandary. I was in Basel over the weekend. The BIS released its annual report in time for its annual general meeting, and I was lucky enough to find myself seated at lunch next to the authors of some of the work. I said, “You know, I can’t imagine a variable that really captures what I think of as the range of effects that something like China might have and China’s labor force might have on the process of pricing in the global economy. You have this paper that you’ve written, and it’s reflected in the annual report, and you have five different measures . . .” He basically replied that they haven’t solved that problem and that the measures they used, in and of themselves, could readily be criticized, but they got some results. He swore to me that they had beaten on this equation with every possible negative rationale that would explain it other than being valid, and it still kept coming back at them as though something was there. So I guess I am prepared now to look a little harder and try some of this ourselves, which we have been pretty skeptical about doing. But there’s a big gap between the notion that there are 800 million Chinese who might potentially be engaged in global economic activity and the reality of what’s determining prices in real time today. The fact that these people are potentially there but are nowhere to be seen other than in the rural areas of China, growing their own food, just makes it very difficult to think that one has captured something. So I am certainly sympathetic with the notion that there are key bottlenecks—there are some features through the commodity markets or there are some other aspects within manufacturing in particular sectors where you see global capacity effects. But disentangling the relative price pieces of this story from something that might relate to the interaction of overall capacity and inflation is very, very difficult. I think we’re just beginning to do that. In terms of this outlook, Steve may want to make a few comments about where we think we see global growth and how that might matter." FinancialCrisisReport--343 Mr. Lippmann told the Subcommittee that Mr. D’Albert approved his taking the short position in or around November 2005, but said the trade was so big and controversial that Mr. Lippmann also had to get the approval of Rajeev Misra, Global Head of Credit Trading, Securitization and Commodities, who was based in London. 1302 Mr. Lippmann said that, in or around November 2005, Mr. Misra reluctantly gave his approval for the short position, even though Mr. Misra believed mortgage related securities would continue to increase in value over time. Building the Short Position. Mr. Lippmann told the Subcommittee that he used some existing short positions that had been undertaken as hedges to begin building his position. 1303 He said that, throughout 2006, he gradually accumulated a larger short position, which eventually reached $2 billion. According to Mr. Lippmann, Deutsche Bank senior management reluctantly went along. 1304 He told the Subcommittee that, at one point in 2006, Boaz Weinstein, who reported to Mr. Misra, told him that the carrying costs of his position, which required the bank to pay insurance-like premiums to support the $2 billion short position, had become so large that he had to find a way to pay for them. According to Mr. Lippmann, the bank’s senior management asked him to persuade them that he was right by demonstrating that others were willing to “short” the market as well. Mr. Lippmann told the Subcommittee he was then motivated to convince his clients that they ought to short the mortgage market, arrange the shorts for them, and make enough in fees from those transactions to pay for the costs of his multi-billion-dollar short. 1305 Mr. Lippmann told the Subcommittee that he spent much of 2006 pitching his clients to short the mortgage market. He said that he often made presentations to prospective clients sharing with them his “strategy on how to cash in on a slowing housing market.” 1306 He said that, in early 2006, he expended approximately 200 hours trying to convince AIG to short single name RMBS, but was unsuccessful. He told the Subcommittee that he also believed that his presentations helped convince AIG to stop buying RMBS and CDO securities and stop selling CDS protection for those deals. In an August 2006 email, Mr. Lippmann wrote: “In 05 for a time, we sold EVERY single one to AIG. They stepped out of the market in March of 06 after speaking with me and our research people (and I don’t doubt other dealers).” 1307 Mr. Lippmann 1301 9/2005 “Shorting Home Equity Mezzanine Tranches, A Strategy to Cash in on a Slowing Housing Market,” DBSI_PSI_EMAIL00502892-29. 1302 Subcommittee interview of Greg Lippmann (10/18/2010). 1303 Id. 1304 Id. 1305 Id. 1306 Id. 1307 8/26/2006 email from Greg Lippmann to Richard Axilrod at Moore Capital, DBSI_PSI_EMAIL01618236. told the Subcommittee that Mr. Lamont, who co-led Deutsche Bank’s CDO Group, was not pleased that Mr. Lippmann had convinced AIG, a very large purchaser of long interest in RMBS and CDO securities, to stop buying them. CHRG-109shrg24852--117 PREPARED STATEMENT OF ALAN GREENSPAN Chairman, Board of Governors of the Federal Reserve System July 21, 2005 Mr. Chairman and Members of the Committee, I am pleased to be here to present the Federal Reserve's Monetary Policy Report to the Congress. In mid-February, when I presented our last report to the Congress, the economy, supported by strong underlying fundamentals, appeared to be on a solid growth path, and those circumstances prevailed through March. Accordingly, the Federal Open Market Committee (FOMC) continued the process of a measured removal of monetary accommodation, which it had begun in June 2004, by raising the Federal funds rate 1/4 percentage point at both the February and the March meetings. The upbeat picture became cloudier this spring, when data on economic activity proved to be weaker than most market participants had anticipated and inflation moved up in response to the jump in world oil prices. By the time of the May FOMC meeting, some evidence suggested that the economy might have been entering a soft patch reminiscent of the middle of last year, perhaps as a result of higher energy costs worldwide. In particular, employment gains had slowed from the strong pace of the end of 2004, consumer sentiment had weakened, and the momentum in household and business spending appeared to have dissipated somewhat. At the May meeting, the Committee had to weigh the extent to which this weakness was likely to be temporary--perhaps simply the product of the normal ebb and flow of a business expansion--and the extent to which it reflected some influence that might prove more persistent, such as the further run-up in crude oil prices. While the incoming data highlighted some downside risks to the outlook for economic growth, the FOMC judged the balance of information as suggesting that the economy had not weakened fundamentally. Moreover, core inflation had moved higher again through the first quarter. The rising prices of energy and other commodities continued to place upward pressures on costs, and reports of greater pricing power of firms indicated that they might be more able to pass those higher costs on to their customers. Given these considerations, the Committee continued the process of gradually removing monetary accommodation in May. The data released over the past 2 months or so accord with the view that the earlier soft readings on the economy were not presaging a more serious slowdown in the pace of activity. Employment has remained on an upward trend, retail spending has posted appreciable gains, inventory levels are modest, and business investment appears to have firmed. At the same time, low long-term interest rates have continued to provide a lift to housing activity. Although both overall and core consumer price inflation have eased of late, the prices of oil and natural gas have moved up again on balance since May and are likely to place some upward pressure on consumer prices, at least over the near-term. Slack in labor and product markets has continued to decline. In light of these developments, the FOMC raised the Federal funds rate at its June meeting to further reduce monetary policy accommodation. That action brought the cumulative increase in the funds rate over the past year to 2\1/4\ percentage points. Should the prices of crude oil and natural gas flatten out after their recent run-up--the forecast currently embedded in futures markets--the prospects for aggregate demand appear favorable. Household spending--buoyed by past gains in wealth, ongoing increases in employment and income, and relatively low interest rates--is likely to continue to expand. Business investment in equipment and software seems to be on a solid upward trajectory in response to supportive conditions in financial markets and the ongoing need to replace or upgrade aging high-tech and other equipment. Moreover, some recovery in nonresidential construction appears in the offing, spurred partly by lower vacancy rates and rising prices for commercial properties. However, given the comparatively less buoyant growth of many foreign economies and the recent increase in the foreign exchange value of the dollar, our external sector does not yet seem poised to contribute steadily to U.S. growth. A flattening out of the prices of crude oil and natural gas, were it to materialize, would also lessen upward pressures on inflation. Overall inflation would probably drop back noticeably from the rates experienced in 2004 and early 2005, and core inflation could hold steady or edge lower. Prices of crude materials and intermediate goods have softened of late, and the slower rise in import prices that should result from the recent strength in the foreign exchange value of the dollar could also relieve some pressure on inflation. Thus, our baseline outlook for the U.S. economy is one of sustained economic growth and contained inflation pressures. In our view, realizing this outcome will require the Federal Reserve to continue to remove monetary accommodation. This generally favorable outlook, however, is attended by some significant uncertainties that warrant careful scrutiny. With regard to the outlook for inflation, future price performance will be influenced importantly by the trend in unit labor costs, or its equivalent, the ratio of hourly labor compensation to output per hour. Over most of the past several years, the behavior of unit labor costs has been quite subdued. But those costs have turned up of late, and whether the favorable trends of the past few years will be maintained is unclear. Hourly labor compensation as measured from the national income and product accounts increased sharply near the end of 2004. However, that measure appears to have been boosted significantly by temporary factors. Other broad measures suggest hourly labor compensation continues to rise at a moderate rate. The evolution of unit labor costs will also reflect the growth of output per hour. Over the past decade, the U.S. economy has benefited from a remarkable acceleration of productivity: Strong gains in efficiency have buoyed real incomes and restrained inflation. But experience suggests that such rapid advances are unlikely to be maintained in an economy that has reached the cutting edge of technology. Over the past 2 years, growth in output per hour seems to have moved off the peak that it reached in 2003. However, the cause, extent, and duration of that slowdown are not yet clear. The traditional measure of the growth in output per hour, which is based on output as measured from the product side of the national accounts, has slowed sharply in recent quarters. But a conceptually equivalent measure that uses output measured from the income side has slowed far less. Given the divergence between these two readings, a reasonably accurate determination of the extent of the recent slowing in productivity growth and its parsing into cyclical and secular influences will require the accumulation of more evidence. Energy prices represent a second major uncertainty in the economic outlook. A further rise could cut materially into private spending and thus damp the rate of economic expansion. In recent weeks, spot prices for crude oil and natural gas have been both high and volatile. Prices for far-future delivery of oil and gas have risen even more markedly than spot prices over the past year. Apparently, market participants now see little prospect of appreciable relief from elevated energy prices for years to come. Global demand for energy apparently is expected to remain strong, and market participants are evidencing increased concerns about the potential for supply disruptions in various oil-producing regions. To be sure, the capacity to tap and utilize the world's supply of oil continues to expand. Major advances in recovery rates from existing reservoirs have enhanced proved reserves despite ever fewer discoveries of major oil fields. But, going forward, because of the geographic location of proved reserves, the great majority of the investment required to convert reserves into new crude oil productive capacity will need to be made in countries where foreign investment is currently prohibited or restricted or faces considerable political risk. Moreover, the preponderance of oil and gas revenues of the dominant national oil companies is perceived as necessary to meet the domestic needs of growing populations. These factors have the potential to constrain the ability of producers to expand capacity to keep up with the projected growth of world demand, which has been propelled to an unexpected extent by burgeoning demand in emerging Asia. More favorably, the current and prospective expansion of U.S. capability to import liquefied natural gas will help ease longer-term natural gas stringencies and perhaps bring natural gas prices in the United States down to world levels. The third major uncertainty in the economic outlook relates to the behavior of long-term interest rates. The yield on 10-year Treasury notes, currently near 4\1/4\ percent, is about 50 basis points below its level of late spring 2004. Moreover, even after the recent widening of credit risk spreads, yields for both investment-grade and less-than-investment-grade corporate bonds have declined even more than those on Treasury notes over the same period. This decline in long-term rates has occurred against the backdrop of generally firm U.S. economic growth, a continued boost to inflation from higher energy prices, and fiscal pressures associated with the fast approaching retirement of the baby-boom generation.\1\ The drop in long-term rates is especially surprising given the increase in the Federal funds rate over the same period. Such a pattern is clearly without precedent in our recent experience.--------------------------------------------------------------------------- \1\ Under current law, those longer-run pressures on the Federal budget threaten to place the economy on an unsustainable path. Large deficits could result in rising interest rates and ever-growing interest payments on the accumulating stock of debt, which in turn would further augment deficits in future years. That process could result in deficits as a percentage of gross domestic product rising without limit. Unless such a development were headed off, these deficits could cause the economy to stagnate or worse at some point over the next couple of decades.--------------------------------------------------------------------------- The unusual behavior of long-term interest rates first became apparent last year. In May and June 2004, with a tightening of monetary policy by the Federal Reserve widely expected, market participants built large short positions in long-term debt instruments in anticipation of the increase in bond yields that has been historically associated with an initial rise in the Federal funds rate. Accordingly, yields on 10-year Treasury notes rose during the spring of last year about 1 percentage point. But by summer, pressures emerged in the marketplace that drove long-term rates back down. In March of this year, long-term rates once again began to rise, but like last year, market forces came into play to make those increases short lived. Considerable debate remains among analysts as to the nature of those market forces. Whatever those forces are, they are surely global, because the decline in long-term interest rates in the past year is even more pronounced in major foreign financial markets than in the United States. Two distinct but overlapping developments appear to be at work: A longer-term trend decline in bond yields and an acceleration of that trend of late. Both developments are particularly evident in the interest rate applying to the 1 year period ending 10 years from today that can be inferred from the U.S. Treasury yield curve. In 1994, that so-called forward rate exceeded 8 percent. By mid-2004, it had declined to about 6\1/2\ percent--an easing of about 15 basis points per year on average.\2\ Over the past year, that drop steepened, and the forward rate fell 130 basis points to less than 5 percent.--------------------------------------------------------------------------- \2\ Dollar interest rate swaps 5 years forward and maturing in 10 years declined 19 basis points per year on average over the same period. Comparable euro (pre-1999, Deutschemark) swaps declined 27 basis points, sterling swaps 35 basis points, and yen swaps 23 basis points.--------------------------------------------------------------------------- Some, but not all, of the decade-long trend decline in that forward yield can be ascribed to expectations of lower inflation, a reduced risk premium resulting from less inflation volatility, and a smaller real term premium that seems due to a moderation of the business cycle over the past few decades.\3\ This decline in inflation expectations and risk premiums is a signal development. As I noted in my testimony before this Committee in February, the effective productive capacity of the global economy has substantially increased, in part because of the breakup of the Soviet Union and the integration of China and India into the global marketplace. And this increase in capacity, in turn, has doubtless contributed to expectations of lower inflation and lower inflation-risk premiums.--------------------------------------------------------------------------- \3\ Term premiums measure the extent to which current prices of bonds discount future uncertainties.--------------------------------------------------------------------------- In addition to these factors, the trend reduction worldwide in long-term yields surely reflects an excess of intended saving over intended investment. This configuration is equivalent to an excess of the supply of funds relative to the demand for investment. What is unclear is whether the excess is due to a glut of saving or a shortfall of investment. Because intended capital investment is to some extent driven by forces independent of those governing intended saving, the gap between intended saving and investment can be quite wide and variable. It is real interest rates that bring actual capital investment worldwide and its means of financing, global saving, into equality. We can directly observe only the actual flows, not the saving and investment tendencies. Nonetheless, as best we can judge, both high levels of intended saving and low levels of intended investment have combined to lower real long-term interest rates over the past decade. Since the mid-1990's, a significant increase in the share of world gross domestic product (GDP) produced by economies with persistently above-average saving--prominently the emerging economies of Asia--has put upward pressure on world saving. These pressures have been supplemented by shifts in income toward the oil-exporting countries, which more recently have built surpluses because of steep increases in oil prices. The changes in shares of world GDP, however, have had little effect on actual world capital investment as a percentage of GDP. The fact that investment as a percentage of GDP apparently changed little when real interest rates were falling, even adjusting for the shift in the shares of world GDP, suggests that, on average, countries' investment propensities had been declining.\4\--------------------------------------------------------------------------- \4\ Nominal GDP figures by country are estimated in dollars by the International Monetary Fund using purchasing power parities (PPP) of currencies. These GDP figures are used to calculate weights applied to national saving and investment rates to form global measures. When the GDP figures are instead measured at market exchange rates, the results are similar. The PPP estimates emphasize the economic factors generating investment and the use of saving. Exchange rates emphasize the financial forces governing the financing of investment across borders. Both approaches are useful.--------------------------------------------------------------------------- Softness in intended investment is also evident in corporate behavior. Although corporate capital investment in the major industrial countries rose in recent years, it apparently failed to match increases in corporate cashflow.\5\ In the United States, for example, capital expenditures were below the very substantial level of corporate cashflow in 2003, the first shortfall since the severe recession of 1975. That development was likely a result of the business caution that was apparent in the wake of the stock market decline and the corporate scandals early this decade. (Capital investment in the United States has only recently shown signs of shedding at least some of that caution.) Japanese investment exhibited prolonged restraint following the bursting of their speculative bubble in the early 1990's. And investment in emerging Asia excluding China fell appreciably after the Asian financial crisis in the late 1990's. Moreover, only a modest part of the large revenue surpluses of oil-producing nations has been reinvested in physical assets. In fact, capital investment in the Middle East in 2004, at 25 percent of the region's GDP, was the same as in 1998. National saving, however, rose from 21 percent to 32 percent of GDP. The unused saving of this region was invested in world markets.--------------------------------------------------------------------------- \5\ A significant part of the surge in cashflow of U.S. corporations was accrued by those financial intermediaries that invest only a small part in capital assets. It appears that the value added of intermediation has increased materially over the past decade because of major advances in financial product innovation.--------------------------------------------------------------------------- Whether the excess of global intended saving over intended investment has been caused by weak investment or excessive saving--that is, by weak consumption--or, more likely, a combination of both does not much affect the intermediate-term outlook for world GDP or, for that matter, U.S. monetary policy. What have mattered in recent years are the sign and the size of the gap of intentions and the implications for interest rates, not whether the gap results from a saving glut or an investment shortfall. That said, saving and investment propensities do matter over the longer-run. Higher levels of investment relative to consumption build up the capital stock and thus add to the productive potential of an economy. The economic forces driving the global saving-investment balance have been unfolding over the course of the past decade, so the steepness of the recent decline in long-term dollar yields and the associated distant forward rates suggests that something more may have been at work over the past year.\6\ Inflation premiums in forward rates 10 years ahead have apparently continued to decline, but real yields have also fallen markedly over the past year. It is possible that the factors that have tended to depress real yields over the past decade have accelerated recently, though that notion seems implausible.--------------------------------------------------------------------------- \6\ The decline of euro, sterling, and yen forward swap rates also steepened.--------------------------------------------------------------------------- According to estimates prepared by the Federal Reserve Board staff, a significant portion of the sharp decline in the 10-year forward 1 year rate over the past year appears to have resulted from a fall in term premiums. Such estimates are subject to considerable uncertainty. Nevertheless, they suggest that risk takers have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons. These actions have been accompanied by significant declines in measures of expected volatility in equity and credit markets inferred from prices of stock and bond options and narrow credit risk premiums. History cautions that long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress. Such perceptions, many observers believe, are contributing to the boom in home prices and creating some associated risks. And, certainly, the exceptionally low interest rates on 10-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of homebuilding, home turnover, and particularly in the steep climb in home prices. Whether home prices on average for the Nation as a whole are overvalued relative to underlying determinants is difficult to ascertain, but there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels. Among other indicators, the significant rise in purchases of homes for investment since 2001 seems to have charged some regional markets with speculative fervor. The apparent froth in housing markets appears to have interacted with evolving practices in mortgage markets. The increase in the prevalence of interest-only loans and the introduction of more-exotic forms of adjustable-rate mortgages are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But some households may be employing these instruments to purchase homes that would otherwise be unaffordable, and consequently their use could be adding to pressures in the housing market. Moreover, these contracts may leave some mortgagors vulnerable to adverse events. It is important that lenders fully appreciate the risk that some households may have trouble meeting monthly payments as interest rates and the macroeconomic climate change. The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices. Nevertheless, we certainly cannot rule out declines in home prices, especially in some local markets. If declines were to occur, they likely would be accompanied by some economic stress, though the macroeconomic implications need not be substantial. Nationwide banking and widespread securitization of mortgages make financial intermediation less likely to be impaired than it was in some previous episodes of regional house-price correction. Moreover, a decline in the national housing price level would need to be substantial to trigger a significant rise in foreclosures, because the vast majority of homeowners have built up substantial equity in their homes despite large mortgage-market-financed withdrawals of home equity in recent years. Historically, it has been rising real long-term interest rates that have restrained the pace of residential building and have suppressed existing home sales, high levels of which have been the major contributor to the home equity extraction that arguably has financed a noticeable share of personal consumption expenditures and home modernization outlays. The trend of mortgage rates, or long-term interest rates more generally, is likely to be influenced importantly by the worldwide evolution of intended saving and intended investment. We at the Federal Reserve will be closely monitoring the path of this global development few, if any, have previously experienced. As I indicated earlier, the capital investment climate in the United States appears to be improving following significant headwinds since late 2000, as is that in Japan. Capital investment in Europe, however, remains tepid. A broad worldwide expansion of capital investment not offset by a rising worldwide propensity to save would presumably move real long-term interest rates higher. Moreover, with term premiums at historical lows, further downward pressure on long-term rates from this source is unlikely. We collectively confront many risks beyond those that I have just mentioned. As was tragically evidenced again by the bombings in London earlier this month, terrorism and geopolitical risk have become enduring features of the global landscape. Another prominent concern is the growing evidence of antiglobalization sentiment and protectionist initiatives, which, if implemented, would significantly threaten the flexibility and resilience of many economies. This situation is especially troubling for the United States, where openness and flexibility have allowed us to absorb a succession of large shocks in recent years with only minimal economic disruption. That flexibility is, in large measure, a testament to the industry and resourcefulness of our workers and businesses. But our success in this dimension has also been aided importantly by more than two and a half decades of bipartisan effort aimed at reducing unnecessary regulation and promoting the openness of our market economy. Going forward, policymakers will need to be vigilant to preserve this flexibility, which has contributed so constructively to our economic performance in recent years. In conclusion, Mr. Chairman, despite the challenges that I have highlighted and the many I have not, the U.S. economy has remained on a firm footing, and inflation continues to be well contained. Moreover, the prospects are favorable for a continuation of those trends. Accordingly, the Federal Open Market Committee in its June meeting reaffirmed that it ``. . . believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.'' FOMC20071031meeting--147 145,MR. HOENIG.," Thank you, Mr. Chairman. I’ll take just a second here because I realize how difficult today’s decision is and that it involves balancing contrasting and rather elevated risks. One risk is that the current housing and financial environment will cascade the real economy immediately into a slowdown, and that would cost output and jobs and prove after all to involve little effect on rising inflation. To do nothing in this instance, I realize, would at least seem to be a poor choice. The other risk, however, is that inflation is less contained than we would like to think. Aggregate demand is at least holding and looks firm. Commodity prices, not just energy, show a rising trend and are unusually high. The dollar has depreciated, as Brian pointed out, and if it continues to fall, will add to further inflationary pressures. Unit labor costs are increasing, and these inflationary factors are real and show themselves to be present in TIPS measures and in terms of expected inflation, as I mentioned yesterday, in a lot of anecdotal discussions that I have had. To ease further in this instance would also seem to be a poor choice. I realize that the intensity of these two countervailing forces complicates our decision, and I know that I might be only one view on this, among others who have a different view. But as I see it, we are having to choose a policy that involves tradeoffs around these two choices. One choice is to ease now. We would take an action that is oriented toward the short run, and the immediate easing could be looked at as an insurance policy, as I have heard it described, designed to mitigate further the possibility that the current upheaval in the housing and financial markets will lead to an unwanted slowdown in the real economy. If the economy strengthens, as President Lacker has pointed out, we can always reverse that easing—so we tell ourselves. The other choice is to hold firm now. Inflationary risks, as I’ve described above, are real; and while they are unlikely to affect us in the short run, they most certainly could affect us in the longer run if we continue to ease. If inflation above acceptable levels gets entrenched into the U.S. and global economies, make no mistake—as we all have experienced, this has happened before. Inflation does creep in. It doesn’t jump in—it’s a little at a time. Also, if we ease today and things don’t turn immediately, we will be reset for another discussion of what the market expects when we come to December. The cost to remedy inflationary momentum later is also high— indeed, as we all know. So what is the better choice, then, when adjusted for long-run and short-run considerations regarding these elevated risks? Personally, I think that we should hold where we are. When I analyze how the U.S. and global economies are performing and look at the projections for these economies that we shared here, I judge this to be the better long-run decision. We moved rates down significantly at our last meeting. Indeed, we front-loaded the action to ensure a strong result. Also, we are very close to neutral, if not there, I realize, and we need to be slightly firm if we are to hold inflation and inflationary expectations better in check. It strikes me that inflation is at the higher end of what most individuals prefer. If we need to move down, we can do so later. It is, in fact, easier to lower rates than to raise them back up. Our issue today, I think, remains for the moment principally liquidity, and we should remind the world that we have stepped up to this issue and reassure it that we are ready to meet the need further—and other needs, if necessary. But for now the risks on both sides of this policy decision are elevated, and we need to wait, watch, and be ready to act depending on how events play out. As to the statement, then, I prefer alternative B for the most part. I would prefer something along the lines in paragraph 4 that “financial markets remain uncertain,” and then “thus the Committee will continue . . .” or paragraph 4 in alternative C. Thank you very much, Mr. Chairman." fcic_final_report_full--553 Public Hearing on the Role of Derivatives in the Financial Crisis, Dirksen Senate Of- fice Building, Room , Washington, DC, Day , June ,  Session : Overview of Derivatives Michael Greenberger, Professor, University of Maryland School of Law Steve Kohlhagen, Former Professor of International Finance, University of California, Berkeley, and former Wall Street derivatives executive Albert “Pete” Kyle, Charles E. Smith Chair Professor of Finance, University of Maryland Michael Masters, Chief Executive Officer, Masters Capital Management, LLC Session : American International Group, Inc. and Derivatives Joseph J. Cassano, Former Chief Executive Officer, American International Group, Inc. Finan- cial Products Robert E. Lewis, Senior Vice President and Chief Risk Officer, American International Group, Inc. Martin J. Sullivan, Former Chief Executive Officer, American International Group, Inc. Session : Goldman Sachs Group, Inc. and Derivatives Craig Broderick, Managing Director, Head of Credit, Market, and Operational Risk, Goldman Sachs Group, Inc. Gary D. Cohn, President and Chief Operating Officer, Goldman Sachs Group, Inc. Public Hearing on the Role of Derivatives in the Financial Crisis, Dirksen Senate Of- fice Building, Room , Washington DC, Day , July ,  Session : American International Group, Inc. and Goldman Sachs Group, Inc. Steven J. Bensinger, Former Executive Vice President and Chief Financial Officer, American In- ternational Group, Inc. Andrew Forster, Former Senior Vice President and Chief Financial Officer, American Interna- tional Group, Inc. Financial Services Elias F. Habayeb, Former Senior Vice President and Chief Financial Officer, American Interna- tional Group, Inc. Financial Services David Lehman, Managing Director, Goldman Sachs Group, Inc David Viniar, Executive Vice President and Chief Financial Officer, Goldman Sachs Group, Inc. Session : Derivatives: Supervisors and Regulators Eric R. Dinallo, Former Superintendant, New York State Insurance Department Gary Gensler, Chairman, Commodity Futures Trading Commission Clarence K. Lee, Former Managing Director for Complex and International Organizations, Of- fice of Thrift Supervision Public Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Gov- ernment Intervention and the Role of Systemic Risk in the Financial Crisis, Dirksen Senate Office Building, Room , Washington DC, Day , September ,  Session : Wachovia Corporation Scott G. Alvarez, General Counsel, Board of Governors of the Federal Reserve System John H. Corston, Acting Deputy Director, Division of Supervision and Consumer Protection, U.S. Federal Deposit Insurance Corporation Robert K. Steel, Former President and Chief Executive Officer, Wachovia Corporation Session : Lehman Brothers Thomas C. Baxter, Jr., General Counsel and Executive Vice President, Federal Reserve Bank of New York FOMC20060629meeting--172 170,MR. WARSH.," Thank you, Mr. Chairman. Let me support the move of 25 basis points on the merits. I don’t feel as though I’m constrained by market expectations for this meeting; rather, on the merits, I think that’s the right thing to do. Before getting into a discussion of the language, maybe I can give a couple of perspectives, Mr. Chairman, on the markets themselves. My sense of things is that a bit of a herd mentality remains in the markets in that they have been waiting for our every utterance and, in some ways, they have been guided by us for a very, very long time. The discussion we’re having today is really the tough one because we recognize that we need to wean the markets from the degree of certainty that we no longer possess. I think this discussion is really quite healthy in doing so. In light of that perspective, I think that alternative B strikes the right balance. Without trying to wordsmith the statement at this point, I think that, although I share Vince’s view that ultimately the markets will get to a probability for August that is more balanced, it will take some time. That is, I think the markets’ first reaction to alternative B and to the various versions that we’re talking about will have some “stickiness” to the view that they have now. They will believe that we have stopped giving them guidance, that we’ve gotten out of that business, and that we are somehow culpable for that. We have led them to the river, and now we are telling them that what they do is really their decision after all. My own view is that this shift is a very, very good thing; but it is not going to be without some pain, and I think swipes will be made at us. The Chairman’s monetary policy testimony will perhaps represent just a little bit of that. But a dispersion of market views as to what we should be doing, what the state of the economy is, and what the prospects are for inflation is a very healthy thing. We will be introducing some volatility into the markets, probably in a more meaningful way than they may have seen, but on balance I think such a shift is all to the good. With that backdrop—that these markets are not focused on nuance—and the recognition that the discussion we’re having is about nuance, let me say a few things in support of alternative B. First, in the rationale section, where we say that inflation expectations remain contained, I think the markets will take a couple of shots at us and say, “Boy, you said they were contained previously. You say they’re contained now. What was all that that we heard in between?” The way that I get comfortable with the statement that inflations expectations are contained is that some of the movements in the markets, in the inflation surveys, in the TIPS markets, and in the commodities markets show they have been responsive to our views. I also feel that we can honestly describe them as being contained, but the container may be bigger than we had said it was before. [Laughter] I guess I’m not troubled by that. If we introduced language such as “unwelcome,” the markets would take it as a reprise of the Chairman’s remarks from a few weeks ago and would take the view that we were anticipating that they move up the fed funds futures markets for August. I think that view would be very problematic in light of what I hear is the central tendency of people’s views here—that we want that bet to be fairer, closer to 50-50, and I fear that our historical use of “unwelcome” would go against what we’re collectively trying to accomplish. Let me make another comment, about the assessment of risk where we say, “The Committee judges that some inflation risks remain.” I think that people in the markets are going to focus on the word “some.” “Some” in recent meetings has meant some further policy firming—that is, more than one move; “some” was a strong word. In this context, after some time and understanding, which will not be at 2:16 or 2:30 or even today or tomorrow, they’re going to recognize that “some” actually weakens the statement somewhat. Saying “some inflation risks remain” rather than “the Committee judges inflation risks remain” will, on balance, modestly lower the fed funds futures for August and beyond and will more likely bring us back to a point where we will have a fair fight come our August decision. I think that taking out “some” is likely to be a good change. So, on balance, Mr. Chairman, I support alternative B. Some of the suggestions that have been made about how to characterize our views vis-à-vis neutrality and whether or not we’re mildly restrictive strike me as leading to a discussion in the markets that might not be terribly helpful at this time. Our walking away from what the markets perceive to be firm and obvious guidance is a bigger move for them than I think this discussion may be suggesting, and I’d rather not add a new notion of neutrality, and a discussion about whether we are less loose or more tight strikes me as inopportune at this moment. I concur with a comment that President Yellen made at the outset about thinking about our August decision with an option model theory approach. This approach is basically that we don’t want to exercise that option until we have to. Alternative B preserves our options, on balance, for a fair fight and a fair discussion come the August meeting. Thank you, Mr. Chairman." FOMC20060510meeting--91 89,MR. MOSKOW.," Thank you, Mr. Chairman. Most of my business contacts indicated that overall economic activity remains on a solid footing and that resource utilization has tightened further. Both of the major temporary-help firms headquartered in our District said that hiring remains strong nationwide. They continued to say that skilled workers are in short supply. This topic was also on the minds of our contacts in manufacturing and construction. As I’ve noted previously, we’ve heard a few reports from manufacturers that labor shortages were causing delays in supplier deliveries. Strengthened labor demand, however, has not yet spread to lower-skilled workers. So while wages for skilled individuals continue to increase briskly, pay rates for other workers are up only modestly. We’re also seeing signs of pressure on nonlabor resources. Some of our contacts have run into problems with the costs and availability of trucking and rail shipping capacity, and a manufacturer of drilling equipment reported supply disruptions because its vendors were heavily backlogged. Several contacts noted that price pressures have intensified for many commodities, as we’ve discussed before. Of course, everyone was talking about the surge in energy costs. Some retailers noted that sales had slowed, and they attributed the softness to higher energy prices. Others were concerned about the impact of energy going forward. In contrast, our manufacturing contacts reported that they generally have no plans to scale back production in response to the recent increases. There is not much new to report on the Delphi negotiations. The period for Delphi workers to sign up for early retirement is just starting. Delphi, General Motors, and the UAW hope that many will accept the buyout. This would leave fewer union workers vulnerable to being laid off as Delphi downsizes, which would make the negotiations easier for all the parties involved. On a final note, several of my directors continue to be concerned about the amount of liquidity in financial markets. They say prices and terms for more and more deals are bordering on speculative. Turning to the outlook, we’ve had quite a bit of news since our last meeting. Much of it suggests increased risks on the inflation front. Of course, the March reading on core inflation was just one month, but the twelve-month change in core PCE inflation is now back up to 2 percent. And as President Lacker said, the six-month change is now up to 2.4 percent. Moreover, energy prices have jumped again. The dollar has weakened a bit more, and inflation expectations have risen. In response to the latest data, the forecasts from our indicator models of inflation have moved up some. Currently, these project 2007 core PCE inflation between 2 percent and 2.4 percent. To be sure, things are far from getting out of hand: Resource utilization measures currently are only modestly on the tight side, and we are all well aware of the uncertainty surrounding those measures. Furthermore, the recent ECI data suggest that wage pressures remain muted. That said, other measures of wage growth have been rising. Looking at the markup of prices over labor costs, one would think that there’s plenty of room for profit margins to absorb higher wages. But as Bill Poole suggested in the issue we discussed before, the business people I talked to haven’t gotten that message. Their attempts to maintain margins in the face of increasing costs represent an upside risk to the inflation outlook. So I agree with the upward nudge to the Greenbook inflation forecast, but I’d go a bit further. Given the Greenbook path for the funds rate, I think core inflation of 2¼ percent is a more reasonable point forecast for 2007. In terms of growth, the expansion still appears solid. The softening in housing that we have been anticipating is more obvious now. There’s a possibility that moderation might turn to something bigger, but I don’t see this as a large risk. Of course, $3-a-gallon gasoline should restrain demand somewhat, and we’ll need to keep a close eye on how consumers respond to yet another hit to their purchasing power. But employment continues to rise at a good pace, generating healthy increases in income, which should support household demand. Businesses are supporting spending on capital goods, and growth prospects abroad continue to suggest some optimism on export demand. So I think growth will average around potential over the course of the projection period." CHRG-111hhrg53242--16 Mr. Baker," Thank you, Mr. Chairman, Mr. Hensarling, and members of the committee. I am pleased to be back in this very familiar room and enjoy the opportunity and appreciate your courtesy in asking me to participate. I am Richard Baker, President and CEO of the Managed Funds Association (MFA), which represents the majority of the world's largest hedge funds and are the primary advocate for sound business practices for professionals in hedge funds, funds of funds, and managed futures. Our funds provide liquidity and price discovery to markets, capital for companies to grow, and risk management services to investors such as our Nation's pension funds. Our work enables them to meet their commitments to their retirees. With an estimated $1.5 trillion under management, the industry is significantly smaller than the $9.4 trillion mutual fund industry or the $13.8 trillion banking industry. I make note of this fact for the reason to assess the appropriate level of risk that our sector could present to broader market function. Further, many hedge funds use little or no leverage, as has been stated earlier this morning, which additionally limits their contribution to market risk. In a recent study, 26.9 percent do not deploy leverage at all. And a recent analysis by the Financial Services Authority found that industry-wide, over a 5-year period, fund leverage averaged between two and three to one. This is certainly not the generally accepted view of leverage in our industry. The industry's modest size, coupled with the relatively low leverage, give reasons for those to view that we are not and have not been contributors to the current dislocation in the market and, unfortunately, that has led to the broad deployment of taxpayer dollars. Notwithstanding these facts, our funds have a shared interest with other market participants in restoration of investor confidence and in establishing a more stable and transparent marketplace. These important objectives we believe can be attained with careful analysis and construction of a smart regulatory structure. This will require appropriate and sensible regulation. It is aided by the adoption of industry-sound practices, which we have promoted at the MFA, and it will require investors to engage in their own due diligence. There is no substitute for asking the right questions before you write the check. Our members recognize that mandatory SEC registration for those advisers who are not currently registered for all private pools of capital is a key regulatory reform. Registration under the Investment Advisers Act, we believe, is the smartest approach. Currently, over half of our members are registered in this manner with the SEC. The Advisers Act is a comprehensive framework, and among many other elements, requires disclosure to the SEC regarding the advisers' business, detailed disclosure to clients, policies and procedures to prevent insider training, maintenance of books and records, periodic inspection, and examination by the SEC. We do believe it is important to establish an exemption from registration, however, for the smallest investment advisers that have de minimis amount of assets under management. This exemption should be narrowly drawn to ensure that an inappropriate loophole from registration is not created. Also the provision should coordinate, not duplicate, we hope, regulation at the State level. Good regulation is also efficient regulation. In that regard, we do have some concerns with the Administration's proposed legislation that would impose duplicative registration requirements on a number of our commodity trading advisers, most of whom who are already regulated by the CFTC. We hope, Mr. Chairman, that we would be able to work with the committee to remedy this particular concern. With regard to a subject of some recent interest, credit default swaps, we have worked with regulators to reduce risk and improve market efficiency. We support efforts to increase standardization and central clearing or exchange trading of OTC derivatives. However, it is essential to maintain the ability of market participants to enter into customized OTC contracts. All market participants should post appropriate collateral for OTC transactions. And that collateral should importantly be segregated, meaning that it is protected. And there should be reporting to the regulator as deemed appropriate. The subject of systemic risk is also of current concern as well. There should be a systemic risk regulator with oversight of the key elements of the entire financial system, but it should only be enabled with confidential reporting by our firms to that regulator. A clear mandate for the regulator should be established to protect the integrity of the financial system, not individual market participants. The regulator should have clear authority to act as required by his evaluation of the circumstance and in a decisive manner. We believe these views are consistent with the Administration's stated goals. I appreciate this courtesy to present these views, and look forward to working with the committee toward effective resolution. Thank you, Mr. Chairman. [The prepared statement of Mr. Baker can be found on page 30 of the appendix.] " CHRG-109shrg24852--19 Chairman Greenspan," Thank you, Mr. Chairman. I have excerpted only part of that rather extended statement. Mr. Chairman and Members of the Committee, I am pleased to be here to present the Federal Reserve's Monetary Policy Report to the Congress. In recent weeks, employment has remained on an upward trend, retail spending has posted appreciable gains, inventory levels have been modest, and business investment appears to have firmed. At the same time, low long-term interest rates have continued to provide a lift to housing activity. Although both overall and core consumer price inflation have eased of late, the prices of oil and natural gas have moved up again on balance since May and are likely to place some upward pressure on consumer prices, at least over the near term. Should the prices of crude oil and natural gas flatten out after their recent run-up--the forecast currently embedded in futures markets, incidentally--the prospects for aggregate demand appear favorable, and upward pressures on inflation would be reduced. Thus, our baseline outlook for the U.S. economy is one of sustained economic growth and contained inflation pressures. In our view, realizing this outcome will require the Federal Reserve to continue to remove monetary accommodation. This generally favorable outlook, however, is attended by some significant uncertainties that warrant careful scrutiny. With regard to the outlook for inflation, future price performance will be influenced importantly by the trend in unit labor costs, or its equivalent, the ratio of hourly labor compensation to output per hour. Over most of the past several years, the behavior of unit labor costs has been quite subdued. But those costs have turned up of late, and whether the favorable trends of the past few years will be maintained is unclear. Hourly labor compensation as measured from the national income and product accounts increased sharply near the end of 2004. However, that measure appears to have been boosted significantly by temporary factors. Over the past 2 years, growth in output per hour seems to have moved off the peak that it reached in 2003. However, the cause, extent, and duration of that slowdown are not yet clear. Energy prices represent a second major uncertainty in the economic outlook. A further rise could materially cut into private spending and thus damp the rate of economic expansion. More favorably, the current and prospective expansion of U.S. capability to import liquefied natural gas will help ease long-term natural gas stringencies and perhaps bring natural gas prices in the United States down to world levels. The third major uncertainty in the economic outlook relates to the behavior of long-term interest rates. The yield on 10-year Treasury notes, currently near 4\1/4\ percent, is about 50 basis points below its level of late spring 2004. Two distinct but overlapping developments appear to be at work: A longer-term trend decline in bond yields and an acceleration of that trend of late. Some, but not all, of the decade-long trend decline in bond yield can be ascribed to expectations of lower inflation, a reduced risk premium resulting from less inflation volatility, and a smaller real term premium that seems due to a moderation of the business cycle over the past few decades. In addition to these factors, the trend reduction worldwide in long-term rates surely reflects an excess of intended saving over intended investment. What is unclear is whether the excess is due to a glut of savings or a shortfall of investment. Because intended capital investment is to some extent driven by forces independent of those governing intended saving, the gap between intended saving and investment can be quite wide and variable. It is real interest rates that bring actual capital investment worldwide and its means of financing, global savings, into equality. As best we can judge, both high levels of intended saving and low levels of intended investment have combined to lower real long-term interest rates over the past decade. Since the mid-1990's, a significant increase in the share of world gross domestic product produced by economies with persistently above average saving--predominantly the emerging economies of Asia--has put upward pressure on world saving. These pressures have been supplemented by shifts in income toward the oil-exporting countries, which more recently have built surpluses because of steep increases in oil prices. Softness in intended investment is also evidence. Although corporate capital investment in the major industrial countries rose in recent years, it apparently failed to match increases in corporate cashflow. Whether the excess of global intended saving over intended investment has been caused by weak investment or excessive saving--that is, weak consumption--or, more likely, a combination of both does not much affect the intermediate-term outlook for world GDP or, for that matter, U.S. monetary policy. What have mattered in recent years are the sign and the size of the gap of intentions and the implications for interest rates, not whether the gap results from a saving glut or an investment shortfall. That said, saving and investment propensities do matter over the longer-run. Higher levels of investment relative to consumption build up the capital stock and thus add to the productive potential of an economy. The economic forces driving the global saving-investment balance have been unfolding over the course of the past decade, so the steepness of the recent decline in long-term dollar yields and the associated distant forward rates suggests that something more may have been at work over the past year. Inflation premiums in forward rates 10 years ahead have apparently continued to decline, but real yields have also fallen markedly over the past year. Risk takers apparently have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons. These actions have been accompanied by significant declines in measures of expected volatility and equity in credit markets. History cautions that long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress. Such perceptions, many observers believe, are contributing to the boom in home prices and creating some associated risks. And, certainly, the exceptionally low interest rates on 10-year Treasury notes and hence on home mortgages have been a major factor in the recent surge of homebuilding, home turnover, and particularly in the steep climb in home prices. Whether home prices on average for the Nation as a whole are overvalued relative to underlying determinants is difficult to ascertain, but there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels. Among other indicators, the significant rise in purchases of homes for investment since 2001 seems to have charged some regional markets with speculative fervor. The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices. Nevertheless, we certainly cannot rule out declines in home prices, especially in some local markets. If declines were to occur, they likely would be accompanied by some economic stress, though the macroeconomic implications need not be substantial. Historically, it has been rising real long-term interest rates that have restrained the pace of residential building and have suppressed existing home sales. The trend of mortgage rates, or long-term interest rates more generally, is likely to be influenced importantly by the worldwide evolution of intended saving and intended investment. We are the Federal Reserve will be closely monitoring the path of this global development few, if any, have previously experienced. We collectively confront many risks beyond those I have just mentioned. As was tragically evidenced again by the bombings in London earlier this month--and, I might add, some questions about what is going on in London today--terrorism and geopolitical risk have become enduring features of the global landscape. Another prominent concern is the growing evidence of anti-globalization sentiment and protectionist initiatives, which, if implemented, would significantly threaten the flexibility and resilience of many economies. This situation is especially troubling for the United States, where openness and flexibility have allowed us to absorb a succession of large shocks in recent years with only minimal economic disruption. That flexibility is, in large measure, a testament to the industry and resourcefulness of our workers and businesses. But our success in this dimension has also been aided importantly by more than two and a half decades of bipartisan effort aimed at reducing unnecessary regulation and promoting the openness of our market economy. Going forward, policymakers will need to be vigilant to preserve this flexibility, which has contributed so constructively to our economic performance in recent years. In conclusion, Mr. Chairman, despite the challenges I have highlighted and the many I have not, the U.S. economy has remained on a firm footing, and inflation continues to be well contained. Moreover, the prospects are favorable for a continuation of those trends. Accordingly, the Federal Open Market Committee in its June meeting reaffirmed that it ``. . . believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.'' Thank you very much. I look forward to your questions. " FOMC20061025meeting--74 72,MR. POOLE.," Thank you, Mr. Chairman. Let me start by saying that I think the Greenbook outlook is a very good central tendency outlook. I am going to make some comments that are more on the downside of that, which come from hunches and gut instinct. I want to emphasize that I don’t want to make policy on the basis of gut instinct, but I think it helps to keep an open mind about some of the things that might be going on. First, on the positive side, my UPS contact says that he is expecting a peak season with a glut of volume and not enough lift. They’re going to have to move express business over to trucks. So if you’re counting on getting a last minute present at Christmastime, I urge you to order a little earlier than you might otherwise. That’s his expectation. On the labor side, UPS has some fairly big increases coming next year as a consequence of recent contracts they signed. They had a long negotiation with pilots, but on the ground side, obviously the less skilled workers, they’re expecting about 3½ percent compensation, very much in line with a normal situation. My Wal-Mart contact said that they have not experienced the pickup in sales that they would have anticipated from the decline in energy prices. They had expected an increase of about 65 basis points. They always measure their sales as same-store, year over year. They haven’t seen that. They’re going to be lucky to get 2 percent year-over-year in October. My contact says that weekly information suggests that October is slowing down week by week as we go through the month. Wal-Mart received a lot of attention recently in the press about their slowdown in building new stores next year. They probably had a lot more press than the actual size of the slowdown warrants. They are expecting to increase their square footage 7.6 percent in ’07 compared with 8.4 percent in ’06—so the slowdown is hardly gigantic. Construction costs this year are rising 17 percent; next year they’re anticipating 11 to 12 percent. So there is a slowdown in the increase, but 11 to 12 percent is still a pretty big increase in construction costs. My contact in the trucking industry says—and this may make a little more explicit what Richard Fisher was saying—that things in the industry are continuing to slow down. He says it’s the first time in his experience—and he’s been with the company twenty years or more—that the seasonal peak has not yet started. Ordinarily the seasonal peak in shipping for the holiday shopping season would have started. It just hasn’t started, and I think he said they’re running—I forget exactly what the number was—8 percent below a year ago. (Incidentally, one thing that I was thinking when Richard was talking was that sometimes the business people have a hard time doing the seasonal adjustment, so when you compare the third quarter with the second quarter, they may not be seeing a seasonally adjusted slowdown because the volume is bigger in the third than in the second.) My trucking industry contact says that the slower business seems pretty evenly distributed geographically—perhaps a greater softness in the Southeast than in other parts of the country. It is more concentrated in home improvement—I think Home Depot is one of the big customers—and probably autos, but the softness is spread fairly generally across commodity categories. We’ve also spent a lot of time talking recently with contacts in the housing industry. The word that we’re getting is that some of the smaller and even regional builders have perhaps six months, and if they don’t see a pickup, they’re going to be filing for bankruptcy. They are very, very hard pressed. A lot of them overbuilt. They are stuck with a big inventory. They have the carrying costs of that inventory, and laying off workers doesn’t solve that problem. They may bring the new construction down very low, but it doesn’t solve the problem of what to do with the unsold inventory. So without a pickup in housing, I think we can anticipate some bankruptcy filings in that area. People around the table here and, I think, generally have been treating oil price declines as an unambiguous positive, and I would like to raise a caution flag on that. I remember from my first year in graduate school Milton Friedman pounding into me that a price never declines without a shift in either the supply curve or the demand curve. Over and over again, that’s what Friedman would say. Now, on the supply side in oil, as far as I know, there have been no gigantic new supplies that have come on the market, and the optimistic view on oil is that last winter and spring or starting in the fall perhaps a year ago, there was maybe a $10 to $20 premium built into crude on the basis of geopolitical and weather uncertainties. So a possibility is that prices in the mid to upper seventies were above what was clearing current supply and demand. Inventories accumulated—we know that there has been a big inventory accumulation in the United States for sure—and eventually, with nothing really bad happening on the geopolitical front and with no hurricanes hitting, the prices dropped back down. It seems to me that is the optimistic way of looking at what’s happened to oil prices. But I think we should not rule out the possibility that some fundamental weakness in world demand is showing up in the demand for energy and that might have something to do with the softness. I take that as a hunch, not by any means as a certainty; but I think we ought to be open to that possibility. Clearly, the yield curve has been inverted for quite a few months. The market seems to be quite persistent in believing that some time next year there are going to be some declines in short-term interest rates, presumably because of some combination of slower real growth and more-benign inflation. Possibly it’s not all expectations related. It may simply be that the underlying demand for funds is softening—that’s surely true in the mortgage and housing industry—and that is what’s driving yields down. So I think that it’s important to keep an open mind to the possibility that a more fundamental slowing than we see in the current numbers is taking place and to make sure that we don’t dismiss incoming data and say it can’t really be happening. Thank you." FOMC20071031meeting--205 203,CHAIRMAN BERNANKE.," Thank you. Thank you all. Well, it has been said many times, but this is very, very close, and I’ve thought about it quite a bit, obviously. I have a lot of sympathy for President Plosser’s very clear analysis. There have been good data since the last meeting. We have talked about the importance of spillovers. We have not so far seen evident spillovers from housing into other sectors. We did take a preemptive action in the last meeting. Inflation is a concern. I think not immediately, but some of the factors like input costs are there, and market expectations alone are obviously not a reason to move. All of those things are valid, and I have thought about all of them. So why do I favor a cut? Most of the arguments have been made. The downside risks are quite significant, if the housing situation, including prices, really deteriorates. I think part of the difference between what the market sees about housing and what we see is that we are a little more sanguine about price behavior than the market is, and a decline in prices has effects both on consumers and on the credit system. So I think that risk is fairly important and may swamp some of the other issues. There is some new information that is relevant. The senior loan officer survey and other information suggest that credit conditions are tightening and that this will have an effect, I believe, in some significant markets, certainly including housing. Other information, like consumer sentiment and consumers’ views of the labor market, suggests some slowing and some weakening. The decline in sentiment in the markets in the past two weeks is very interesting. On one level I feel as though we failed to communicate somehow; however, I don’t know exactly where the mistake was. The markets seem to be responding to information about earnings reports and projections of future activity and so on, both in the financial sector and in the real sector, and as a number of people have said, I don’t think we can entirely ignore that information. So I think there are some good reasons on the real side to take out a bit more insurance, as has been said. I agree with the Vice Chairman that the credit markets probably could stand the surprise, but they have become somewhat more uncertain, and I think their basic problem is macro uncertainty. It has to do with concerns about tail risk, and that is something that we can, I think, address a bit. The point has been made a number of times, first by President Yellen, that the current rate could be construed as being slightly restrictive and that creates an argument for a somewhat lower rate. An additional argument is that the core inflation rate has come down some since last year, and so the real federal funds rate on that basis has gone up. Finally, an argument that I would bring to you is about tactics, and the Vice Chairman also alluded to this. Most of the paths that we submitted include a path for policy that is perhaps slightly lower than the current one, and the question is how we do this. If we take alternative B, which I think is the most obvious alternative, on the one hand we don’t take an action and on the other hand we express alarm about the economy and say we’ll probably be cutting in the future. That makes calibrating how the longer-term expectations will respond to that very difficult. I think it would, on balance, tighten expectations a bit because we didn’t act, but it does create some uncertainty. The advantage of alternative A, even as we take a cut, is that we will, I hope, curb expectations for sustained additional cuts through several mechanisms. First, in the economic growth paragraph, we have switched language from actions “intended to help forestall”—very indirect—to “should help forestall,” suggesting that we are now more confident in our ability to prevent bad outcomes in the economy. Second, we have—and this will certainly be noticed—taken note of energy and commodity prices, among other factors, and we have highlighted our concerns about inflation. Third, the rough balance of risks certainly indicates that we are not eager to cut again quickly unless the data clearly support it. So a lot of this is tactical, about how to take control of expectations— you know, how to manage the market’s views of our policies. And I just felt a bit more comfortable with taking the action but then using that to recalibrate our balance of risks. For what it is worth, 75 basis points of easing has been pretty much the standard Fed medicine for financial crises ever since 1970 or so; in that respect we are in good company. That’s my recommendation—25 basis points with alternative A. Any questions or comments?" FOMC20060131meeting--93 91,MR. LACKER.," Thank you, Mr. Chairman. Fifth District economic activity continued to advance broadly in December and January. Service-sector employment and revenue strengthened, and retailers reported generally strong sales and a pickup in hiring. In manufacturing, the signals are mixed. Shipments flattened out in December and turned down in January, and our new orders index turned negative as well. At the same time, we’ve seen a very sharp rise in our index of expected manufacturing shipments six months out. Major swings in this index do a pretty good job of predicting subsequent upturns in orders and shipments. The last time we saw a rise nearly this steep was at the beginning of 2002, and a sharp rebound in orders and shipments soon followed. While the figures for prices paid and prices received for both manufacturing and services have come down off their November highs, they remain noticeably elevated, and measures of expected price trends have moved up over the past two months. On the national economy, until I saw the fourth-quarter GDP report, I was thinking that economic growth was on pretty solid footing. Friday’s report came in weaker than expected, of course, but as Dave Stockton mentioned, it appears plausible that several temporary factors are at work. So I continue to think that prospects for economic growth are pretty good this year. Both employment and consumer spending are likely to continue expanding at a healthy pace, and the fundamentals for business investment point toward fairly robust spending growth. At our last meeting, I, like many others, believed that the threat that energy-price increases would pass through to core inflation and inflation expectations had diminished since the immediate aftermath of Hurricane Katrina. However, I wasn’t convinced that the threat was entirely behind us, and unfortunately, my concerns on that score remain. Oil prices have nearly returned to their September highs. The fourth-quarter core PCE price index came in at 2.2 percent, 0.3 above the Greenbook’s estimate, and the Greenbook has reversed course and marked up the ’06 inflation forecast a bit. The staff is now expecting core PCE inflation to rise to 2.3 percent in the middle of 2006 and not to fall below 2 percent until 2007 and then only slightly below. This forecast represents a bulge that is somewhat more extended than I would like to see. So, for today, I believe we should strive not to move the near-term yield curve down. In the broader context of the historic nature of today’s meeting, however, it’s quite striking that among the prominent subjects are a quarter-point bulge in inflation and the issue of whether long-run and trend inflation should be 1.5 percent or 2.0 percent. Few now doubt whether the Federal Reserve can or will keep inflation stable, a question that was seriously in play decades ago. Your leadership in the intervening years, Mr. Chairman, completed the work begun by your predecessor to restore the expectation of price stability that had been lost in the transition from the prior commodity standard. Given the number of centuries that regime was in place, I believe future monetary historians would be justified in marking the Volcker–Greenspan era as a millennial transition. This achievement required altering public expectations about the trend rate of inflation that we would tolerate. It also required substantially damping the association between strong real growth and resurgent inflation. Moreover, it required demonstrating that there was no need for adverse cost shocks to spawn higher trend inflation. The key to all of this, in my mind, was establishing a pattern of predictable FOMC behavior that was well understood by the public. Leading this transition as you did, Mr. Chairman, required tremendous acumen and tremendous courage. Personally, Mr. Chairman, I count serving with you, however briefly, as one of the greatest privileges an economist could imagine." fcic_final_report_full--488 Government Actions Create a Panic More than any other phenomenon, the financial crisis of 2008 resembles an old-fashioned investor and creditor panic. In the classic study, Manias, Panics and Crashes: A History of Financial Crises , Charles Kindleberger and Robert Aliber make a distinction between a remote cause and a proximate cause of a panic: “ Causa remota of any crisis is the expansion of credit and speculation, while causa proxima is some incident that saps the confidence of the system and induces investors to sell commodities, stocks, real estate, bills of exchange, or promissory notes and increase their money holdings.” 58 In the great financial panic of 2008, it is reasonably clear that the remote cause was the build-up of NTMs in the financial system, primarily— as I have shown in this analysis—as a result of government housing policy. This unprecedented increase in weak and risky assets set the financial system up for a crisis of some kind. The event that turned a potential crisis into a full-fledged panic—the proximate cause of the panic—was also the government’s action: the rescue of Bear Stearns in March 2008 and the subsequent failure to rescue Lehman Brothers six months later. In terms of its ultimate cost to the public, this was one of the great policy errors of all time, and the reasons for the misjudgments that led to it have not yet been fully explored. The lesson taught by the rescue of Bear was that all large financial institutions—and especially those larger than Bear—would be rescued. The moral hazard introduced by this one act irreparably changed the position of Lehman Brothers and every other large firm in the world’s financial system. From that time forward, (i) the critical need for more capital became less critical; the likelihood of a government bailout would reassure creditors, so there was no need to dilute the shareholders any further by raising additional capital; (ii) firms such as Lehman, that might have been saved through an acquisition by a larger firm or an infusion of fresh capital by a strategic investor, drove harder bargains with potential acquirers; (iii) the potential acquirers themselves waited for the U.S. government to pick up some of the cost, as it had with Bear—an offer that never came in Lehman’s case; and (iv) the Reserve Fund, a money market mutual fund, apparently assuming that Lehman would be rescued, decided not to sell the heavily discounted Lehman commercial paper it held; instead, with devastating results for the money market fund industry, it waited to be bailed out on the assumption that Lehman would be saved. But Lehman was not saved, and its creditors were not bailed out. At a time when large mark-to-market losses among U.S. financial firms raised questions about which large financial institutions were insolvent or unstable, the demise of Lehman was a major shock. It overturned all the rational expectations about government 58 Charles P. Kindleberger and Robert Aliber, Manias, Panics, and Crashes: A History of Financial Crises , 5th edition, John Wiley & Sons, Inc., 2005, p.104. 483 policies that market participants had developed after the Bear rescue. With no certainty about who was strong or who was weak, there was a headlong rush to U.S. government securities. Banks—afraid that their counterparties would want a return of their investments or their corporate customers would draw on lines of credit—began to hoard cash. Banks wouldn’t lend to other banks, even overnight. As Chairman Bair suggested, that was the financial crisis. Everything after that was simply cleaning up the mess. CHRG-111hhrg74855--261 Mr. McCullar," Thank you very much, Mr. Chairman. Chairman Markey, Ranking Member Upton and members of the subcommittee, I profoundly appreciate the opportunity to testify before you today. I am representing the American Public Power Association, as you said. We represent the interests of more than 2,000 publicly owned, not-for-profit electric utility systems across the country serving approximately 45 million Americans, and the majority of our systems are serving communities with populations of 10,000 people or less. DMEC, my company, provides generation and other services to nine municipal distribution utilities in the State of Delaware and is constituted as both a load-serving entity and a generation owner in the PJM RTO. I have also served as the chairman of the PJM members committee which means I am very familiar with markets and processes within the RTO. I also represent and I often remind my colleagues at PJM that I represent the folks who at the end of the day write the checks to pay for all of these services and our mission is to make sure those checks are as reasonable as possible for the value received. My statement is going to focus on three areas, energy markets in general, the regulatory overlap between FERC and the CFTC, mandatory clearing of over-the-counter derivative contracts. While energy markets suffer from volatility for many reasons including storage capacity, weather and economics, in recent years the price of energy commodities has not been determined solely by these traditional variables. Manipulation and speculation for profit in energy markets have often caused artificially high prices. APPA and DMEC have therefore consistently supported increased transparency in these markets to mitigate market manipulation. For example, APPA passed two resolutions the last few years in support of increased transparency in regulation in over-the-counter or OTC natural gas markets, therefore we support the provisions of H.R. 3795 that enhance transparency in these markets including reporting by large traders of OTC positions and the application of aggregates speculative position limits. Because of these strong concerns with market manipulation, APPA and DMEC recognize that the CFTC can help to police and prevent manipulation in the energy markets but CFTC and FERC should work together to prevent manipulation in the energy markets that are run by RTOs, including PJM. However, we urge Congress to avoid creating duplicative authorities between CFTC and FERC over the many other aspects of power supply and transmission markets that are run by the RTOs. In regions with RTOs, market participants buy and sell a variety of electric products and services in the centralized RTO-run markets. One such market is for the purchase and sale of Financial Transmission Rights or FTRs which APPA members and other Load Serving Entities use to hedge the cost of transmission congestion created when moving their power from the generation sources to their retail customers which is often referred to as load. While these Financial Transmission Rights are financial contracts, their terms, conditions and rates are comprehensively regulated by FERC and they should remain under FERC jurisdiction. LSE's access to FTRs is absolutely essential to their ability to serve their retail loads at reasonable rates and with less price volatility. RTO markets are fully regulated by FERC and are set out in FERC-approved tariffs. The rates, terms and conditions applicable to any RTO product under a FERC tariff should not be subject to concurrent jurisdiction by CFTC. Concurrent jurisdiction could result in inconsistent regulations and uncertainty over the enforceability of transactions. Because of this concern, if concurrent jurisdiction is found, CFTC should be required to consult with FERC regarding these markets and should be given statutory authority to cede jurisdiction to FERC. However, as I mentioned, we recognize CFTC has helped to police and prevent manipulation of prices in energy markets. APPA would therefore support concurrent FERC and CFTC jurisdiction over market manipulation in RTO administered markets. APPA would urge the two agencies to pool their resources and expertise to provide more comprehensive oversight in this specific area. I would also like to mention the critical importance of continuing to allow LSEs and energy end users to use non-cleared, individually negotiated OTC transactions to hedge the price of energy fuels in order to continue to offer the best electric rate possible to our customers. APPA supports the clearing language in H.R. 3795 that provides an exemption from clearing for LSEs and end users. Specifically, requiring not-for-profit public power systems to clear would pose significant financial hardships to them and the local governments that own them without addressing any of the systemic problems that cause the financial crisis in which we now find ourselves. Derivatives end users such as Plug Power Systems do not pose systemic risks to the market as do the bank-to-bank exchanges for the purposes of profit making, therefore, derivative end users should not be subject to the same type of regulation as other entities. " FOMC20071031meeting--75 73,VICE CHAIRMAN GEITHNER.," As the Chairman said at the Economic Club of New York, it is likely to emerge stronger. I think the outlook looks about the way it did in September. Just a few quick points. Financial market conditions are substantially better than during the peak of the panic in mid-August; but the improvement, as many of you said, is still quite limited and uneven. Sentiment is still quite fragile, and I think we still seem likely to face a protracted period of adjustment ahead as the markets work through the substantial array of challenges remaining. Growth in the United States and in the world economy in my view seems likely to slow— more here, of course, than elsewhere. Here, even though the nonhousing, non-auto parts of the U.S. economy don’t yet show significant evidence of a considerable slowdown of actual or expected demand, I think that still seems likely. In our central scenario, though, housing construction weakens further. Housing demand slows further because of the tightening of credit conditions. Prices fall further. Consumer spending slows a bit, and businesses react by scaling back growth in hiring and investment, and this produces several quarters of growth modestly below trend. I think that growth outside the United States is likely to slow a bit. It will slow toward potential, if not all the way to potential, in those economies that have been growing above potential. Although the world is larger in relative terms and somewhat less vulnerable to a U.S. slowdown than it once was, it seems to me very unlikely that domestic demand in the rest of the world will accelerate as domestic demand slows in the United States. So the risks to this outlook for U.S. growth still seem to lie to the downside. The magnitude of the downside risks may be slightly less than in September, but they remain substantial. I think the main source of this downside risk to growth is the interaction between expectations of recession probability and the credit market dynamics. Each feeds the other. As the outlook for housing deteriorates and the recession probability stays elevated, financial institutions and investors stay cautious. That caution, in turn, slows the pace of recovery in markets—in asset-backed, securitization, and structured-credit markets—and in credit growth more broadly. As expectations adjust to anticipate a longer, more-substantial period of impairment in markets, then recession probability at least potentially increases. I think that the underlying inflation numbers and the measures we use to capture underlying inflation do not suggest any meaningful acceleration in underlying inflation, and we still expect the core PCE to run at a rate below 2 percent over the forecast period. In some ways, though, the inflation outlook now feels a bit worse. It feels worse because of the modest rise in breakevens that we saw following our last meeting and because of sentiment in markets around gold, commodity and energy prices, and the dollar. The fact that breakevens at long horizons have risen or failed to fall as monetary policy expectations have shifted down is not the most comforting pattern out there. So I think we need to be very careful not to encourage any sense in markets that we’re indifferent to those potential risks. Having said that, I think the risks to that inflation forecast are roughly balanced. The range of tools we have for measuring equilibrium combined with what you see in financial market expectations suggests that monetary policy, to assess the real short-term interest rate, is at or above most estimates of neutral and, therefore, is still exerting some modest restraint on growth. The expectations now built into markets imply too much easing over the next eighteen months, more than I think we’re likely to have to do. But I think the appropriate path of monetary policy lies under the Greenbook’s assumption. Thank you." FOMC20080805meeting--122 120,MR. ROSENGREN.," Thank you, Mr. Chairman. The Boston forecast used for the June meeting expected that the unemployment rate would peak at approximately 5.7 percent. Unfortunately, with the July employment report, the unemployment rate has already reached 5.7 percent, and we expect the economy is likely to grow less than potential for the next several quarters. With the unemployment rate rising in the past three months by 0.7 percentage point and payroll employment declining for the past six months, I am concerned that there remains a significant risk that the second half of this year would look a lot like the ""severe financial stress"" or ""typical recession"" scenarios. My concern reflects the potential impact of further deterioration among financial institutions and financial markets that may create a significant headwind for the economy and the likelihood that economic problems are growing in other countries, which would slow one of the few bright spots in the economy--exports. Since our last meeting, much has been written about the problems at the GSEs. Concern with the viability of the GSEs and potential future losses has contributed to mortgage rates rising despite our past easing, the weak economy, and diminished demand for mortgages. With financial institutions showing little interest in lending to subprime or jumbo borrowers, the increased cost for individuals that qualify for conforming loans is likely to weaken the one part of the housing market that had been relatively resilient to financial problems to date. For potential buyers, higher interest rates and the likelihood that housing prices will continue to fall provide little current incentive to purchase a home, while the job losses are providing an immediate need for some owners to sell their homes. We need the housing market and housing prices to stabilize, which I had hoped would occur in the second half of this year, but now it looks as though it will be deferred until next year. Falling housing prices have created significant collateral damage. Liquidity problems that began one year ago remain in play. The capital-constrained financial institutions that are forced to shrink their balance sheets may pose a significant additional problem in the second half of this year. While many of the largest banks that suffered significant losses last year were able to raise additional capital fairly readily, the capital losses on newly issued bank equity may have reduced many investors' appetite for providing new capital for banks until it is clear that the economy is recovering. The falling national housing prices and problems in commercial real estate in some sectors of the economy are now affecting regional and community banking institutions, many of which are unlikely to get equity infusions and thus will be forced to shrink. A reduction in the willingness to lend, as represented by the Senior Loan Officer Opinion Survey, has often portended a reduction in credit to bank-dependent borrowers. As we get a more traditional credit crunch compounding the liquidity problems, I am concerned that credit will be less available to consumers and businesses and further slow consumption and business investment. Since the June meeting, the stock market has fallen 7 percent; and with the number of large financial institutions experiencing very elevated CDS spreads and stock prices in the single digits, the failure of one or more relatively large domestic or foreign financial institutions is a real possibility. In such an environment, the assumption of annual equity prices rising 7 percent in the rest of this year and 12 percent in 2009 as assumed in the Greenbook would seem to have some significant downside risk. Elevated unemployment rates and a flat or slightly falling trend in wage and salary inflation suggest an absence of the inflationary pressures in labor markets that would lead to rising inflation once energy and food prices stabilize. These factors give me some confidence that we will see core and total inflation in 2009 close to 2 percent. Since our last meeting, labor markets have been weaker than expected, and oil prices and many other commodity prices have fallen, in part as a result of the concern with a slowing global economy. Although total inflation measures are clearly higher than any of us would want, these readings appear to be transitory responses to supply shocks that are not flowing through to labor markets. In fact, evidence from the labor market would seem to indicate that the downside risks to the economy are affecting labor markets through job losses but are not creating an environment in which labor tries to offset supply shocks with higher wage demands. Thank you. " FOMC20060920meeting--121 119,MS. YELLEN.," Thank you, Mr. Chairman. Since our last meeting, the data bearing on the near-term economic outlook suggest both slower economic growth and a bit less core price inflation going forward. In terms of economic activity, the recent news has been uniformly negative, resulting in a significant downward revision to growth in the Greenbook. Indeed, compared with the outlook of other forecasters, the Greenbook’s projection of real GDP growth for the second half of this year is quite pessimistic; it would now rank in the lower 5 percent tail of the distribution of individual Blue Chip forecasters. I think this pessimism is not completely unfounded, however, largely because of my worries about the housing sector. The speed of the falloff in housing activity and the deceleration in house prices continue to surprise us. In the view of our contacts, the data lag reality, and it seems a good bet that things will get worse before they get better. A major homebuilder who is on one of our boards tells us that home inventory has gone through the roof, so to speak. [Laughter] He literally said that. With the share of unsold homes topping 80 percent in some of the new subdivisions around Phoenix and Las Vegas, he has labeled these the new ghost towns of the West. In fact, he described the situation at a recent board meeting in Boise. He had toured some new subdivisions on the outskirts of Boise and discovered that the houses, most of which are unoccupied, are now being dressed up to look occupied—with curtains, things in the driveway, and so forth—so as not to discourage potential buyers. The general assessment is that this overhang of speculative inventory implies that permits and starts will continue to fall. Inventory ratios will rise, and the market probably will not recover until 2008. So far, builders remain hesitant to cut prices, fearing that doing so will cause a surge in cancellation rates on sold but unfinished homes. However, builders now routinely offer huge incentives, and price cuts appear inevitable. We have been following the Case Schiller house-price index, which is based on house-price data in ten large urban markets, three of which are in California. Beginning in May of this year, futures contracts on this price index also began trading; they suggest that house prices will be falling at an annual rate of about 6 percent by the end of this year. Of course, trading in this new futures market is still somewhat thin, but it is a signal that we need to keep a very close eye on the incoming data and watch whether the housing slowdown is turning into a slump. Turning to inflation, core measures of consumer price inflation remain well above my comfort zone, but the latest readings on consumer prices have been modestly better. Unlike the Greenbook, I think the outlook for inflation has actually improved a bit since our last meeting largely because of the recent drop in commodity and crude oil prices. The relief on energy prices is, of course, very welcome, but we do have to be careful not to overestimate the extent to which past energy price pass-through has been boosting core inflation. For example, airfares might seem like an obvious case in which outsized consumer price increases reflect energy price pass-through. However, our staff recently calculated the share of jet fuel costs to total airline operating expenses and estimated that the jump in those costs likely accounted for less than half the rise in airfares this year. Instead, airfares may reflect strong demand and constrained capacity as indicated by very high airline passenger load factors. Still it seems likely that energy pass-through has played at least some role in the run-up of core inflation this year, so any energy price pressure on core inflation is likely to dissipate over time. Now, as David noted, the Greenbook has completely offset the favorable effects on core inflation from lower energy prices by boosting the growth rate of labor costs. In contrast, I attach a little less weight to the recent data on compensation per hour. My guess is that most of the difference between hourly compensation and the ECI does relate to profit-linked items like bonuses and stock options, and that suggests to me that marginal costs of production are not rising significantly faster. Even if they are, it remains true that markups are high. So with sufficient competitive pressures, firms have room to absorb cost increases without fully passing them into prices. Finally, I want to add my compliments to those of others to the Board’s staff for a very interesting analysis of inflation dynamics and monetary policy. As I mentioned at our last meeting, it may be unduly pessimistic to assume that the recent rise in inflation will be highly persistent. Over the past ten years, estimated reduced-form models suggest that core inflation generally returns to its sample average after several quarters. Recently our staff examined persistence at a more disaggregated level and found that the same general pattern also holds for each of the major components of the core PCE price index, with price inflation for durables only slightly more persistent than price inflation for nondurables and services. In the current situation, this suite of regressive models indicates that core PCE inflation should fall to just below 2 percent by the middle of next year. I am not quite as optimistic as these simple models, but on balance my concerns about the inflation outlook have been slightly alleviated by recent developments." CHRG-111shrg382--41 PREPARED STATEMENT OF KATHLEEN L. CASEY Commissioner, Securities and Exchange Commission September 30, 2009 Chairman Bayh, Ranking Member Corker, and distinguished members of the Committee, thank you for inviting me to testify about the international cooperation to modernize financial regulation.Why International Cooperation is Necessary I am pleased to have the opportunity to testify on behalf of the Securities and Exchange Commission on this very important topic. International cooperation is critical for the effectiveness of financial regulatory reform efforts. In reaffirming their commitment to strengthening the global financial system, the G-20 Finance Ministers and Bank Governors recently set forth a number of actions to ``maintain momentum [and] make the system more resilient.'' The G-20 banking statement correctly recognizes that due to the mobility of capital in today's world of interconnected financial markets, activity can easily shift from one market to another. Only collective regulatory action can be effective in fully addressing cross-border activity in our global financial system. As an SEC Commissioner and Chairman of the Technical Committee of the International Organization of Securities Commissions (IOSCO), I bring the perspective of both a national securities market regulator and a member of the international organization charged with developing the global response to the challenges posed to securities markets by the financial crisis. I also represent the SEC and IOSCO in the Financial Stability Board (FSB), where the U.S. financial regulatory policy representation is led by the Department of Treasury, with the SEC and the Federal Reserve Board both serving as members. The financial crisis has made it clear that we must address regulatory gaps and overlaps. The Commission has recently proposed action to this end in a number of different areas, recognizing, however, that some regulatory gaps and market issues cannot be fully addressed without legislative action. The Commission already is working to achieve consistency on the domestic and international levels, including through IOSCO and the FSB, with banking, insurance, futures, and other financial market regulators. In this vein, the Commission also is working to ensure respect in the global regulatory environment for the integrity of independent accounting and auditing standard-setting processes for the benefit of investors. The Commission looks forward to continuing and improving on this cooperation as part of a reformed regulatory landscape.Mechanisms for International Cooperation in Securities Market Regulation The Commission has actively worked to achieve consistency in regulatory policy and implementation on an international basis through multilateral, regional, and bilateral mechanisms for many years. The SEC was a founding member of IOSCO, and has maintained a leading role in the organization. The Commission's commitment to international cooperation has become increasingly important to its mission in recent years in response to the increasingly global nature of financial markets. In addition to my chairmanship of IOSCO's Technical Committee, Commission staff leads or is very active in IOSCO's standing committees and taskforces. Commission staff also represents IOSCO in the Joint Forum on Financial Conglomerates, which was established by the Basel Committee on Banking Supervision, IOSCO and the International Association of Insurance Supervisors (IAIS) to deal with issues that cut across the banking, securities and insurance sectors. For example, SEC staff participates in the Joint Forum's Working Group on Risk Assessment and Capital, which has undertaken a number of cross-sectoral initiatives that have arisen out of the financial crisis. While IOSCO represents the primary vehicle for development of common international approaches to securities market regulation, the FSB is a key mechanism for the Commission to engage internationally on broader financial market issues. The FSB has a broader scope, with membership comprised of national regulatory and supervisory authorities, standard setting bodies and international financial institutions. In addition, its mission is to address vulnerabilities and to encourage the development of strong regulatory, supervisory and other policies in the interest of financial stability. The Commission also is represented in oversight bodies charged with maintaining the public accountability of international accounting and auditing standard-setters. SEC Chairman Schapiro is a member of the Monitoring Board of the International Accounting Standards Committee Foundation. Through this Board, the SEC and other capital market authorities that permit, have proposed to permit, or require the use of International Financial Reporting Standards in their jurisdictions have a means to carry out more effectively their mandates regarding investor protection, market integrity, and capital formation. The Commission also is represented through IOSCO in the Monitoring Group for the Public Interest Oversight Board, which serves as a mechanism for promoting the public interest in the development of international standards for auditing by the International Federation of Accountants. In addition to multilateral, global engagement, the Commission participates in regional and bilateral mechanisms for discussion and promotion of common approaches to regulation. SEC Commissioner Aguilar is the Commission's liaison to the Council of Securities Regulators of the Americas, or COSRA, which aims to develop high quality and compatible regulatory structures among authorities in the Western hemisphere. Commission staff, alongside staff of the Federal Reserve Board, the Commodity Futures Trading Commission, and other U.S. Government agencies, also participates in a number of Treasury-led financial regulatory dialogues, including with the European Commission, Japan, China and India, as well as Australia and our North American partners, Canada and Mexico. Securities-regulatory-focused bilateral dialogues between Commission staff and our counterpart securities regulators in these and other jurisdictions also complement the broader financial sector dialogues; we are engaged in such bilateral efforts with, among others, the U.K. Financial Services Authority and the Japan Financial Services Agency, the Committee of European Securities Regulators (CESR), and the China Securities Regulatory Commission, Securities and Exchange Board of India, and Korea Financial Supervisory Commission. Furthermore, the Commission and a number of other securities regulators have recently entered into bilateral ``supervisory'' memoranda of understanding that go well beyond sharing information on enforcement investigations. These supervisory MOUs, such as those the SEC has signed with the U.K.'s Financial Services Authority and the German consolidated financial services regulator (known as the ``BaFin''), represent groundbreaking efforts by national securities regulators to work together to cooperate in their oversight of financial firms that increasingly operate across borders. Thus, the infrastructure for international cooperation on securities regulatory policy is well-developed, and the Commission plays a key role in promoting rising levels of cooperation. These efforts build on the success the Commission has achieved in raising standards of cross-border enforcement cooperation. Over two decades ago, the Commission entered into its first bilateral memoranda of understanding for the sharing of information in securities enforcement matters. To date, the Commission has concluded bilateral agreements with 20 jurisdictions that remain in force today. These bilateral agreements were the impetus for the creation of the IOSCO Multilateral Memorandum of Understanding (MMoU) in 2002. Since then, authorities in 55 jurisdictions, including the SEC, have already implemented the principles for cross-border enforcement cooperation contained in the MMoU and another 27 jurisdictions have committed to do so. With each additional MMoU signatory, the scope and ability of the SEC to pursue wrongdoers across borders significantly increases. This ability is increasingly important as more and more SEC investigations involve some international component. In addition to continuing to work to increase the number of jurisdictions that share information pursuant to the MMoU, the Commission also is continually working to increase the level of enforcement cooperation that it provides foreign counterparts as well as the level of cooperation provided by our global counterparts. The SEC was among the first securities regulators to receive the legal authority to assist foreign counterparts in investigations of securities fraud. Today, the SEC has broad authority to share supervisory information as well as assist foreign securities authorities in their investigations using a variety of tools, including exercising the SEC's compulsory powers to obtain documents and testimony. To further facilitate international cooperation, the SEC supports the passage of H.R. 3346 that would give authority to the Public Company Accounting Oversight Board, which the SEC oversees, to share confidential supervisory information with foreign auditor oversight bodies. The Commission believes that granting this authority to the PCAOB would enhance auditor oversight, audit quality and, ultimately, investor protection.Key Securities Regulatory Reform Issues and International Cooperation The Commission has led or supported the development of a number of international securities market regulatory initiatives to support the strengthening of the global financial system in the wake of the financial crisis. These initiatives, developed through IOSCO, its joint working group with the Committee on Payment and Settlement Systems (CPSS), and the Joint Forum, have been developed in conjunction with calls from the G-20 and FSB to ensure that all systemically important financial institutions, markets, and instruments are subject to an appropriate degree of regulation and oversight.IOSCO IOSCO's Subprime Task Force issued its report in 2008, examining the underlying causes of the financial crisis and the implications for international capital markets. IOSCO launched a number of ongoing projects in response to recommendations in this report, including in key areas such as issuer transparency and investor due diligence; firm risk management and prudential supervision; valuation and accounting issues. Last fall, following on concerns highlighted by the G-20 Leaders, IOSCO also established task forces on unregulated entities, unregulated financial markets and products, and supervisory cooperation, each of which is discussed in greater depth below. The Commission has contributed significantly to these projects with a view to ensuring that global capital markets address issues relating to the current turmoil in a sound and aligned way.Credit Rating Agencies With regard to credit rating agencies, in February of this year, IOSCO established a permanent standing committee to continually evaluate and seek cross-border consensus for CRA regulation. IOSCO has built on the early work in this area that resulted in the IOSCO CRA Principles and Code of Conduct Fundamentals first adopted in 2003 and 2004. The Code Fundamentals, as amended in 2008 as a consequence of ``lessons learned'' during the early ``subprime crisis,'' has already been substantially adopted by at least seven rating agencies, including the largest ones. Staff of the SEC chair this committee.Unregulated Entities With regard to unregulated entities, following extensive consultation, IOSCO agreed to a set of high-level principles for hedge fund regulation in June of this year. The six principles include requirements on mandatory registration for funds or their advisers, ongoing regulation and provision of information for systemic risk assessment purposes. They also state that regulators should cooperate and share information to facilitate efficient and effective oversight of globally active hedge fund managers and hedge funds. Work continues in IOSCO on defining what type of information should be provided by the hedge fund sector (and their counterparties) to allow regulators to assess the systemic importance of individual actors and identify possible financial stability risks.Unregulated Markets and Products Earlier this month, IOSCO's Task Force on Unregulated Financial Markets and Products issued a number of recommendations concerning regulatory approaches that may be implemented with respect to the securitization and credit default swap (CDS) markets, as these two markets were key elements of the global financial crisis. The Task Force continues to consider whether additional work should be undertaken regarding implementation of the recommendations. In addition, the Commission has worked closely over the past year with international regulators and central banks in gaining first-hand experience in applying the Recommendations for Central Counterparties (RCCPs) to proposed arrangements for OTC credit derivatives transactions. This has highlighted some challenges regarding the application of RCCPs to credit default swaps (CDSs), particularly with respect to valuation models. The CPSS, under the leadership of New York Federal Reserve Bank President William Dudley, and IOSCO have created a joint working group (co-chaired by the European Central Bank) to propose guidance on how central counterparties for OTC derivatives may meet the standards set out by the RCCP and will identify any areas in which the RCCP might be strengthened or expanded to better address risks associated with the central clearing of OTC derivatives. This working group will complete its report by the middle of 2010.Supervisory Cooperation As operations globalize, oversight and supervision require increased cross border cooperation. Supervisory cooperation is a critical tool in gathering information about risks and trends within institutions and across markets. To this end, IOSCO established a Task Force on Supervisory Cooperation this spring to develop principles on regulatory cooperation in the supervision and oversight of market participants, such as exchanges, funds, brokers, and advisers, whose operations cross international borders. Final principles are expected to be published in February 2010.Commodity Futures Markets IOSCO's Task Force on Commodity Futures Markets, which was formed following concerns relating to price and volatility increases in agricultural and energy commodities in 2008, focused on whether futures market regulators' supervisory approaches were appropriate in light of market developments. The Task Force issued its report in March 2009 with recommendations aimed at ensuring that regulators have the appropriate information and tools available to them to monitor futures markets effectively and act against any market manipulation. The Task Force was recently revived, with CFTC Chairman Gary Gensler and U.K. Financial Services Authority Chairman Adair Turner as co-chairs, to continue to address concerns about access to relevant information for effective market surveillance and to promote improvements to regulatory frameworks that may inhibit the ability to detect and enforce market manipulation cases.Joint Forum Cross-Sectoral Projects The Commission, participating through IOSCO in the Joint Forum, which is led by Comptroller of the Currency John Dugan, is taking part in a review of the scope of financial regulation, with a special emphasis on institutions, instruments, and markets that are currently unregulated. The group's focus is on the differentiated nature of regulation in the banking, securities and insurance sectors; current consolidated supervision and unregulated entities or unregulated activities within a conglomerate structure; and the regulation of hedge funds; among other issues. The main deliverable of this workstream will be a report to the FSB and G-20 Finance Ministers and Governors, and is expected by the end of this year. In addition, the Joint Forum's Working Group on Risk Assessment and Capital (JFRAC) recently finalized its report examining the range of various Special Purpose Entities (SPEs) used by financial firms to transfer risk for capital and liquidity management purposes as well as derivatives vehicles and transformer vehicles. Finally, in recognition of the reality that prudential supervision is becoming increasingly risk-sensitive in the different sectors, JFRAC has also undertaken a project to consider methods for risk aggregation that incorporate a characterization and quantification of diversification effects within financial firms. The primary focus of this work will be on aggregation across different types of risk--such as credit, market, insurance, and operational risk--and on similarities and differences between the commercial banking, investment banking, and insurance sectors. A preliminary draft paper will be discussed at the October Joint Forum meeting.FSB / G-20 Participation and U.S. Government Coordination With regard to my role at the FSB, I represent both the Commission and the IOSCO Technical Committee alongside the other U.S. Government participants, namely Governor Tarullo of the Federal Reserve Board and the Under Secretary for International Affairs of the Department of Treasury. The Commission places a high priority on coordinating the U.S. position with its fellow agencies and presenting a strong and unified position in policy discussions at the FSB level. This is accomplished through extensive and informal communication between the staffs of our agencies, including the Office of the Comptroller of the Currency (OCC), the Commodity Futures Trading Commission (CFTC), the Federal Deposit Insurance Corporation (FDIC) and the National Association of Insurance Commissioners (NAIC), among others, and has been highly effective. In this regard, the work that Comptroller of Currency Dugan and I jointly led, under theauspices of the Financial Stability Forum's efforts to reduce procyclicality of regulation, to explore possible improvements to the accounting for loan loss provisioning is particularly noteworthy.Importance of the Role of Technical Experts and Independent, Consultative Rulemaking The international financial regulatory architecture that I have just outlined has proven its robustness in the level of cooperation since the outbreak of the financial crisis. The G-20 leaders' focus on financial regulation has provided more high-level and political attention to these ongoing efforts. With the conversion of the Financial Stability Forum into the FSB and expansion of its membership to the G-20, the architecture is evolving to reflect the growing importance of emerging markets and international cooperation in light of the interconnectedness of the global financial system. While the Commission supports and participates in the work of all of these international organizations, I would like to take this opportunity to highlight the different roles that these international organizations should play as nations increasingly seek to cooperate with regard to international financial regulatory policy. The FSB, for example, comprises officials from across the spectrum of financial regulation, and so is very useful as a discussion forum to determine broad trends in the financial system. Through FSB discussions, gaps in regulation can be more readily identified and prioritized. The G-20 focus on these results also is helpful in ensuring that the pace of reform is maintained and that a clear international framework emerges. Given the complexity of the financial markets, however, it is critical that technical regulatory bodies such as those represented in IOSCO, as well as statutorily mandated independent regulators, such as the Commission, have control over their agendas and the ultimate outcomes of their regulatory and standard-setting work. The regulators and supervisors of each financial sector have specific goals for regulation, which may differ slightly from sector to sector, but are all important. For example, a key goal of securities regulators is investor protection; this goal is not the focus of bank or insurance supervisors, who have other priorities. Only by allowing the technical experts to develop regulatory approaches to address areas of concern in their sector can we ensure that all regulatory goals are being met. Moreover, implementation and enforcement depend on legal mechanisms and processes that vary jurisdiction by jurisdiction, and sector by sector. One example where this approach has been successful is raising standards for international securities law enforcement cooperation. The development of the IOSCO MMoU, and the push to further expand the number of jurisdictions providing cooperation as well as deepen the level of cooperation they provide, has significantly raised standards of cooperation in the securities sector over the past decade. The FSB's effort to promote standards in non-cooperative jurisdictions will provide opportunities to raise the level of cooperation across a broad range of financial regulatory enforcement concerns. The Commission looks forward to continuing the constructive dialog with our colleagues at the Fed, Treasury, and other agencies, in continuing to develop the common U.S. position in the future. For more specifics on the outcome of the recent G-20 meeting, I defer to Mark Sobel of the Treasury Department, as the Commission did not directly participate in the Summit or the G-20 process leading to Pittsburgh.Conclusion While the Commission's particular focus--and that of IOSCO--on investor protection and efficient and fair markets has remained constant and somewhat distinct from that of banking supervisors and regulators of other market segments, our recent collaborative work--both at home and internationally--has shown significant progress in strengthening the global financial regulatory system. It remains the case that investor protection and a focus on efforts to enhance investor confidence are vital to interests of financial stability on national and global levels. In its June White Paper, the Administration named as one of its five key objectives of financial regulatory reform the raising of international regulatory standards and improvement of international cooperation. The Commission, through IOSCO, the FSB, other cross-border mechanisms, and coordinating domestically with fellow financial regulators, stands ready to continue its collaborative work with the aim of enhancing our ability to identify and address systemic risks early across the world's financial markets. International cooperation is essential to the success of any financial regulatory reform that we undertake. Thank you for this opportunity to address such timely and relevant global regulatory issues. ______ FOMC20080430meeting--95 93,MR. ROSENGREN.," Thank you, Mr. Chairman. Without judgmental adjustments, the Boston Fed forecast is somewhat more optimistic than the Greenbook. As in the Greenbook, our GDP is weak in the first half of this year, though neither of the first two quarters actually turns negative. Our slightly more optimistic forecast assumes that consumption and business fixed investment are weak, but not as weak as in the Greenbook, and then the fiscal and monetary stimuli are sufficient for the economy to pick up in the second half of this year. In a sense, the Greenbook represents another mode in the forecast distribution with probability roughly equal to our forecast. The big risk to our forecast is that the financial turmoil and housing price declines, which are not fully reflected in the Boston model, result in a greater drag on the economy. Such an outcome would largely close the gap between the Greenbook and our forecast. In short, the downside risks to our forecast are appreciable. With a monetary policy assumption similar to the Greenbook's, we have core PCE below 2 percent in 2009, but the unemployment rate remains well above the NAIRU even at the end of 2010. If we sought to keep inflation below 2 percent but did not want an extended period in which the unemployment rate was above the NAIRU, our model would require more easing than currently assumed in the Greenbook. Since the last meeting, the economic data have remained weak. Private payroll employment declined by approximately 100,000 jobs on average over the past three months, and the unemployment rate increased 0.3 percentage point. In addition, the labor market weakness was widespread across industries. Such labor market weakness is likely to aggravate an already troubling housing story. To date, falling housing prices have disproportionately affected subprime borrowers and those who purchased securitized products. However, if housing prices continue to decline rapidly, that will begin to affect more prime borrowers and a wide array of financial institutions. Smaller financial institutions that were largely unaffected by the financial turmoil last August are beginning to see increases in delinquencies, and those with outsized exposures in construction loans are now experiencing significant duress. Commercial real estate loans are also now experiencing increased delinquencies. Like the Greenbook, I am concerned that commercial real estate may be the next sector to experience problems. However, the biggest concern remains that rising delinquencies and falling housing prices cause a much higher rate of mortgage defaults than we have experienced historically. Should these mounting problems become more pronounced, we are likely to see credit availability for small- and medium-sized businesses affected. That sector has not to date been significantly affected by the financial turmoil. Many financial indicators have improved since the last meeting, as was highlighted in Bill's report. The stock market has moved up. Many credit spreads have narrowed. Treasury securities and repurchase agreements are trading in more-normal ranges, and credit default swaps for many financial firms have improved. Nonetheless, several ominous trends remain in financial markets. The LIBOR�OIS spread has widened, so borrowers tied to LIBOR rates have seen those rates rise more than 25 basis points since the last meeting. Similarly, the TAF stop-out rate in the last three auctions was higher than the primary credit rate, providing another indicator that banks remain in need of dollar term funds. Finally, the asset-backed commercial paper market is once again experiencing difficulties. Rates on asset-backed commercial paper have been rising, and there is a risk that more of the paper will end up on bank balance sheets. Higher food and energy prices are both a drag on the economy and a cause for concern with inflation. But despite the extended sequence of supply shocks, I do not see evidence that inflation expectations are no longer anchored. Labor markets do not indicate that the commodity price increases are causing wage pressures, and such pressures are even less likely if the unemployment rate continues to increase. Many of the financial indicators of inflation, such as the five-year-forward rate, have fallen significantly from their peaks earlier this year. Finally, core PCE over the past year has been 2 percent, and most econometric-based forecasts expect that the weakness we are experiencing should result in core and total PCE inflation at or below 2 percent next year. Overall, the downside risks to demand that I listed in the outset seem the more compelling cause for concern. Thank you. " CHRG-111shrg52619--202 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM SCOTT M. POLAKOFFQ.1. It is clear that our current regulatory structure is in need of reform. At my subcommittee hearing on risk management, March 18, 2009, GAO pointed out that regulators often did not move swiftly enough to address problems they had identified in the risk management systems of large, complex financial institutions. Chair Bair's written testimony for today's hearing put it very well: `` . . . the success of any effort at reform will ultimately rely on the willingness of regulators to use their authorities more effectively and aggressively.'' My questions may be difficult, but please answer the following: If this lack of action is a persistent problem among the regulators, to what extent will changing the structure of our regulatory system really get at the issue? Along with changing the regulatory structure, how can Congress best ensure that regulators have clear responsibilities and authorities, and that they are accountable for exercising them ``effectively and aggressively''?A.1. A change in the structure of the regulatory system alone will not achieve success. While Congress should focus on ensuring that all participants in the financial markets are subject to the same set of regulations, the regulatory agencies must adapt using the lessons learned from the financial crisis to improve regulatory oversight. OTS conducts internal failed bank reviews for thrifts that fail and has identified numerous lessons learned from recent financial institution failures. The agency has revised its policies and procedures to correct gaps in regulatory oversight. OTS has also been proactive in improving the timeliness of formal and informal enforcement action.Q.2. How do we overcome the problem that in the boom times no one wants to be the one stepping in to tell firms they have to limit their concentrations of risk or not trade certain risky products? What thought has been put into overcoming this problem for regulators overseeing the firms? Is this an issue that can be addressed through regulatory restructure efforts?A.2. OTS believes that the best way to improve the regulatory oversight of financial activities is to ensure that all entities that provide specific financial services are subject to the same level of regulatory requirements and scrutiny. For example, there is no justification for mortgage brokers not to be bound by the same laws and rules as banks. A market where unregulated or under-regulated entities can compete alongside regulated entities offering complex loans or other financial products to consumers provides a disincentive to protect the consumer. Any regulatory restructure effort must ensure that all entities engaging in financial services are subject to the same laws and regulations. In addition, the business models of community banks versus that of commercial banks are fundamentally different. Maintaining and strengthening a federal regulatory structure that provides oversight of these two types of business models is essential. Under this structure, the regulatory agencies will need to continue to coordinate regulatory oversight to ensure they apply consistent standards for common products and services.Q.3. As Mr. Tarullo and Mrs. Bair noted in their testimony, some financial institution failures emanated from institutions that were under federal regulation. While I agree that we need additional oversight over and information on unregulated financial institutions, I think we need to understand why so many regulated firms failed. Why is it the case that so many regulated entities failed, and many still remain struggling, if our regulators in fact stand as a safety net to rein in dangerous amounts of risk-taking?A.3. While undesirable, failures are inevitable in a dynamic and competitive market. The housing downturn and resulting economic strain highlights that even traditionally lower-risk lending activities can become higher-risk when products evolve and there is insufficient regulatory oversight covering the entire market. There is no way to predict with absolute certainty how economic factors will combine to cause stress. For example, in late 2007, financial institutions faced severe erosion of liquidity due to secondary markets not functioning. This problem compounded for financial institutions engaged in mortgage banking who found they could not sell loans from their warehouse, nor could they rely on secondary sources of liquidity to support the influx of loans on their balance sheets. While the ideal goal of the regulatory structure is to limit and prevent failures, it also serves as a safety net to manage failures with no losses to insured depositors and minimal cost to the deposit insurance fund.Q.4. While we know that certain hedge funds, for example, have failed, have any of them contributed to systemic risk?A.4. Hedge funds are unregulated entities that are considered impermissible investments for thrifts. As such, OTS has no direct knowledge of hedge fund failures or how they have specifically contributed to systemic risk. Anecdotally, however, we understand that many of these entities were highly exposed to sub-prime loans through their investment in private label securities backed by subprime or Alt-A loan collateral, and they were working with higher levels of leverage than were commercial banks and savings institutions. As defaults on these loans began to rise, the value of those securities fell, losses mounted and capital levels declined. As this occurred, margin calls increased and creditors began cutting these firms off or stopped rolling over lines of credit. Faced with greater collateral requirements, creditors demanding lower levels of leverage, eroding capital, and dimming prospects on their investments, these firms often perceived the sale of these unwanted assets as the best option. The glut of these securities coming to the market and the lack of private sector buyers likely further depressed prices.Q.5. Given that some of the federal banking regulators have examiners on-site at banks, how did they not identify some of these problems we are facing today?A.5. The problem was not a lack of identifying risk areas, but in understanding and predicting the severity of the economic downturn and its resulting impact on entire asset classes, regardless of risk. The magnitude and severity of the economic downturn was unprecedented. The confluence of events leading to the financial crisis extends beyond signals that bank examiners alone could identify or correct. OTS believes it is important for Congress to establish a systemic risk regulator that will work with the federal bank regulatory agencies to identify systemic risks and how they affect individual regulated entities. There is evidence in reports of examination and other supervisory documents that examiners identified several of the problems we are facing, particularly the concentrations of assets. There was no way to predict how rapidly the market would reverse and housing prices would decline. The agency has taken steps to improve its regulatory oversight through the lessons learned during this economic cycle. For its part, OTS has strengthened its regulatory oversight, including the timeliness of enforcement actions and monitoring practices to ensure timely corrective action.Q.6. There have been many thrifts that failed under the watch of the OTS this year. While not all thrift or bank failures can or should be stopped, the regulators need to be vigilant and aware of the risks within these financial institutions. Given the convergence within the financial services industries, and that many financial institutions offer many similar products, what is distinct about thrifts? Other than holding a certain proportion of mortgages on their balance sheets, do they not look a lot like other financial institutions?A.6. In recent years, financial institutions of all types have begun offering many of the same products and services to consumers and other customers. It is hard for customers to distinguish one type of financial institution from another. This is especially true of insured depository institutions. Despite the similarities, savings associations have statutory limitations on the assets they may have or in the activities in which they may engage. They still must have 65 percent of their assets in housing related loans, as defined. As a result, savings associations are not permitted to diversify to the same extent as are national banks or state chartered banks. Within the confines of the statute, savings associations have begun to engage in more small business and commercial real estate lending in order to diversify their activities, particularly in times of stress in the mortgage market. Savings associations are the insured depositories that touch the consumer. They are local community banks providing services that families and communities need and value. Many of the institutions supervised by the OTS are in the mutual form of ownership and are small. While many savings associations offer a variety of lending and deposit products and they are competitors in communities nationwide, they generally are retail, customer driven community banks. ------ FOMC20080805meeting--117 115,MS. PIANALTO.," Thank you, Mr. Chairman. My outlook for economic growth and inflation over the next few years is broadly similar to the one that I held last meeting, although I think that the prospects for both inflation and economic growth in the near term have deteriorated since June. To a close approximation, my outlook ends up looking very similar to the Greenbook's baseline scenario. The most significant change I am making to my outlook is to mark down the prospects for business fixed investment this year and next, based on the reports that I am hearing from the manufacturers in my District. There is an interesting short-term/long-term dynamic taking place in the manufacturing sector. The manufacturing CEOs with whom I have spoken say that over the long term they are very bullish on America. The dollar depreciation, increased transport costs, and rising wages in China all favor more U.S.-based production. A senior executive from Alcoa told me that, in his 35 years of working in the manufacturing sector, he has never seen the fundamentals point so strongly toward the United States as a profitable location for manufacturing. The short term, however, presents a more mixed picture for manufacturers. Although some industries, such as power generation equipment and aerospace, are running flat out and expect to continue doing so, companies in other manufacturing industries have received or expect to receive order cancellations. In particular, the manufacturers that supply the automotive and commercial construction sectors are reporting a worsening outlook. Perhaps the best way to summarize the sentiments that I am hearing from manufacturers is to say that they see a bright future but they see challenging conditions over the next 12 months. We all know that housing markets are extremely weak. Housing prices began their decline earlier in Cleveland than in the rest of the country, and we are now seeing some stability in housing prices. Despite that hopeful glimmer, we have not seen any pickup in home sales. Based on this experience, it seems that we still have a long way to go nationally before we see any pickup in residential construction. In regard to financial markets, my chief concern is that lending is going to be constrained by lenders needing to maintain sound capital ratios in the face of asset write-downs and loan charge-offs. Balance sheet constraints and a declining risk appetite on the part of bankers mean that some worthy borrowers are going to be rationed out of credit markets, further restraining economic activity. Turning to inflation, I anticipate that price pressures will intensify further before we see some relief, just as the Greenbook baseline scenario depicts. Manufacturers are still raising their prices in response to rising prices for raw materials that they purchase. Some companies have had fixed-price contracts in place for five and ten years, and as these contracts mature, the companies are passing on huge price increases to their customers. Consequently, I think that even after a point at which energy and commodity prices flatten out, prices at the wholesale and retail levels are likely to adjust upward for a while longer. I just said that manufacturers are expecting some challenging times ahead. One reason is that many of them are caught between weakening demand conditions and soaring input costs. Sherwin-Williams represents an extreme case, but I think it illustrates the situation pretty starkly. The CEO of Sherwin-Williams told me last week that their business is down more than 20 percent in sales channels both to new construction and to existing homes. They have been in business for 126 years, and the last time this occurred was during the Great Depression. Despite these dismal sales, they are having to raise prices. The CEO told me that the company typically raises prices once a year, but in July they announced their third price increase this year. In the entire history of the company, they have never before had three price increases in one year. So I continue to see the risk to my projection for output as being to the downside for the reasons that we have been discussing for some time--high energy prices, severe financial stress, and a depression in the housing markets. The risk to my inflation outlook is weighted to the upside because I am concerned that inflation could remain elevated for too long, potentially destabilizing inflation expectations. The Greenbook baseline scenario expects the near-term inflation picture to worsen in the second half of this year before improving gradually over the entire forecast period. This pattern is a concern to me. In that environment, I worry that inaction on our part before next year could be seen as complacency on our part. So when I stack up the two risks against one another, I regard them as fairly equal right now. But my outlook is conditioned on a federal funds rate path that begins to increase about a quarter earlier than called for in the Greenbook baseline. I will speak to the relevance of this factor when we discuss monetary policy in the next go-round. Thank you, Mr. Chairman. " FOMC20080916meeting--155 153,MR. KROSZNER.," Thank you very much. Since the last meeting, there have obviously been a number of flare-ups in the fires that have been burning in the financial markets--the GSEs and then certainly what's come this past weekend and what's likely to come over this week and into the future. A number of people have mentioned things ranging from AIG to pressures on money market funds to some large financial institutions. There are some very large regional banks and a very large thrift that will be facing a lot of challenges as the uncertainties in the markets continue. I won't repeat what Governor Kohn said about the continuing pressures on the bank balance sheets. I think it is important to take into account that those pressures will be there going forward not only on U.S. institutions but also increasingly on international institutions. No one has mentioned UBS yet, but that's another institution about which there's a lot of concern, and if you look at CDS quotes there, they are skyrocketing also. Much as Governor Warsh said, I think that people are worried about what the next shoe to drop will be and whom we have to challenge. Whom do we have to get more information about to make us feel comfortable? If that suddenly becomes everyone, then of course the markets don't function. I just want to focus quickly on consumption and consumer credit markets and then on inflation, and then I'll conclude. We have made some references to how consumers have acted in the past and whether they will continue to act this way. In some sense the consumer has been on a marathon since the early 2000s, facing an incredible amount of shocks--a lot of contraction in 2001, significant declines in stock market wealth, September 11, corporate governance scandals, sustained job losses, and low real income growth. Nonetheless, the consumer continued to consume. But now the consumer seems to be flagging. We have perhaps a very modest effect of the stimulus, which obviously can lead to negative payback for the rest of the year--so a drag going forward as well as drags from housing and stock market wealth, continuing job losses, rising unemployment, and pressures on income. Although many of these shocks were similar to ones that happened earlier in the decade, it seems that consumers do not have the same resilience now that they did at one point. It's not surprising that, after having run this marathon, they're going to be a bit tired. Part of it could also be the credit conditions that are putting much more pressure on them. Just to give you an anecdotal report, but it's from one of the largest providers of consumer credit in the economy. After stabilization basically through our FOMC meeting in August, we've seen some significant deterioration in delinquencies and in the performance of those who get into delinquencies--they roll right to full chargeoff much more rapidly. So we have seen not exactly a qualitative change but a significant deterioration. Also, the ability to securitize credit cards has changed dramatically. After our having opened the window and the markets having opened up in the second quarter, they basically haven't been able to do anything in the third quarter, and that's before this weekend. Obviously that's not going to be helping them. Of course, there are some offsetting factors that can help the consumer. The very significant decline in mortgage rates has led to quite a response, according to this very large provider of consumer credit in the United States. The number of applications for mortgages, particularly for refis, has doubled over the last couple of weeks. So people do respond to prices, and that can help to ease some of their income burdens. Obviously, the reduction in energy prices and many food prices is helpful on that. But of course, what has been good news for U.S. consumers may not be good news for international consumers. As a lot of people have mentioned, the rest of the world is seeing a very significant slowdown. I think the elevated commodity prices had helped to mask a lot of the underlying fiscal and structural problems in these economies, actually much like rising housing prices in the United States had masked the problems in underwriting standards and what was going on in the mortgage market. So I think there are going to be significant challenges in a lot of countries around the world. The boost that we had earlier this year from the international sector is something we can't rely on. On inflation, we're heartened by some of the lower energy prices. But I want to relate one anecdote. In a meeting at the OECD, the CEO of one of the largest private oil producers in the world was asked what reference price he used because obviously he has to make tens of billions of dollars of decisions on investment and so they thought here's someone who would really have a good notion of what the price of oil would be going forward. Without hesitation the person responded, ""$100, plus or minus $50."" [Laughter] That kind of uncertainty from someone who is really in the markets and making those kinds of decisions shows us that we have a reasonable degree of uncertainty in inflation pressures going forward. That said, I think the Greenbook forecast is where I would be also, although we're at uncomfortably elevated levels now. There are a lot of reasons to believe that, although they may be even a bit more elevated in the coming quarter, there are likely forces to bring things back down. This is particularly credible in the context of both survey-based and market-based expectations being quite contained, the market-based expectations being at the low of the year or even over the last couple of years. So this brings me to support alternative B for no change today. On the statement, I do believe that some greater recognition of the stress would be valuable. I think it would be valuable to have something in the first sentence of paragraph 2 that focuses on the strains--perhaps just a single sentence about the strains--and then we can put the other pieces on consumption and housing into the next sentence. It is important in the final paragraph to leave our options open if we do see significant negative feedback effects so that we can make a move that wouldn't be a shock to the markets but it also wouldn't be something that the markets could bank on. Thank you, Mr. Chairman. " FOMC20070807meeting--69 67,MR. PLOSSER.," Thank you, Mr. Chairman. Since our last meeting, the news in the Third District has been generally positive. Economic activity continues to expand in the tri-state area but at a less rapid pace than at our previous meeting. Our Business Outlook Survey indicates that the District’s manufacturing output continued to expand in July, although at a somewhat slower pace than in June. The June measure, you may recall, was more than 18 in our Business Outlook Survey, the highest level that it had been since April 2005. In July the index dropped to a little over 9, although it was still significantly positive. Shipments of new orders increased in July, and the outlook for manufacturers’ own capital spending plans remains positive and is at a level typical of an expansion. Firms in our survey generally see improvements in their businesses coming in the second half of the year. Residential construction, however, continues to be very weak in the region, but we have not seen, at least according to OFHEO indexes, any absolute price declines in our area. This is confirmed by our business contacts, who report that they have not seen steep or broad-based declines in house prices, except for properties along the Jersey shore, where the boom was most prevalent. At our last meeting I characterized the nonresidential investment market as firm, and that characterization continues today. Office vacancy rates in the Philadelphia region remain very low and declining, and rents in office and warehouse spaces remain at a record high. Although reports on retail sales in our region have been mixed, sales appear to have improved somewhat in late June and early July, especially at higher-end retail establishments. Bank lending has continued to advance but at a more moderate pace than at the time of our last meeting. Our banking and other business contacts indicate that banks have money to lend to customers with good credit ratings, and so I don’t get the sense that area businesses are facing a credit crunch of the normal type. Banks are comfortable with their lending standards and do not expect to make any big changes along this dimension in the foreseeable future. For the most part our banks were not in the subprime business and obviously don’t intend to start now, [laughter] and thus they have not seen an appreciable deterioration in their balance sheets or in those of the businesses to which they lend—their customers. Clearly, there is nervousness, but as yet there seem to be few consequences for the real economy. June employment growth in the region was below trend, but the region’s unemployment rate remains relatively low. Our staff expects employment to continue to grow at a moderate pace going forward and expects the region’s unemployment rate perhaps to rise modestly by the second quarter of next year. Yet businesses continue to report tight labor markets. One very large builder, who is headquartered in our area and who builds mostly high-end homes, has actually reported that he cannot finish a number of homes that he has under contract and that buyers are waiting to move into. He cannot find labor. Because of the crackdown on illegal immigrants, who do a lot of the landscaping, a lot of roofing work, and all the labor that goes into finishing these homes, he cannot hire these workers, and so he actually has to put off closing deals because he cannot find workers to complete the homes. On the inflation front in the District, employment costs in the Northeast are increasing at about the same pace as in the nation. Area manufacturers continue to report higher production costs, but there is relatively little evidence of pass-through of those higher costs to customers as they see it. Consumer prices are growing more slowly in the region than in the nation. So in summary, the Third District economy continues to expand at a moderate pace. While there is nervousness caused by the recent volatility in the financial markets, businesses do not yet see that affecting their current growth or prospects for future growth. Business contacts as well as the Philadelphia staff expect this moderate pace of expansion to be continued in the coming months. At the national level, the news has been mixed. On the positive side, employment and income growth remain solid. Manufacturing output continues to improve, and core inflation and inflation expectations remain contained, although both remain higher than I would like to see in the long run. On the negative side, news on business fixed investment and housing has been disappointing. After encouraging signs of stabilization early in the year, the sales of both new and existing homes have continued to decline. Sales of homes declined 6.6 percent in June and almost 8 percent in the second quarter. At the time of our last meeting, I expressed the view that I was getting hopeful that economy was on track to return to near-trend growth later this year. Setting aside the issue that our perception of long-term trend growth in real GDP may need reassessment in light of the benchmark revisions, as we’ve been discussing—and I’ll return to this point in a moment—the recent data on housing are suggestive of a weaker third quarter and perhaps fourth quarter as well. Though I think the underlying steady-state demand for housing is lower than the pace of housing demand before we saw the downturn begin, which implies that much of the adjustment in housing supply is part of a healthy adjustment to a new equilibrium, the stock of unsold homes continues to cause a drag on residential investment. I also think that there is some risk of temporary weakness in business fixed investment going forward simply because of increased uncertainty. So the return to trend growth, which I think will happen within the forecast period, may be delayed by a few quarters and may not get under way solidly until late in the first half of next year. You know the old saying: “If you can’t forecast well, forecast often.” [Laughter] The biggest economic news headlines since our last meeting have focused on the volatility of the financial markets and the repricing of risk. I am inclined to put minimal weight on the current financial conditions for a slowdown in the pace of economic activity going forward. Although risk spreads have widened in the past three weeks or so, the cost of capital for high quality borrowers has hardly changed and remains relatively low by historical standards. This suggests to me that what we are seeing in the marketplace—at least right now but which could change, as we’ve all noted—is a change in the relative price of various measures of types of risk. The cost of capital for some borrowers is increased, but demand for business investments that originate from large corporations with good credit ratings has not changed and is not likely to be adversely affected very much in the repricing of risk, if that’s what this represents. This news was reinforced to me by my conversations with area bankers, as I mentioned earlier, who say that they have plenty of money to lend to good credit risks. There is no evidence of a general credit crunch from their point of view. My general view regarding the limited nature of the credit repricing is reinforced by the fact that default rates on auto loans, credit cards, and other types of consumer debt instruments have not changed much, suggesting that the spillover effects, at least to date, have not been very measurable. Thus, I think that the decline in the subprime market is primarily a result of lax underwriting. Those lenders are now paying the price, but we must be very careful not to act or appear to act in a way that supports bad bets or lax underwriting standards without more widespread evidence of systemic problems affecting the real economy. Let me now turn to what I think is a more fundamental factor for gauging the strength of the economy going forward and, therefore, the appropriate stance for monetary policy. In the most recent Greenbook, the Board staff revised down the rate of growth of structural productivity more or less in line with the reduction in real GDP growth, as we have been discussing. It is certainly reasonable to think that this new information about the pace of real GDP growth during the past three years contains information about the rate of growth of structural productivity going forward. But that is not an infallible signal. In my thinking about how monetary policy needs to be set, distinguishing temporary decreases in the rate of growth of productivity from permanent decreases is a critical piece of the puzzle. A transitory decrease would not affect the steady-state equilibrium real rate to my mind. But a permanent decrease would imply a lower steady-state equilibrium real rate and, thus, a lower natural rate for the federal funds rate. If the equilibrium real rate is lower, holding the fed funds rate constant, of course, would imply an implicit tightening of monetary policy. I am still grappling with the implications of these benchmark revisions for future productivity growth. At this point in my forecast, I’m assuming that the revisions imply a rebenchmarking of the growth rate of structural productivity, but that rebenchmarking or that lowering of the trend rate of growth of real GDP is not enough so that core inflation can decelerate toward price stability in the next two or three years or so under a constant fed funds rate. But the reduction in the growth rate of structural productivity does feed through to a somewhat looser required path of the fed funds rate through 2008 to 2009. In my forecast, appropriate policy has the fed funds rate rising to 5½ percent in the first quarter of ’08, holding steady there for two or three quarters, and then gradually drifting down toward a more neutral rate consistent with lower inflation expectations and lower trend output growth. With this path of the fed funds rate, I expect the economy to return to near potential real GDP growth in the first or the second quarter of 2008. I expect the housing correction to continue through the first half of 2008, but the drag lessens over the year. I expect the core inflation rate to be somewhat higher in the second half of the year than in the first half, but I expect the economy by 2009 to grow near its potential growth rate, which I now assume to be 2.8 percent, about 0.2 percent lower than I had last time, with the unemployment rate close to its natural rate of 5 percent and core inflation at about 1.5 percent. I have two other brief comments I’d like to make about our forecasting exercise and some information I think is relevant. We continue to focus on the PCE price index, and I have some objections to that. I continue to believe that the CPI is a better measure, if for no other reasons than that it is more familiar to the public and that it is not revised. We were lucky this time in the GDP revisions that the PCE price index was not revised very much, and I think we run the risk that focusing too heavily on a measure that does get revised can cause us some difficulty. I also have some concern about the empirical ability of core PCE to actually be a very good predictor of headline PCE inflation at the end of the day. So I am still struggling with our choice of the index there. The other item that I would like to emphasize—and it was driven home to me in a meeting with some reporters in the not-too-distant past—is that I do believe that moving toward measures of uncertainty that include some fan charts would be useful. I was hesitant at first about that in part because getting appropriate measures of uncertainty that are internally consistent across all our forecasts and all our models would be very difficult. Yet some, what I would view as very sophisticated, journalists continue to confuse the issue of the range of our forecasts and our central tendencies with the issue of uncertainty or certainty. They do not understand that our central tendency is an agreement about what our point forecast is but that it may reveal very little or nothing about the degree of uncertainty in our forecasts. So I think it is very important that we quantify that in some way to be clearer and to eliminate some of that confusion. I’ll stop there. Thank you, Mr. Chairman." FOMC20070131meeting--182 180,MR. POOLE.," We have two important pieces of information coming in at 8:30 tomorrow morning. I hope the staff can give us a quick first read to start our meeting. I know that instant analysis is risky, but I ask for it anyway. [Laughter]" FOMC20060808meeting--81 79,MR. KROSZNER.," Thank you very much. As the comments indicate, this is probably the most challenging time that we have had before us in my long history here at the FOMC. [Laughter] The mix of continuing inflation pressures and decelerating growth are providing more concerns on both fronts than I have heard around the table and than I myself have had since I’ve been here. First let’s think about some of the growth prospects. I broadly share the Vice Chairman’s view that the fundamentals are in place for reasonable growth going forward. Certainly there are some risks. But whether we are looking at survey-based measures, at orders and shipments, or at a variety of different things, we don’t really see signs of very significant deceleration or contraction. We see more a moderation that would be either in line with the Greenbook or a bit lower than the Greenbook. Certainly a key risk to growth that a lot of people have discussed is residential investment. If you look at where we are in residential investment, we’re back only to mid-2003; 2004 and 2005 were incredibly strong years. So being in 2003 is not that bad. If you look at the graph, residential investment falls off rather precipitously to get us back to 2003 with great rapidity. The question I have is whether it will flatten out or whether it will go down further. The Greenbook forecasts have gradually been moving down and now reflect more downward pressure going forward. I think that we’re not seeing the full effects on house prices reflected in the numbers because in the housing market, for reasons I don’t think we fully understand, there tend to be queuing rather than just price changes. So it may take a while for the price data to actually reflect the lower effective prices that people are seeing. Obviously house prices will have a potentially important effect on the wealth effect and on consumption down the line, which I think the Greenbook does a good job of putting into place. Another challenge is elevated prices for energy and commodities. Energy prices, particularly, may be taking a little bite out of people’s disposable income. On the other hand, we have been seeing continued strong business fixed investment. A small concern I have is, if we continue to hear about slowing consumption and reports from Wal-Mart and others that retailing is really slowing, why are these businesses producing? Are they investing to produce goods that people will want to buy, or will we see in nine months or a year that maybe some misallocation of resources has occurred and that things aren’t as strong as we had thought? There’s no particular sign of such misallocation of investment. It just seems that there is a bit of tension between the discussions of continued strength of capital expenditures and the statements of business contacts that they are going to continue to invest even though they see a slowing coming down the line. This is a variation of what Governor Warsh was saying—it’s almost as though they are saying that some other sector will have that slowing, not their sector. In some sense, we should take very cold comfort from the fact that the economy may be slowing. We had quite a discussion about how there’s not much of an inflation–output tradeoff, but at least in this period there are real questions of whether you do get much benefit in terms of lower inflation from slower growth. There may be some benefit, but it seems to be attenuated compared with the past. Obviously some of the recent numbers on inflation continue to be worrisome, but fortunately both the survey measures and the market-based measures seem to be reasonably contained looking forward. Survey measures, whether of the man in the street or of the professional forecaster, seem to be quite flat. The TIPS rates for both the near-term forwards and the longer-term forwards have not moved up much. Some of the near-term forwards have moved up a bit, but that doesn’t seem surprising given the rise in energy prices that we have seen both from the Middle East and from issues in Alaska. The real key is looking forward as to what is likely to occur. Are the things we’re seeing now transitory factors or persistent factors? That’s a very, very difficult call. Reasonable arguments have been made that a number of these factors, particularly with respect to shelter services, are perhaps a bit more short-lived. Shelter services are about 19 percent of core PCE and about 30 percent of core CPI, and obviously they have been leading the band up. As many people have said, we have been seeing price increases in a lot of areas, but I don’t put quite as much stock in that because many of the categories in both the PCE and the CPI are arbitrary. The issue is really what the relative size and the relative importance are. Shelter services and owners’ equivalent rent, which composes a vast majority of shelter services, are an important piece. I think that there’s a reasonable chance that this factor is likely to be transitory, although it may last for several months and possibly quarters. But that is the key question—whether these forces are likely to be transitory or likely to be more persistent. Coming back to inflation expectations, that’s really where I see the markets both registering their view of persistence and telling us something about whether they believe that we will keep inflation well contained. At least so far, those expectations are suggesting that we will. It’s extremely important that we maintain those expectations. It’s very costly to try to regain credibility if credibility is lost. I think the markets are willing to say, “Well, there may be some transitory inflation, and we’re willing to wait and see whether to mark up our longer-term expectations.” Certainly once longer-term expectations are marked up, the situation becomes highly problematic because it’s very difficult to rein in the changes in expectations, particularly in behavior. So basically I think we need to keep a very, very watchful eye on where expectations are going. I’m heartened that they haven’t moved too far despite, as many people have said, high core PCE prices for a number of years and elevated levels in the most recent numbers. Thank you, Mr. Chairman." FOMC20060510meeting--130 128,MR. KROSZNER.," Thank you very much, Mr. Chairman. You will hear me singing a familiar song from last time, although not exactly the same song, and unfortunately I did forget my tap shoes. The song that I want to sing from last time is the continued strength and resilience of the economy plus concerns about inflation expectations moving out of line. Consumption growth has been moderating a bit, but exactly as Governor Olson said, with the continuation of some of the changes in the tax laws, real disposable income will still have a boost. We have seen very strong global demand, particularly on the consumption side in many countries that have been lagging in consumption. In addition, we are also seeing strong investment demand, both domestically and internationally, and I think that is something that we have to take into account going forward. As for the key risks going forward, one, of course, is the housing market. There has been a lot of discussion of that, and I do not think I have very much more to add. We have to see what the lagged effects of interest rate changes are there, but that is something to be determined. Some puzzles that have persisted since last time concern the lack of pass-through of a number of things. Of the heightened energy and commodity prices to core inflation, we have seen some uptick. But I share Governor Kohn’s analysis, or his conclusions from the analysis, that there are some signs but that one should not be overly wary because we have had a bit of downtick, then a bit of uptick. When we are talking about monthly movements of 0.1 percent, a simple rounding error can make things seem suddenly much higher or much lower. It could be a 50 percent difference from what we expect when we really are just seeing a rounding error, although we do have to be very aware of this. Obviously, we have not seen pass-through of higher productivity gains to compensation. This situation puzzles me quite a bit because, historically, by now we would be seeing more robustness of compensation, not just real disposable income, but compensation. We have not seen that. Productivity apparently continues to move fairly strongly. Looking forward, I am concerned about this area even though the current data seem to suggest that the costs of labor are perfectly reasonable. Rather than looking just at the current data but using a little theory to look forward suggests that this may be an area that could be coming up in the future. Even if there are higher costs in the labor market, are they going to be pushed through to final demand prices? We have had a good discussion of the evidence on what has happened in the past. Will you necessarily see the margins staying up or moving down, and will that cause the changes in underlying cost to be passed forward? Potentially it won’t, and potentially there could be large movements. But, again, we are in somewhat uncharted territory. We do not have a lot of evidence here. Another set of puzzles concerns the yield curve term premiums, and we, of course, have already had a lot of discussion about those and about the slight uptick in both the survey-based and market-based measures of inflation expectations. Obviously, that is something that we need to be very, very concerned about because the last thing that we want is to allow our actions in any way to be interpreted as a lack of concern about inflation, which could lead to an unanchoring of inflation expectations. That said, I certainly do not see such unanchoring in the markets. Also, the yield curve, although it has certainly moved up from being flat or even slightly negative, is still showing a difference between the two-year and the ten-year of only 15-20 basis points, which is not very large. And the much flatter yield curves are a worldwide phenomenon, driven by factors not just within the United States and not just about U.S. expectations. I also very much agree with President Stern that we should not put too much emphasis on high- frequency numbers. We have to think about the recent numbers in a more systematic way. What are we likely to see going forward? What are the risks going forward, given some theory, given some historical experience? Coming back to the theme that I sang about last time—about Fed credibility not being the impossible dream, but a reality—I think we do have that reality, and it is certainly something we do not want to give up. Just to tweak President Geithner a bit, I hope his comments should not be interpreted as saying that we want to introduce uncertainty into the marketplace. The last thing that the FOMC should be doing is introducing uncertainty. Certainly we do not want to be producing moral hazard and having inappropriately low uncertainty when real risk factors may be out there. We certainly want to be very wary of that; we do not want to contribute to that. But as Tim said, and I very much agree, we are in a very uncertain time, and to suggest that we are uncertain about where the economy is going is valuable. But to suggest that the market participants are not focusing enough on uncertainty, that there should be more uncertainty, and that we should do something about it is perhaps not the way to go. Thank you, Mr. Chairman." FOMC20050322meeting--97 95,MR. HOENIG.," Mr. Chairman, looking at the economy, we expect growth will be in line with what others have said—in the 4 percent range this year and slightly above 3½ percent next year. With trend growth of about 3¼ percent, obviously the output gap and labor market slack are diminishing. There are a whole host of reasons for that, which Dave already outlined, and I won’t repeat them. I will say that from the Tenth District perspective, our information supports this more robust March 22, 2005 28 of 116 addition, travel and tourism continued to improve, as the dollar has helped to increase ski visits and hotel occupancy in the mountain states. Labor markets remain strong, with hiring announcements exceeding layoffs by about a 1¼-to-1 ratio since our previous FOMC meeting. And, finally, District manufacturing continues to expand strongly. Production, new orders, and employment all rose in February. Moreover, firms remain optimistic about future activity and plan moderate increases in employment and capital spending going forward this year. I’ll make most of my comments on the inflation outlook, because I do have some concern about that. I was struck by David’s point that, as for inflation breaking out, he would put it in terms of a “not yet” statement. But as I view the outlook, I expect, even with the fed funds rate rising as we currently are projecting, that inflation will increase and perhaps could accelerate in 2005 and 2006. Here are some reasons for that. First, we have been in an accommodative mode of policy for an extended period of time now—years, not quarters—with the fed funds rate below most estimates of neutral over much of that period. Core inflation, by whatever measure you pick—core CPI or PCE or the market-based core PCE—drifted higher last year. Not only did core inflation drift higher, it was unexpectedly higher than earlier projections. This unexpected increase is notable because it occurred even though real GDP growth was as expected and the fed funds rate was being increased. If inflation could increase that much last year in the presence of sizable slack and a rising fed funds rate, I am concerned that, with less slack in the economy this year, we will end up with yet higher inflation. In addition, a number of indicators suggest continuing inflationary pressures. For example, we have higher cost pressures resulting from higher commodity prices, which we mentioned, and March 22, 2005 29 of 116 in unit labor costs that may not be dramatic yet, but they are increasing. Wage pressures are emerging in our District. About a quarter of the employers we contacted said that they’ve had to raise wages more than normal, particularly for skilled workers. We are also seeing evidence of increased pricing power in the Tenth District, as firms have more confidence in their ability to raise output prices even without an increase in input costs. For example, we asked our survey participants a special question about whether their ability to raise prices had improved since the beginning of just this year. Of 77 responses, more than half said clearly yes. The final reason I see an upside risk for inflation is that monetary policy does, in fact, remain accommodative. The federal funds rate is currently below most estimates of the neutral rate. Even with the Greenbook’s assumptions of tighter policy, the fed funds rate will end the year below or at the lower end of estimates of the medium-run neutral rate. This poses a significant upside risk to inflation, because it is likely that much of the slack in the economy will have been eliminated by the end of the year. With output close to potential and core inflation elevated, I think we should aim to be comfortably within the range of neutral by the end of the year, not at the lower end. Overall, with growth above trend, I am concerned that there is an upside risk to inflation even with the funds rate path consistent with the projections we are seeing currently. I believe we should begin moving more aggressively to bring the fed funds rate closer to the long-run neutral rate sooner. I would submit that, as long as the funds rate remains significantly below neutral, the risk that we will need to raise it 50 basis points can be managed. Now, I say that, but I also realize that a 50 basis point increase, while it could be justified, would surprise financial markets. So perhaps we should begin to signal the market that a more aggressive return to neutral is at least possible. But March 22, 2005 30 of 116 prefer to shorten it and drop any reference to measured pace. After reading the minutes in three weeks, markets will know that a more aggressive policy is possible. In other words, we don’t have to provide a long explanation today. And in fact, in testimony you gave earlier, I think you dropped the “measured” language; therefore, I don’t think changing that part of the statement would surprise the markets at all. Thanks." CHRG-111hhrg74855--2 Mr. Markey," Welcome to the Subcommittee on Energy and Environment and this very important hearing. As early as next week, the House will vote on legislation to strengthen the oversight of financial derivatives markets. This legislation provides the Commodities Futures Trading Commission a broad new authority to regulate over-the-counter trading in derivatives. This reform is long overdue. Over the past 2 years, we have once again learned the hard way that deregulation of financial markets is a recipe for robbery and ultimately recession. I have long supported tough regulation of derivatives beginning in the late 1980s when I chaired what was then the Subcommittee on Telecommunications and Finance. In the early 1990s, I chaired the first Congressional hearings on the potential for over-the-counter derivatives to create systemic risk in global financial markets, and I warned of the risks that unregulated derivative dealer like AIG and Bear Stearns could pose for those markets. I have also worked to strengthen competition and oversight in electricity markets. I was the author of the transmission access provisions of the Energy Policy Act of 1992, which promoted competition by requiring transmission owners to provide independent power providers with access to the grid. In the Energy Policy Act of 2005, I was amongst the principal supporters of the provision that gave the Federal Energy Regulatory Commission authority to protect against fraud and manipulation in electricity and natural gas markets. So today's hearing isn't about whether or not we need strong oversight of energy markets; clearly, we do. It is about getting regulation right. We must ensure that financial regulatory reform doesn't disrupt FERC's ability to properly structure and oversee organized energy markets. Otherwise, we will undermine FERC's ability to ensure reliable and affordable service for American consumers. We must not let this effort to solve one crisis, create yet another. The derivatives bill reported by the Agriculture Committee threatens to do just that. The bill's definition of swap is so broad that it is likely to cover a number of FERC-related products, including but not limited to Financial Transmission Rights that play a key role in the functioning of the organized electricity markets. These products are inextricably linked to the physical operation of the grid and they exist only because FERC has approved their terms and conditions. Congress has given FERC strong authority to protect against manipulation of these markets and there is broad agreement that FERC has exercised that authority thoroughly and competently. Nevertheless, under the pending derivatives bill, anything that falls within the definition of a swap is under the exclusive jurisdiction of the CFTC, and CFTC has no authority to exempt any swap from the full set of regulations that apply to financial markets. What is the upshot of all of this? Well, FERC could be excluded from regulating the very markets it has created to ensure a reliable and affordable supply of electricity. In FERC's place would be substituted the CFTC, an agency with no expertise in this area. Such an outcome is unacceptable. Chairman Waxman and I have proposed a straightforward and reasonable solution. First, the derivatives legislation should fully preserve FERC's existing statutory authority. Second, whether FERC and CFTC have overlapping authority, the two agencies should conclude a Memorandum of Understanding that sets the boundaries of their respective authority so as to ensure effective regulation. And third, in any area where the two agencies agree that FERC should have primacy, CFTC should be allowed to decline to exercise its regulatory authority. We will be working in the coming days to ensure that a resolution along these lines can be reached before the derivatives bill is brought to the House floor. We expect that the members of the subcommittee and the full committee will play an active role in this discussion. This afternoon's hearing will help us to flesh-out the issues and potential solutions. I thank the witnesses for their participation, especially the two chairmen who are sitting in front of us. They are working hard in trying to find a way of resolving these issues. We appreciate their efforts. Let me now turn and recognize the ranking member of the subcommittee, the gentleman from Michigan, Mr. Upton. " FinancialCrisisReport--627 In a later presentation put together to propose a new compensation arrangement for the SPG Trading Desk’s trading activities, Mr. Birnbaum was unequivocal that the net shorts the desk had acquired were not hedges to offset risk, but “outright” short investments to produce profits: “By June, all retained CDO and RMBS positions were identified already hedged. ... SPG trading reinitiated shorts post BSAM [Bear Stearns Asset Management] unwind on an outright basis with no accompanying CDO or RMBS retained position longs. In other words, the shorts were not a hedge. ” 2815 In his 2007 self-evaluation, Michael Swenson, head of the Mortgage Department = s SPG Trading Desk, described the net short positions undertaken by the firm in this way: “It should not be a surprise to anyone that the 2007 year is the one that I am most proud of to date. ... extraordinary profits (nearly $3bb [billion] to date). … I directed the ABS desk to enter into a $1.8 bb short in ABS CDOs that has realized approx. $1.0bb of p & l [profit and loss] to date. … [W]e aggressively capitalized on the franchise to enter into efficient shorts in both the RMBS and CDO space.” Mr. Swenson’s description of the net short position he “directed” to be built in CDOs and the resulting $1 billion in profit makes no reference to client demands. Mr. Salem, a trader on the ABS Desk, was equally clear in his 2007 self-evaluation that the desk made a deliberate bet on the direction of the mortgage market: “Mike, Josh, and I were able to learn from our bad long position at the end of 2006 and layout the game plan to put on an enormous directional short.” 2816 Each of these three Mortgage Department employees played a key role in building the firm’s net short positions. Their own statements indicate that they perceived acquiring the 2007 net short positions to be for the benefit of the firm, and not to build an inventory of assets to respond to anticipated client demand. Other internal documents also portray the net short positions as decisions made by the firm to advance its own financial interests. In an internal presentation to the Goldman Board of Directors regarding the “Subprime Mortgage Business,” for example, the Mortgage Department wrote that, in the first quarter of 2007, “GS reverse[d] long market position through purchase of fund to include assets in Anderson and then short them, but Mr. Bieber thought Mr. Sparks would want to “preserve that ability for Goldman”); 12/29/2006 email from Mr. Birnbaum to Mr. Lehman, GS MBS-E-011360438, Hearing Exhibit 4/27-5 (when discussing certain proposed CDO deals that would generate $1 to $3 billion in short positions and reference certain RMBS securities, Mr. Birnbaum stated: “On baa3 [RMBS securities with credit ratings of BBB-], I’d say we definitely keep it for ourselves. On baa2 [RMBS securities with BB ratings], I’m open to some sharing to the extent that it keeps these customers engaged with us.”). 2815 10/3/2007 “SPG Trading B 2007,” presentation prepared by Joshua Birnbaum with input from other SPG employees, but which was not ultimately provided to senior management, GS MBS-E-015654036, at 44 [emphasis in original]. Mr. Birnbaum reaffirmed his analysis in a 2010 written response to Subcommittee questions. See Mr. Birnbaum’s response to Subcommittee QFR at PSI_QFR_GS0509. 2816 9/7/2007 Fixed Income, Currency and Commodities Annual Individual Review Book, Salem 2007 Self-Review, GS-PSI-03157, at 71. single name CDS and reductions of ABX.” 2817 In September 2007, the Goldman Board of CHRG-111shrg54589--12 EXCHANGE COMMISSION Ms. Schapiro. Thank you very much, Chairman Reed. Mr. Chairman, Ranking Member Bunning, and Members of the Subcommittee, I am very pleased to have this opportunity to testify on behalf of the Securities and Exchange Commission concerning the regulation of over-the-counter derivatives. The severe financial crisis that has unfolded over the last 2 years has revealed serious weaknesses in the structure of U.S. financial regulation. One of these gaps is the gap in regulation of OTC derivatives, which under current law are largely excluded or exempted from regulation. The current regulatory framework has permitted certain opaque securities-related OTC derivatives markets to develop outside of investor protections afforded by the securities laws. The SEC is committed to working closely with this Committee, the Congress, the Administration, and our fellow regulators to close this gap and restore a sound structure for U.S. financial regulation. I am pleased to be able to report to you that U.S. regulatory authorities have reached a broad consensus on the pressing need for a comprehensive regulatory framework for OTC derivatives. This consensus covers all of the basics of sound financial regulation in the 21st century, including record keeping and report requirements, appropriate capital and margin requirements, transparent and efficient markets, clearing and settlement systems that monitor and manage risk, business conduct and disclosure standards to protect the interests of market participants, and vigorous enforcement against fraud and other wrongdoing. The SEC is also strongly supportive of ongoing initiatives to promote the standardization and central clearing of OTC derivatives. The SEC, working in closing consultation with the Board of Governors of the Federal Reserve System and the Commodity Futures Trading Commission, and operating under the parameters of the current legislative structure, already has taken a number of actions to help further centralized clearing for OTC derivatives, including providing temporary conditional exemptions for three central counterparties to begin centrally clearing credit default swaps. More needs to be done, however, and in building a new regulatory framework for OTC derivatives, it is vital that the system be designed to protect the public interest, manage systemic risk, and promote capital formation and general economic welfare. Treasury Secretary Geithner's May 13th letter to the congressional leadership outlined the Administration's plan for establishing a comprehensive framework for regulating OTC derivatives. Multiple Federal regulatory agencies will play critical roles, including those represented here today. In fashioning a regulatory framework for OTC derivatives, it is crucial to recognize the close relationship between the regulated securities and futures markets and the now mostly unregulated markets for OTC derivatives. For example, with respect to the securities markets, when an OTC derivative references an issuer of securities, such as a public company or a security itself, it can be used to establish synthetic long or short exposures to an underlying security or group of securities. In this way, market participants can replicate the economics of either a purchase or sale of securities without purchasing or selling the securities themselves. Because market participants can use these securities-related OTC derivatives to serve as synthetic substitutes for securities, the markets for these OTC derivatives are interconnected with the regulated securities markets. Moreover, the markets for these securities-related OTC derivatives implicate the policy objectives for capital markets that Congress has set forth in the Federal securities laws, including investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation. For this reason, it is important that Congress carefully consider whether securities-related OTC derivatives should be subject to the Federal securities laws so that the risk of arbitrage and manipulation is minimized. And, certainly, a similar analogy can be made to the futures markets by the CFTC. My goal today is to assist the Congress in its efforts to craft legislation that empowers the respective regulatory authorities to do their jobs effectively and cooperatively. I am confident that, working together, we will meet the challenge that is so important to the financial well-being of individual Americans. I would be pleased to answer your questions. Thank you. " FOMC20050630meeting--368 366,MS. YELLEN.," Thank you, Mr. Chairman. At our last FOMC meeting, I worried about a slowdown in growth and a pickup in inflation. I hypothesized and hoped that both would prove transitory. On the whole, I consider recent data reassuring that the soft patch in the spring was just that—maybe not even that—and not a precursor of a more entrenched slowdown. While the Greenbook subscribes to the view that the slowdown in growth was transitory, the staff has made an upward revision, by a couple of tenths, to its forecast for core PCE inflation for this year and next year, now projecting inflation of about 2 percent in both years. I’m a bit less pessimistic on inflation than the staff. Recent data on core inflation have been pretty good of late. Moreover, I see the fundamentals—namely, the pressures on future inflation—as providing room on balance for some optimism. The most worrisome factor is that oil prices have risen further, although this should tend to boost core inflation more this year than next year. As David noted, the recent jump in compensation per hour should probably be discounted, since it appears to be due to one-time factors. On the encouraging side, I see a noticeable decline— about 17 basis points—in inflation compensation at both the 5- and 10-year horizons, high markups, an appreciation in the dollar, a leveling off of commodity prices, very modest increases in the ECI, June 29-30, 2005 132 of 234 The situation with regard to slack, as David noted and emphasized, is complicated because the unemployment rate is relatively low, near most estimates of NAIRU. But several other measures, as he pointed out and as we also routinely monitor—including the employment-to­ population ratio, capacity utilization, the output gap, and the other indicators that David showed us— do suggest that slack remains. One final point on the inflation outlook is that one of the best forecasters of future inflation is past inflation. And I’m told that this is a point that was emphasized at a special topic session a couple of years ago. On this score, things look fairly good, with core PCE price inflation at 1.7 percent over the past 12 months. While I guess I can and have quibbled a bit about the inflation outlook for the next year, overall I think the Greenbook forecast seems reasonable. Real GDP appears poised to grow just slightly above its potential rate, gradually eliminating remaining slack. And core inflation, while currently near the upper end of my comfort zone, at least to me seems likely to moderate a bit over the next few years. The Greenbook forecast depicts an almost textbook scenario of an economy continuing along the path toward a rather attractive steady state. Going forward, there are obviously some sizable risks, and I count the unwinding of possible house and bond market bubbles as one or two that are high on my list. But I think the most likely outcome is—as in the Greenbook projection— that we will continue to move in a positive direction over the next couple of years. And given what we now know, I think the funds rate path assumed in the Greenbook, which is very close to the market’s current view, is appropriate. That is, we are likely to need to raise rates a couple more times before slowing the pace of tightening rather substantially. And I want to emphasize that, in June 29-30, 2005 133 of 234 economy moving along this textbook path during a period characterized by some quite difficult circumstances. I know that Monday’s pre-FOMC briefing emphasized that economic activity has been burdened by some major drags over the past year or so. These include the oil shock, the deterioration in the trade balance, and the still low level of investment spending relative to GDP. The result is that we’ve had to keep interest rates exceptionally low for a long time, just to get respectable economic growth. In fact, respectable and not stellar growth is all we have gotten, even with exceptionally low long-term yields and unexpectedly rapid gains in house prices. And those are two factors that, on their own, would be working to push up the equilibrium real funds rate. So the merely respectable growth in the economy has really rested on the backs of just a few interest rate-sensitive sectors: business investment, consumer durables, and housing. From that perspective, it’s really not all that surprising that house prices have risen a great deal, and it’s not surprising to hear our directors and other contacts comment that liquidity is abundant and that lending is taking place for deals that one of our directors simply characterized as “stupid.” I think he meant by historical standards. [Laughter] My point is that to offset the drags, we’ve needed to give the economy a strong dose of stimulus, which inevitably boosted the housing sector—and that just to get reasonable economic growth. That is equivalent to saying that the equilibrium real fed funds rate is unusually low—1.4 percent in the Greenbook path. So, for me, the policy imperative that follows is that we need to be careful not to overdo the pace of policy tightening. I noted that in recent months several FOMC members have commented that we usually know we’ve come to the end of the tightening phase when we have tightened one or two times too many. I think we should be especially attentive to this concern this time around, June 29-30, 2005 134 of 234 John Williams’s analysis yesterday highlighted the fact that if house and/or bond prices fall, the zero bound could become an issue we would be discussing again. To conclude, I’m all for raising the funds rate by 25 basis points at this meeting, and I believe the language in the press release should seek to maintain the path for the expected fed funds rate that now exists in the market. My worry is that unless we’re careful in crafting the language as we raise the rate today—and likely again in August—markets will start to build in more increases in subsequent months than they have so far. I think we are nearing the point when we will need to start pausing, and I hope we can maintain that expectation in the market in the period ahead." FOMC20080318meeting--88 86,MR. WARSH.," Thank you, Mr. Chairman. To join the growing chorus in the discussion today, I would say that there are very significant policy challenges across five areas on both sides of our mandate. First, the real economy is materially weaker. Second, inflation risks are quite discomforting. Third, we have genuine issues with respect to financial stability. Fourth, we have very real problems with respect to the credit channel and credit availability. Finally, as I think a couple of others have said, we have risks in terms of possible disorderly moves on the dollar. In terms of what markets believe that we believe are the big concerns, I think they rightly understand that we are very worried about downside risks to the economy. They believe that we are very focused on financial stability risks; and with the three new facilities announced in recent periods, they are coming to believe that we are finding an effective means to deal with a credit intermediation system that is, to perhaps overstate only a little, broken. But market participants may not yet believe that we are as concerned as we ought to be about inflation risks and about risks with respect to the path of the exchange value of the dollar. With that summary having been made, let me talk, first, about financial market conditions. About the deterioration in market functioning since the last FOMC meeting, Bill spoke in great detail. Over the past couple of weeks, not just in the episode with Bear Stearns, counterparty risk has become the dominant concern in markets. As has been pointed out around this table, it is increasingly difficult to separate liquidity issues from solvency issues. So what should we take from this deterioration in counterparty risks? If we look at a range of financial institutions that have different degrees of implied backstops by the government based on their size and their regulatory structure, we think about the GSEs that have an implied government guarantee and even Ginnie Maes, which have the full faith and credit backing of the U.S. government and about which the Board staff shared some data yesterday with us. The spreads on all of these look as though they have widened substantially. We have seen very real deterioration. But when you see that it is happening for the Ginnie Maes, just as with many of these other securities, it suggests that this is substantially, but not completely, about liquidity risk because the credit risk of Ginnies ostensibly can't be called into question. Financial institutions, more broadly than financial markets, are having a hard time finding their way. We have talked around this table before about their balance sheet problems, and most recently we have talked about their income statement problems in figuring out what their core business is. In the markets in the last couple of days, we have had the broker�dealers with widening CDS spreads and falling share prices, and of course, that is about their mortgage exposure and liquidity concerns. But I think, most fundamentally, that the business model of investment banks has been threatened, and I suspect the existing business model will not endure through this period. As a result, the current architecture of the regulation of financial institutions and of the business model across ranges of financial institutions--commercial banks, investment banks, and hedge funds--will change through this period. The old model, at least in investment banking, of high imputed leverage works incredibly well in a world of high liquidity and doesn't work as well when liquidity is in short supply. Why do I think this matters? It matters because it suggests that any catalyst for improvement from financial institutions feeding into the real economy for the rest of 2008 or even for the first half of 2009 is quite suspect. These institutions are spending all their time and attention on their own business models, figuring out how they can survive this period, not on providing credit to the real economy. So I don't look to financial institutions to be very good shock absorbers or very good catalysts going forward. My concern, broadly, about financial institutions is highlighted when I think about the need, across all these institutions, to raise significant capital for safety and soundness purposes and, in addition, for credit availability purposes. It strikes me that this broad class is systematically undercapitalized, and we need to use all our tools to persuade them that it is in their interest and in the interest of the broad economy for them to raise capital. But finding capital, certainly over the next six months, will be a very real challenge. The capital markets are not in a very strong position to satisfy issuer needs at present. That obviously can improve over the next couple of months, but there is no certainty. Sovereign wealth funds and other sources of investment that we have been talking about for some time--and we saw their real interest in investing in financial institutions at the end of last year or early this year-- are quite beaten down. Those that I talked to, who are very sophisticated investors from places in Asia and the Middle East, do not want to appear as though they are doormats for these financial institutions. Their own political structures make the losses they have had to endure front page news. I think the expectation that sovereign wealth funds are going to continue to be a source of funding in this period is well overstated. Moreover, private equity--the case for opportunistic capital--has little ability to get leverage in this environment, and so if they don't reduce their target hurdle rates, I don't expect them to be able to come to the rescue. All of that, again, suggests to me that the real economy will have to wait awhile for improvement as this repair is slow and not at all certain over the next six to nine months. Obviously, the implication for the real economy is hard to speculate about, but I think, looking at some rough measures, maybe a third of the credit availability of the real economy has been taken out during this period--maybe more than that. I would say that the last week makes it hard for us to judge how much more credit channel capability and balance sheet capacity have left the real economy, but it suggests a picture for the real economy that is worthy of real concern. Now, when I look to the real economy, I would just underscore the comments I have heard from others. A couple of CEOs who have been incredibly optimistic, at least in my discussions with them in the past couple of years--these are CEOs of leading consumer product companies--have thrown in the towel. They have given up trying to justify and explain away weakness. Across the auto sector, a couple of the new owners of the auto companies are now focused on a scenario in which units are in the 14.5 million range rather than the 15 million or 15.5 million range, largely because of weakness of consumption in terms of consumer purchases. But that really goes back to credit, and in some ways the credit availability to fund those auto purchases is a chance for another stepdown in the next month. I think that business cap-ex is as threatened as has been represented today. It is the only area for which my own sense is probably more negative than the Greenbook's in terms of weakness to expect out of Europe and the United Kingdom. It is hard for me to think, as we go through this period, that Europe and the United Kingdom would stay as decoupled as recent data suggest. Their economies are tied to their banking system more concretely than we are tied to ours, and I suspect that their large financial institutions are going to suffer real problems during this upcoming period. If not, it is certainly a risk factor. Let me turn to the last two issues--inflation and currency. On the inflation front, there is little reason to be confident that inflation will decline. There are reasons to believe that our inflation problems will become more pronounced and, I fear, more persistent. The recent run-up in energy prices and commodity prices in the context of weaker global demand is troubling. No doubt partly it is a move to real assets by the financial community--that is, a hedge against all of this is certainly, to the Governor Kohn's point, raising commodity prices. But I am not sure what catalyst will change that over at least the next six months. As the Board staff has noted, there has been some rise in inflation compensation and inflation expectations. There is acceleration in the fall of the exchange rate of the dollar, suggestive of increasing import inflation. Moreover, it is not obvious to me that a slowing economy in this cycle, in the short term at least, will do our work for us on the inflation front. Finally, let me turn to currency. Given this particular confluence of events, the accelerated depreciation of the dollar is troubling, and I think the risks of a disorderly move on the dollar in the upcoming six weeks are hard to discount. The catalyst of that could be a sudden de-pegging by certain countries in the Middle East. But even if that does not come to pass, there is an expectation in the market, where traders are looking for bets where they believe they can make money with certitude, that there is still a free one-way bet on the dollar. That is not healthy for currency movements, regardless of one's view of where the dollar should ultimately be trading against the currencies of our trading partners. At this time, particularly, given our concerns about making sure that the U.S. economy remains open for foreign direct investment-- that this is where others want to invest their capital--it strikes me as a reasonably dangerous prospect if the view is that the dollar will continue its accelerated path. Obviously, this suggests very difficult judgments for the next round of our discussion, and I will take up monetary policy in that context. Thank you, Mr. Chairman. " FOMC20060510meeting--112 110,MR. GUYNN.," Thank you, Mr. Chairman. Since our last meeting, regional data and anecdotal information from our various contacts suggest that the Southeast region economy continues to have good momentum. Let me comment on just a few specific areas where what we’re seeing in our District may help to inform our view of the larger national economy. Regional employment gains continue to be strong, and we’re hearing more and more stories of tighter labor markets for a number of skills, mostly in construction and skilled professional positions, and compensation is going up significantly in a number of those areas. At the same time, we also hear over and over about the lengths to which businesses are going to offset those wage increases with productivity gains, most making greater use of technology and process re-engineering. Like others, we’re continuing to see evidence of cooling in house sales and prices and a growing inventory of unsold homes in some of our markets. The CEO of one of the nation’s largest home builders, who is headquartered in Atlanta and with whom I talk regularly, explained that a number of factors, in his view, have come together to precipitate that slowing—overbuilding, higher mortgage rates, a retreat of housing speculators, earlier conversion of many rental apartments to for-sale units, and now the wait-and-see attitude among those who still expect to purchase at some point. He reinforced my sense that, while the cooling-off in housing is being felt to some extent in most markets, so far it is only the frothy coastal markets, like South Florida, that have seen a significant adjustment. The high cost of energy and industrial commodities is very much on people’s minds in our area, but the pass-through of those costs still seems to be limited. Clearly, transportation costs are up significantly because of cost pass-through. Some construction projects, including a few that were substantially sold out in the preconstruction phase, are being canceled and deposits are being returned because the construction material costs would make projects unprofitable. An example of those cost pressures in construction: A large builder told me last week that what he paid for copper wiring most recently was four times what he paid just a year ago. As an example of energy price pass-through, one member of our Small Business, Agriculture, and Labor Advisory Council related a story last week that is just too good not to share. He said he was at a neighborhood gas station, in the middle of filling the tank of his big SUV, when the pumps suddenly stopped across the entire gas station. An attendant came on the speaker system and announced that they were instituting an increase of ten cents a gallon. [Laughter] And the ringer is that the increase would apply not only to the remainder of the gas he was about to pump but what he had already pumped. [Laughter] Good story. What I would call real-time pass-through. [Laughter] While overall performance seems solid, the outlook is not nearly so bright in the hurricane- affected areas, with which we’re still struggling. The situation is especially difficult in New Orleans, where the damage was due largely to flooding and standing water, compared with the Mississippi coast, where damage was due to storm surge and wind. Debris cleanup and infrastructure repairs still dominate the reconstruction efforts. Even the demolition of damaged structures in New Orleans has barely begun, and there are few signs of any rebuilding in many of the more heavily flooded areas of the city. New Orleans lost not only more than 200,000 jobs but also about the same number of homes, which were either destroyed or suffered major damage. Little progress has been made in replacing either the jobs or the homes, and less than one-half of the pre-Katrina population is now back living in the city. There are a number of reasons for the lack of progress, including complex levee repairs; the need to redraw flood plains and set permit policies; political in-fighting; a shortage of workers and supplies; and insurance complications—just to mention a few. For instance, the Corps of Engineers, which has some 150 people working out of our New Orleans Fed office, managing their projects, expects to repair the levee system by June 1, which is the official start of the new hurricane season. But those repairs will bring the levees only to their pre-Katrina status, and longer-term solutions and spending will take years to implement. Even after eight months, oil and gas supplies still remain disrupted. Just under 23 percent of crude oil and 13 percent of natural gas production in the Gulf remain shut in, and the critical Mars platform, which accounts for about 40 percent of that shut-in, is still not up and running. Critical to the slow recovery process is the lack of housing for either returning or temporary workers. Without housing, the economies in the affected areas will be slow to recover. There are practical realities that also need to be faced. People can’t continue to live in FEMA trailers forever, and those who are doing so are beginning to show signs of stress. We have twelve of our own employees in trailers in our parking lot. We’ve come to the view, which I’ve talked about before, that the experience from our past hurricanes may provide little guidance about either the pace or the path of recovery. We’re monitoring developments very carefully and also initiating some research projects to better understand the recovery process. Turning to the national economy, I’m encouraged that our collective forecast for a rebound in the first quarter was in fact on target, but I am less certain about the path going forward. I, like others, see both upside and downside risks to real output and employment. Major downside risks continue to be rooted in the possible effects of energy cost increases on consumer spending and business costs; potential consequences of a greater-than-anticipated slowdown in housing; and the impact of both short- term and longer-term interest rates, which have risen. Other key factors that could result in better-than-expected outcomes lie in the potential increase in investment spending; a surge in nonresidential and commercial construction; continued strength in consumer spending, particularly in durables and autos; and a pickup in inventory accumulation. While my own staff’s forecasts for this meeting show a slowdown in the second half of the year, I’m not terribly confident about the specific sources from which that slowing will eventually come. Of greater concern to me, however, is the inflation outlook. The core measures continue to be in the upper range of what most of us have indicated is acceptable. The trends in these and headline inflation measures are data that the public observe and that affect inflation expectations, and it behooves us not to ignore them in favor of more-benign forecasts. I am, therefore, concerned that we not do anything today to suggest that we have lost focus on either inflation or the way in which we intend to achieve our inflation objective. Thank you, Mr. Chairman." FOMC20080805meeting--119 117,MR. PLOSSER.," Thank you, Mr. Chairman. Economic conditions in the Third District remain relatively weak, but they are not materially different from what we and our business contacts have been expecting for the past several months. Manufacturing and residential construction sectors continue to show a slow decline. Payroll employment in our three states fell in June, but it is still above the levels of where it was three months ago and so has been performing somewhat better than in the nation as a whole. The pace of retail sales seems to have been softening, and commercial real estate firms indicate that most office and industrial markets have weakened slightly since the spring. My business contacts generally expect weak growth for a while. Manufacturers do expect a rebound during the next six months; but most other sectors, particularly retail sales, anticipate only soft or slightly improving conditions in the near term. Residential real estate is not expected to strengthen appreciably in the second half of the year. Banks expect somewhat sluggish growth in overall lending for the rest of the year, although compared with some regions, banks in our District are in pretty good shape. There are stresses, but they seem to be manageable. Credit, however, is generally available to businesses, and we hear only sporadic information from businesses that they are unable to obtain needed loans. For some time my business contacts have expressed concern about rising energy and commodity and transport prices. Our business outlook survey's prices-paid index rose yet again in July, and it is now at its highest level since March 1980. Although the prices-received index edged down slightly, it remains at a very, very high level relative to historical standards. The BOS's future prices-received index rose to 49.6 percent, which is the highest level it has been since January 1989. This indicates that roughly half the manufacturing firms that responded to our survey expect the prices they receive for their products to be increased over the next six months. To gauge the extent to which manufacturing firms have been able to pass on rising costs to their customers, we asked several special questions about product pricing in our July survey. More than 60 percent of our respondents indicated that, since the beginning of the year, they have been able to raise prices and pass along increased costs to their customers. About 26 percent said this took the form of increases in base prices. Almost half of them had increased base prices. The rest said they have used either surcharges or escalator clauses and, in some cases, combined those with base price increases as well. Surcharges and escalation clauses are not likely to go away anytime soon and may even become more widespread. About 56 percent of our respondents indicated that price escalation clauses and surcharges are likely to be a part of their pricing in the future. Further, since a large number of firms have already built cost increases into their base prices, it is not clear at all that prices will come down quickly, even if oil prices stabilize at a lower level. On the national level, the incoming data since our June meeting have been mixed but largely in line with my expectations for the near-term path of the economy. Real GDP growth for the second quarter came in somewhat weaker than many expected, although I will note that as recently as April many people were expecting negative growth in the second quarter and it is now almost 2 percent. But I think that the strength is a remarkable testament to the ability of this economy to weather shocks from financial market disruptions, a severe housing correction, and surges in energy and commodity prices. Nonfarm payroll employment has fallen an average of 66,000 jobs per month over the last seven months--a weak number to be sure but not nearly as severe as the job losses over the last three recessions, which averaged nearly 180,000 jobs a month. Since our June meeting, we have taken further steps to address fragile financial markets that were manifested by the difficulties surrounding the GSEs and the IndyMac takeover. On balance, my outlook for the economy is little changed, although the financial market developments since our last meeting have marginally increased the uncertainty surrounding my forecast. I do see near-term weak growth for the economy, but I continue to expect an improvement in output and employment growth next year as the economy rebounds closer to trend. Unfortunately, there has been a resurgence in financial market volatility, especially on the part of the banking sector and mortgage markets related to the problems of the GSEs. The liquidity in the interbank and primary dealer markets appears to have improved somewhat relative to the first quarter of this year. I read the conditions in the financial markets and the wide spreads on selected assets as having improved somewhat on net and the spreads we are seeing increasingly reflecting real credit risk as opposed to dysfunctional markets. As I indicated in my questions earlier, we should not use such spreads as the primary criteria for assessing the fragility of the financial markets. Moreover, we must be cautious in using monetary policy or other tools at our disposal as a form of forbearance that delays the necessary adjustments in the pricing of various financial claims. I think we need a high hurdle--that there are real market failures--before we intervene to stem liquidity desires on the part of traders or attempt to influence the price of specific asset classes. To agree with President Bullard's comments, we should begin to deemphasize and destress the importance of systemic risk because I think it is gradually dissipating as firms adjust to the more volatile and risky environment. The current state of the financial markets seems to me to bear some resemblance to the financial headwinds analogy that many people referred to during the early 1990s. Indeed, spreads on many forms of business and consumer loans are behaving now much in the way as they typically behave during recessionary times as credit risks rise. In the early '90s, monetary policy was less accommodative than it is now--at least the funds rate reached a low point of 3 percent from October 1992 to February 1994--and during that time headline PCE inflation ran about 2 to 3 percent. The real funds rate, measured by a one-quarter-ahead forecast of the CPI from the professional forecasters, was minus 0.1 percent over the six quarters from 1993:Q3 to 1994:Q4. Currently, the real funds rate using the same measure of one-quarter-ahead professional forecasters' CPI stands at minus 1.1 percent. The inflation outlook remains a cause of concern. Headline inflation is higher, and there is evidence of modest pass-through to core inflation measures. Inflation compensation on the six-to-ten-year horizon has risen modestly. Inflation compensation at the near term has fallen with recent declines in oil prices, but it remains volatile. The staff has suggested that a portion of the increase in the longer-dated inflation compensation measures may reflect an increase in inflation risk premiums. That is, markets are uncertain about the long-run path of inflation. This is not terribly comforting. It suggests that our credibility may be waning. Despite the recent drop in oil prices, I remain uncomfortable with the longer-term inflation outlook. Indeed, the focus of monetary policy must be on the intermediate to longer term, and we must resist the temptation to act as if our funds rate decisions can manage the outcomes over the very near term. Year-over-year inflation, headline CPI and PCE inflation, have now been consistently above 3 percent since October 1987. Year-over-year core PCE inflation has exceeded 2 percent every month but one since April 2004. That is four years. Businesses are reporting an increased willingness to pass on cost increases. Near term, we might get some moderation in headline inflation, if the recent drop in oil prices holds. This might result in less upward pressure on inflation expectations, at least in the near term. Of course, as has been pointed out, oil prices are notoriously hard to predict, and we may well see a resurgence in oil prices before the year's end; but we don't know. More important, a drop in oil prices will only temporarily mask what I view as the underlying inflationary pressures. Oil prices have clearly exacerbated the recent numbers and may mitigate them in the near term going forward. But my concern is that the real source of intermediate-term to longer-term inflationary pressures comes from our own accommodative policy, whose consequences for inflation will be felt only over time. We are unable to control the rise in oil prices and its consequences for inflation in the short term, but we must hold ourselves accountable for the longer-term consequences of our choices. Should we maintain our accommodative stance for too much longer, my view is that we are likely to see higher trend inflation in the intermediate term and a ratcheting up of inflation expectations. If that scenario unfolds, it will take a much more costly policy action to re-anchor those expectations than the cost of a preemptive move to raise the funds rate in the near term. To be sure, shifting policy to a less accommodative stance will be a difficult decision to make, given the continued volatility in financial markets and the projected near-term weakness in employment and output growth. However, what has been referred to as the tail risk of a very negative growth outcome has decreased since the start of the year, whereas inflation risks have increased. I think the enhancements we have made to our liquidity facilities should be sufficient to address any remaining dysfunctions in the financial markets, but they will not address the credit or solvency issues, nor should we expect them or desire them to do so. The markets will have to do that admittedly heavy lifting. I do not believe that we can wait until employment growth and the financial markets have completely turned around to begin to reverse course. But by our aggressive attention to short-term risk to growth and financial turmoil, we do put at some risk our ability to deliver on our intermediate- and longer-term goals of both price stability and sustainable growth. Thank you, Mr. Chairman. " FinancialCrisisReport--34 Moody’s and S&P began downgrading RMBS and CDO products in late 2006, when residential mortgage delinquency rates and losses began increasing. Then, in July 2007, both S&P and Moody’s initiated the first of several mass downgrades that shocked the financial markets. On July 10, S&P placed on credit watch the ratings of 612 subprime RMBS with an original value of $7.35 billion. Later that day, Moody’s downgraded 399 subprime RMBS with an original value of $5.2 billion. Two days later, S&P downgraded 498 of the ratings it had placed on credit watch. In October 2007, Moody’s began downgrading CDOs on a daily basis, downgrading more than 270 CDO securities with an original value of $10 billion. In December 2007, Moody’s downgraded another $14 billion in CDOs, and placed another $105 billion on credit watch. Moody’s calculated that, overall in 2007, “8725 ratings from 2116 deals were downgraded and 1954 ratings from 732 deals were upgraded,” 55 which means that it downgraded over four times more ratings than it upgraded. On January 30, 2008, S&P either downgraded or placed on credit watch over 8,200 ratings of subprime RMBS and CDO securities, representing issuance amounts of approximately $270.1 billion and $263.9 billion, respectively. 56 These downgrades created significant turmoil in the securitization markets, as investors were required by regulations to sell off assets that had lost their investment grade status, holdings at financial firms plummeted in value, and new securitizations were unable to find investors. As a result, the subprime RMBS and CDO secondary markets slowed and then collapsed, and financial firms around the world were left holding billions of dollars in suddenly unmarketable RMBS and CDO securities. D. Investment Banks Historically, investment banks helped raise capital for business and other endeavors by helping to design, finance, and sell financial products like stocks or bonds. When a corporation needed capital to fund a large construction project, for example, it often hired an investment bank either to help it arrange a bank loan or raise capital by helping to market a new issue of shares or corporate bonds to investors. Investment banks also helped with corporate mergers and acquisitions. Today, investment banks also participate in a wide range of other financial activities, including offering broker-dealer and investment advisory services, and trading derivatives and commodities. Many have also been active in the mortgage market and have worked with lenders or mortgage brokers to package and sell mortgage loans and mortgage backed securities. Investment banks have traditionally performed these services in exchange for fees. lien subprime deals originated in 2006 as well as … 91.8 percent of 2nd-lien deals originated in 2006 have been downgraded.”). 55 2/2008 “Structured Finance Ratings Transitions, 1983-2007,” Credit Policy Special Comment prepared by Moody’s, at 4. 56 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit N, Hearing Exhibit 4/23-108 (1/30/2008 “S&P Takes Action on 6,389 U.S. Subprime RMBS Ratings and 1,953 CDO Ratings,” S&P’s RatingsDirect). Ratings may appear on CreditWatch when events or deviations from an expected trend occur and additional information is needed to evaluate the rating. FOMC20050809meeting--147 145,MS. MINEHAN.," Thank you, Mr. Chairman. In assessing all of the information about the District that our Bank staff had gathered for this Open Market Committee meeting, and in my own interactions with contacts around the region, a few words stand out because they were repeated so often. And they are different words than would come to mind from many of the previous discussions. The words are “lackluster,” “underwhelming,” and even “blah.” New England’s growth has been lagging that of the nation through the entire 2001-2005 period, largely because of the impact of the technology downturn in Massachusetts. For most of 2005, however, it has seemed that the region might be gaining a bit—with employment growing at a pace only slightly behind that of the nation, signs of life in manufacturing, and strong residential real estate markets. We noticed a lull, as almost everybody else did, in the early spring. We thought that lull would dissipate, but it seems that the forward momentum that existed earlier has faltered a bit. It could be the recent hot weather and its impact on retail sales. It could be the impact of high gas August 9, 2005 51 of 110 could be the continuing sense of business caution about hiring and prospective demand. And it could be the effect of the proposed base closings, especially in Maine. But whatever it is, economic activity seems to have flattened out, and one can see this in the consumer confidence and business confidence data. Indeed, consumer confidence in New England fell to 79 in July, with readings on current sentiment about normal—a little bit lower, but still in the normal range. But expectations about future activity were down to their lowest reading since 2001. Now, it’s only a month’s data, and it’s difficult to get excited about one month’s data on consumer confidence, but I think it does tend to pick up the mood in the region. That’s not to say that the region’s economic health is not moving in a positive direction. Employment is growing; it’s just growing slowly. Unemployment is down, but that’s largely because the labor force is down. Moreover, manufacturers and related service companies do report growth. Demand is just not as strong as they once expected, and they’ve been working hard to contain costs and increase market share through acquisitions to maintain revenue growth. Indeed, even the once-hot residential real estate market seems to have moderated a bit. Region-wide inventories of homes for sale have risen, and Freddie Mac home price indexes for the region indicate price appreciation about at the national level, except in Rhode Island where the residential real estate boom continues. Sales of existing homes decreased in the first quarter of 2005 from the previous quarter and levels are below those seen in 2004. Perhaps the lull in economic activity that ushered in the second quarter lingers on in the minds of New England businesses, and maybe the stronger trends that are evident now nationally August 9, 2005 52 of 110 growth is not so much a rising tide that’s lifting all boats but a continual struggle to survive by the businesses within the region. People keep asking where the next new thing is that will fill the downtown office space and get the region really humming again. There’s no good answer to that question except that the region’s history is replete with cycles of downturn and rebirth and reinvention. Indeed, looking at the glass as half full, one benefit of a period of slower but positive growth is that a lot of attention is placed on productivity enhancements in the private sector and on creating more incentives for business growth in the public sector. Turning to the nation, our forecast for the rest of ’05 and ’06 is quite similar to that of the Greenbook, using the same monetary policy and government spending assumptions. We could argue a bit about the Greenbook’s lowered rate of potential growth, and we end up with slightly less inflation and slightly more unemployment, given our sense that the output gap is slightly wider and will not be fully closed by the end of 2006. But a lot of this is splitting hairs. Recent economic data, the seemingly stronger health of the labor markets, and the expected flattening out of oil prices are all good news. The economy is doing well, and inflation seems pretty much in check. And both the Greenbook and we in Boston see that picture continuing into 2006. A key question, of course, in such a halcyon environment, is how one sees the risks to that environment. Concerns abound about upside inflation risks. But in my view, anyway, the risks seemed fairly balanced. As the alternative scenarios point out, the Greenbook might be wrong about the amount of slack in the economy, and the projections of potential might have been shaded lower than is actually the case—that is, should we ever really be able to perceive August 9, 2005 53 of 110 Indeed, one can read a variety of labor market indicators—not just labor force participation, but also long unemployment duration, a low job-finding rate, a low job-separation rate, moderate ECI [Employment Cost Index] wage growth, and overall a continuing subdued pace of employment growth relative to GDP—as suggesting greater levels of labor market slack. Productivity as well could be stronger rather than weaker, as reflected in conversations with every business contact I have; they all continue to emphasize their unflinching focus on cost control and innovation. And profit margins remain quite high by historical standards. We could well have more room to grow without igniting inflationary pressures and over time need less, rather than more, policy constraint. But the fact remains that we have not yet arrived at a place where most would say policy is neutral, let alone a constraint on activity. And cost pressures do reflect some upside risk to inflation. Recent data on banks’ consumer, industrial, and construction lending could be a harbinger of more rather than less strength. Spending on equipment and software could surprise, given anecdotes from the tech sector. So, growth above potential is possible, and that could nudge resource usage upward. Even now, various measures of wage pressures are sending contrary signals. The better reading may be the ECI data, but the upward trend in unit labor costs should not be ignored. Energy costs could well be a problem, though they are as likely to take a bite out of growth as they are to feed an inflation spiral. The projected current account imbalance of 7 percent of GDP is an even larger concern in my view, as the risk of a significant and perhaps sudden adjustment looms larger. If the adjustment takes the form of a large depreciation in the dollar and more pass-through to August 9, 2005 54 of 110 And I remain concerned that abnormally low interest rates produce greater risk-taking that could come home to roost in an unpredictable way. I meet with a group of investment managers prior to the Federal Open Market Committee meetings, mostly to understand better how those individuals are reading markets. One quote from this week’s meeting: “The biggest risk markets face right now is their belief that there is no risk.” With equity volatilities at a very low level and bond risk spreads very narrow, market participants seem to believe things are rosy as far as the eye can see, and they seem to be reaching out the risk spectrum for return. And it would seem that consumers continue to reflect the “don’t worry, be happy” perspective in their spending and saving habits. We know from experience that such confidence can be a harbinger of financial instability to come. Thus, I continue to believe that while the risks to our forecast may be balanced, it would be more costly if we were to err on the side of more rather than less accommodation. It seems clear to me that the move to a less accommodative posture should continue. And if current trends persist, that process possibly should accelerate. It also seems clear to me that the move today that the markets expect is the right move to be taking. And I think we should begin to give some thought to how we ought to start the process of changing our statement. Maybe we don’t need to change it today, but we should set in process some movement toward thinking about how that statement should change. Continuing to reassure markets with the “measured pace” language may be providing too much in the way of certainty. Arguably, markets don’t need this anymore and would benefit from a more realistic assessment of uncertainty. Some would argue, I know, that the ideal time to change is either when we see a need to pause or to accelerate. It’s hard to know when that will be, and I worry August 9, 2005 55 of 110 I think it’s very difficult to react three or four days before a meeting to alternative language and to come up with something that’s satisfactory and moving in the direction of change. If we are going to change our language, I would hope we have a chance, prior to the week before the meeting, to contribute to the underlying thinking that goes into that. And I would argue that we ought to begin that process sooner rather than later." CHRG-111shrg54589--142 RESPONSES TO WRITTEN QUESTIONS OF SENATOR SCHUMER FROM PATRICIA WHITEQ.1. Ms. White, I am very concerned by efforts by the European Commission to implement protectionist restrictions on derivatives trading and clearing. A letter signed by many of the world's largest financial institutions earlier this year under significant pressure from European Commissions, commits them to clearing any European-referenced credit default swap exclusively in a European clearinghouse. This kind of nationalistic protectionism has no place in the 21st-century financial marketplace. What steps can you and will you take to combat these efforts to limit free trade protect free access to markets? If Europe refuses to alter its position, what steps can be taken to protect the United States' position in the global derivatives market?A.1. The Federal Reserve is working with authorities in Europe and other jurisdictions to improve international cooperation regarding the regulation of OTC derivatives markets. Current areas of focus include developing common reporting systems and frameworks for coordination of oversight. The goal of these efforts is to avoid duplicative and possibly conflicting requirements from different regulators. In addition, these efforts lay a foundation for broader recognition that policy concerns can be addressed even when market utilities are located in other jurisdictions.Q.2. Ms. White, one of many important lessons from the financial panic last fall following the collapse of Lehman Brothers and AIG, it is that regulators need direct and easier access to trade and risk information across the financial markets to be able to effectively monitor how much risk is being held by various market participants, and to be able to credibly reassure the markets in times of panic that the situation is being properly managed. A consolidated trade reporting facility, such as the Trade Information Warehouse run by the Depository Trust and Clearing Corporation for the credit default swaps markets, is the critical link in giving regulators access to the information this kind of information. Currently, there is no consensus on how trade reporting will be accomplished in domestic and international derivatives markets, and it is possible that reporting will be fragmented across standards established by various central counterparties and over-the-counter derivatives dealers. Do yon agree that a standardized and centralized trade reporting facility would improve regulators' understanding of the markets, and do you believe that DTCC is currently best equipped to perform this function?A.2. A standardized and centralized trade reporting facility serving a particular OTC derivatives market would improve regulators' understanding by providing them with a consolidated view of participant positions in that market. In general, a centralized reporting infrastructure for OTC derivatives markets is unavailable. An exception is the credit derivatives market, for which the DTCC Trade Information Warehouse (TIW) serves as the de facto standard trade repository. It provides a bookkeeping function, similar to the role of central securities depositories in the cash securities markets. The TIW registers most standardized CDS contracts and has begun registering more complex credit derivatives transactions in accordance with collective industry commitments to supervisors. While no other OTC derivatives markets are presently served by a trade repository, several CCPs serve an analogous function for limited segments of OTC derivatives markets such as LCH.Clearnet for interest rate derivatives and NYMEX Clearport for some commodity derivatives. There may be benefits to a single entity providing trade reporting services for OTC derivatives, but the Board does not believe that there is a good policy reason to force that result. Through collective supervisory efforts, major industry participants have committed to building centralized reporting infrastructure for both the OTC equity and interest rate derivatives markets. The industry has committed to creation of a repository for interest rate contracts by December 31, 2009, and for equity contracts by July 31, 2010. ------ FinancialCrisisReport--621 To date, three Goldman units have been identified as engaging explicitly in investments on behalf of the firm. One, based in New York, is called Goldman Sachs Principal Strategies or “GSPS,” which Goldman is reportedly in the process of dismantling. 2787 The second is the Global Macro Proprietary Trading Desk, which had traders in New York and London and reportedly invested in foreign exchange markets, interest rate markets, stocks, commodities and other fixed income markets. 2788 The third, according to Goldman, is the Special Situations Group or SSG, which is reportedly engaged primarily in long term investments on behalf of the firm and clients, with little short term trading or sales activities. 2789 Proprietary Activities in the Mortgage Area. In the mortgage area, until 2005, Goldman had a dedicated proprietary investment desk in the Mortgage Department called the Principal Finance Group, often referred to as Principal Investments. 2790 According to Goldman personnel, that desk specialized in long term investments on behalf of Goldman in assets such as distressed mortgages and credit card and energy receivables, but only rarely engaged in short term trading. 2791 In 2005, Principal Investments was folded into the Special Situations Group (SSG), which was then a Goldman business unit located in Asia and not part of the Mortgage Department. 2792 After Principal Investments personnel moved to SSG, the Mortgage Department operated without a desk that was explicitly dedicated to proprietary trading during 2006 and 2007. When asked whether the Mortgage Department engaged in proprietary activities during 2006 and 2007, Goldman executives and traders in the Mortgage Department generally resisted providing a direct answer, declined to identify any proprietary trades or investments, and 2786 See 1/19/2011 Goldman press release on 2010 earnings, available at www2.goldmansachs.com. 2787 Subcommittee interview of David Viniar (4/13/2010). See also “More Goldman Traders to Exit for Funds,” Financial Times (1/9/2011). Goldman may be eliminating the desk in response to the Dodd-Frank prohibition on proprietary trading. 2788 See “Goldman to Shut Global Macro Trading Desk,” New York Times (2/16/2011). Goldman may be eliminating this desk in response to the Dodd-Frank prohibition on proprietary trading. 2789 Subcommittee interview of Darryl Herrick (10/13/2010). To the extent that its activities are limited to long term investments, the SSG unit would not be affected by the Dodd-Frank prohibition on proprietary trading which applies only to trading accounts used “principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements),” and does not affect long term investments. See Section 619(h)(6). Under Section 620 of the Dodd-Frank Act, banking regulators are also conducting an 18-month review of all permitted bank investment activities, both long and short term, to gauge the risk of each activity, any negative effect the activity may have on the safety and soundness of the banking entity or the U.S. financial system, and the “appropriateness” of each activity for a federally insured bank. 2790 Subcommittee interview of Darryl Herrick (10/13/2010). 2791 Id. 2792 Id. declined to estimate or calculate how much of the Mortgage Department = s 2007 revenues or profits were proprietary. FOMC20061025meeting--87 85,MS. BIES.," Thank you, Mr. Chairman. Well, again, as some of you have said, in five weeks we don’t have a whole lot of new information. But I’m coming back and starting with housing again. As you know, that continues to be something I watch. Let me just make a few comments and give you recent feedback from some exams and dialogues with brokers that I’d like to share with you. Looking at both starts and permits, we all know that housing is continuing to soften in terms of construction, and we have also identified the increasing number of contract cancellations for new housing. Someone mentioned earlier the noise that we may be having around housing data, and I get this through some of the anecdotal conversations that I’ve had with folks. One topic was the inventory of existing housing for sale. I’m hearing from a couple of real estate brokers that people who may have wanted to sell their homes or may have put them up for sale are withdrawing them from the market. They don’t need to move, and it isn’t worthwhile for them to move if they don’t get the price they want. I think the supply was possibly bigger than what we’re really measuring, and so we’re seeing some understating of what desired house sales would be in terms of inventory. That’s continuing; it is just beginning at this stage, at least in a couple of regions, according to folks with whom I’ve talked. One of the challenges that we’re faced with here is that—again, I try to look for the good news—in the housing purchase process, people file applications for mortgages very often before they qualify to buy the house. When you look at the Mortgage Bankers Association data on purchase mortgage applications, as I mentioned before, they dropped 20 percent from their peak of last summer, but in the past few months they have been leveling off. So if applications are a leading indicator, we may begin to see some moderation in housing purchases. However, the 20 percent drop in purchase mortgage applications means that mortgage brokers are earning a lot less income. If they don’t close a transaction, most of them get no paycheck because three out of four mortgages are originated not in financial institutions but by independent brokers. We’re beginning to see increasing evidence of this in terms of the quality of mortgages that are out there. We continue to track the mortgages that have vintages—in other words, that were originated—in 2005, and we are continuing to see that, as these mortgages age, the early delinquencies for these are greater than early delinquencies for similar-aged mortgages of earlier vintages, which implies a loosening of underwriting standards and more stress on the borrowers. We are also seeing in a small way increased predatory activity with loans. Certain practices have been described to me lately with new products, such as the 2-28 mortgage, which is fixed for two years and then escalates and becomes an ARM tied to LIBOR in the third year. But don’t worry—you can refinance it with the broker and bring your payment down and do it all over again. We’re seeing those kinds of things—mortgages for which people are being qualified by brokers with no escrow account; all of a sudden taxes are due, and borrowers don’t have the money for them. So predatory lending is rearing its head at the lower end of the scale, and it’s something we have to continue to watch for. However, before I leave housing, let me just say that the bottom line is that overall mortgage credit quality is still very, very strong. We’re seeing predatory lending only in pockets of the market. I continue to believe that the rest of the economy—except for autos, I should add—is still very strong. Consumer spending is good, and business fixed investment is very sound. The moderation in energy prices and the growth in consumer income will continue to add support to the economy going forward. Jobless claims have been low and moving in a very narrow range the past few months. As several of you have mentioned, I’m hearing more concern by corporate executives about the inability to hire the talent they need to meet their business plans, and so I’m seeing more indication of tightness in labor markets. Turning to inflation, as many of you have said, core inflation has moderated from the pace in the third quarter. But going forward in the Greenbook forecast, it is still showing significant persistence even though we think we will be growing, at least for a period, below potential. That concerns me because that level is higher than I’m comfortable with in the long run. We might have had some spillover effects from rising commodity and energy prices earlier on, but I was hoping at this point that, with the reversing, we would see more-positive spillover effects that would mitigate inflation. So I am very worried about inflation. At the same time, I know that negative spillover effects on growth due to the rapid decline in housing construction and the moderating house-price appreciation are risks, which we cannot dismiss, to growth; but on net I am still much more concerned about the persistence of inflation. Thank you, Mr. Chairman." FOMC20060629meeting--109 107,MR. KOHN.," Thank you, Mr. Chairman. Incoming data have tended to confirm to a degree both the downside risks to growth and the upside risks to core inflation that we’ve been talking about at recent meetings. Higher inflation interacting with policymaker comments on the inflation situation triggered higher expected real interest rates and more uncertainty about the longer-term future. That in turn further tightened financial conditions, leading to more markdown of growth prospects. Notably, the worry about added inflation pressures has not been confined to the United States, given strong growth abroad, high energy and commodity prices, and a sense that output is close to potential. Widespread policy tightening and greater uncertainty have led to increased caution on the part of investors and tighter global financial conditions. The incoming data certainly have influenced my projections—I expect less growth and more inflation than I did a few months ago. I’m also even less confident, if that’s possible, than I was given these surprises. The key question in my mind is whether the conditions are in place or soon will be in place—that is, after tomorrow—to keep core inflation at considerably lower levels than it has been so far this year. I think they are, and in this regard I’m a touch more optimistic than the staff. I have slightly lower inflation for 2007 with the same policy assumption. Most important, I don’t believe that the extra inflation we’ve had results from the economy producing beyond its long-run potential. We obviously can’t be very confident about this. The decline in the unemployment rate to noticeably below 5 percent occurred only at the beginning of this year, but the behavior of compensation last year and this year suggests to me that the NAIRU is more likely to be under than to be over 5 percent. Perhaps better job- matching through Internet search, declining real minimum wages, and lingering worker insecurity, after the only-moderate increase in employment early in this expansion, have lowered the NAIRU a touch. We should expect compensation growth to pick up as in the staff forecast, but the implications of this pickup for inflation are unclear, given elevated profit margins and what is likely to be a competitive business environment. I do think relative price adjustments are playing an important role in what we’ve been seeing. I suspect I have been implicitly underestimating the effect of higher energy prices on both output and inflation. Before this year, the effect of rising energy prices on inflation was offset by slack in the economy, and the effect on activity was offset by easing monetary policy that was put in place to counter that slack. With both slack and easing policy disappearing, the effects of higher energy prices are showing through in both output and inflation. Another adverse price shock seems to be coming from the housing market, where the previous run-up in prices and the higher interest rates are weakening prospects for home price appreciation. This weakening, in turn, is both reducing activity and raising actual and imputed owners’ equivalent rents. The longer-term inflation effects of both these relative price changes will depend on their persistence and their propagation into other prices. In this regard, President Poole, I see us as perhaps accommodating the first-round effects of the increase in prices but making sure they don’t propagate beyond that, rather than having a price-level target that would bring us back down to the old price level. With regard to persistence, petroleum prices have leveled out since April, and futures markets don’t suggest further increases. It’s difficult to get much of a fix on future rent increases, as prices and rents realign to higher interest rates and lower expected capital gains. In the past, most of that realignment has come through prices; but we don’t have many observations, and the required adjustment appears much larger this time. There are two keys to preventing the relative price changes from becoming embedded in broader and more persistent inflation: low inflation expectations and a competitive business environment. If energy prices do flatten out, headline inflation will come down, and I think that will help to contain the inflation expectations of households and businesses and bring down core inflation. The propagation of higher rates of increase in rents, should they persist, to other prices I found much harder to analyze. After all, homeowners are, in effect, paying themselves higher imputed prices, and it’s not clear that they would change their behavior in labor markets to expect higher wages as a result. Moreover, with respect to owners’ equivalent rent, I think our usual financial market measures of inflation expectations may not be reliable indicators of behavioral shifts. Expected persistent increases in owners’ equivalent rent will boost expected CPI showing up in TIPS spreads but not necessarily affecting other pricing decisions. A persistence of elevated rent increases will put a premium on viewing their implications for future inflation rather than on simply reacting to the incoming data. The competitive environment will depend largely on the degree of resource utilization. In this regard, the negative effects of the oil and housing market developments on activity, along with the tightening in financial conditions, suggest that activity could well run at least a little below the rate of growth of potential for the next several quarters. That will help to limit longer-run inflation pressures. In a sense, the forces that seem to be pushing up inflation are also contributing to the conditions that should hold it in check. In sum, recent inflation data have been an unpleasant surprise, but the source of the price increases—that is, price shocks, not overshooting—and the economic conditions coming into place should imply a softening of core inflation over the next 1½ years. This outcome is based on the assumption that the relative price increases don’t become more broadly embedded in other prices and second-round effects. We’ll talk tomorrow about how policy might contribute to reducing the odds of that possibility. Thank you, Mr. Chairman." CHRG-111hhrg56778--10 Mr. Greenlee," Thank you. Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee, thank you for the opportunity to discuss the supervision and oversight of insurance companies. As you are aware, in this country the primary supervision and regulation of insurance companies is vested with the States. The Federal Reserve does serve as the consolidated supervisor of bank holding companies and financial holding companies established under the Gramm-Leach-Bliley Act, some of which are affiliated with insurance companies. The Federal Reserve is also the primary Federal regulator of State member banks, many of which are engaged in the sale of insurance products. Of the approximately 550 foreign and domestic financial holding companies supervised by the Federal Reserve, 33 are engaged in insurance underwriting activities. As the consolidated supervisor of bank holding companies and financial holding companies, the Federal Reserve routinely conducts inspections of these organizations to ensure that the consolidated organization remains strong and the holding company and its non-bank affiliates do not pose a threat to the company's insured depository institution subsidiaries. To further our supervisory efforts, we issued enhanced guidance on consolidated supervisory expectations in 2008 that underscored the importance of examiners evaluating firm-wide risk exposures. We also reiterated the importance of Federal Reserve supervisors working with the primary regulator of a bank holding company's insured depository institutions as well as State insurance supervisors and other functional regulators. Recent experience shows the need for the consolidated supervision of bank holding companies in addition to and distinct from the supervision of the organization's bank or functionally regulated subsidiaries. Large organizations increasingly operate and manage their businesses on an integrated basis with little regard for the corporate boundaries that typically define the jurisdictions of individual, functional supervisors. Indeed, the crisis has highlighted the financial, managerial, operational, and reputational linkages among the bank, securities, commodity, insurance, and other units of financial firms. With respect to financial holding companies engaged in insurance activities, our consolidated supervisory framework involves the same principles used for bank holding companies more broadly. This begins with an assessment of the potential risk insurance activities pose to the consolidated organization and its depository affiliates. We make appropriate adjustments to our assessment of the firm's risk management practices and overall financial condition to account for the unique risks and the nature of insurance products on underwriting activities. As part of our process, we routinely communicate with the appropriate insurance regulatory authorities about the nature of and risk posed by a firm's insurance activities. To facilitate this information sharing, we established memoranda of understanding with the insurance regulators in all 50 States, the District of Columbia, and Puerto Rico. We also communicate with international insurance supervisors as appropriate. The Federal Reserve also has taken several steps to support our supervisory staff and understanding the risk arising from insurance activities. We have designed and implemented training programs, and have developed a variety of insurance-related examiner tools. We also collaborated with the NAIC on three published reports to facilitate better communication and understanding of banking and insurance regulatory framework risks and capital requirements. In closing, the current financial crisis has clearly demonstrated that risk to the financial system can arise not only in the banking sector, but also from the activities of other financial firms, such as investment banks or insurance companies that traditionally have not been subject to the type of regulation and consolidated supervision applicable to bank holding companies. As Chairman Bernanke stated yesterday, it is important to close this gap in our regulatory structure, and legislative action is needed that would subject all systemically important financial institutions to the same framework for consolidated prudential supervision that currently applies to bank holding companies. I would like to thank the committee for holding this important hearing, and I am happy to answer any questions that you may have. Thank you. [The prepared statement of Mr. Greenlee can be found on page 71 of the appendix.] " FinancialCrisisReport--460 At the end of the first quarter in 2007, however, the Mortgage Department’s VAR of $85 million was contributing a total of 23% to the Firmwide VAR. 1929 During the rest of 2007, the Mortgage Department’s percentage contribution to Firmwide VAR continued to rise until it hit an all-time high of 54% on August 14, 2007, when the Mortgage Department’s VAR reached $110 million on a Firmwide VAR of $165 million. 1930 The 54% contribution rate to Firmwide VAR means that the Mortgage Department’s trading alone accounted for a 54% of total firmwide risk, while all of Goldman’s other trading activities combined – including all equities, commodities, foreign exchange, and interest rate instruments – accounted for the rest. Given the serious financial ramifications of such a large and highly concentrated position, the decision to allow the Mortgage Department to incur such a high level of firmwide risk would have required approval at the highest levels of firm management. Indeed, it was Goldman’s Operating Committee and its Co-President, Mr. Cohn, who decided in February and August 2007, respectively, that the Mortgage Department’s VAR had risen too high and had to be brought down. 1931 Because of the net short’s impact on the Mortgage Department and Firmwide VAR levels, Goldman’s senior executives not only knew about the “big short,” but made frequent inquiries and exercised frequent control over the Mortgage Department’s activities. 1932 On August 16, 2007, for example, Jon Winkelried, who served as Co-President with Mr. Cohn, asked Mr. Sparks: “Do you still feel we are being conservative with our marks .... Good time to make sure we’re conservative.” Mr. Sparks replied: “I try, but it is much harder than you think with all the things we are dealing with – completely dislocated markets with little price transparency, systems/tools that are not where they should be, focused controllers (who I think are doing a very good job in a tough market) and many cooks in the kitchen who like to micro-manage. ... But I hear your message.” Mr. Winkelried replied: “I think you should drop the micro manage theme in this environment.” 1933 1929 3/2007 Goldman Quarterly Risk Review, “Market Risk Management and Analysis,” GS MBS-E-009685958, Hearing Exhibit 4/27-54. 1930 8/14/2007 Market Risk Report, Mortgage Portfolio Summary, GS MBS-E-012380294, Hearing Exhibit 4/27-35 (Mortgage Structured Products, VAR 110.1 on 8/14/07, Percentage Contribution to Firmwide VaR 53.8%). 1931 2/27/2007 email from Richard Ruzika to Tom Montag and Daniel Sparks, GS MBS-E-002204942; 8/15/2007 email from Gary Cohn, “Trading VaR $165mm, ” GS MBS-E-016344758. 1932 8/16/2007 email from Jon W inkelried to Daniel Sparks, “Mort P&L Explanation,” GS MBS-E-010680327-330; 7/25/2007 email from David Viniar to Gary Cohn, “Private & Confidential: FICC Financial Package 07/25/07,” GS MBS-E-009861799, Hearing Exhibit 4/27-26; 2/27/2007 email from Richard Ruzika to Tom Montag, others, GS MBS-E-002204942 ; 8/15/2007 email from Gary Cohn, “Trading VaR $165mm,” GS MBS-E-016344758. 1933 8/16/2007 email from Jon W inkelried to Daniel Sparks, “Mort P&L Explanation,” GS MBS-E-010680327-330. FOMC20080805meeting--31 29,MR. WILCOX.," Thank you, Mr. Chairman. In putting together the economic outlook for the current Greenbook, we confronted three main changes in circumstances relative to the situation as it stood in June. First, the labor market looked distinctly weaker than we had anticipated. In the employment report that was released in early July, payroll employment declined by more in June than we had been expecting, and the unemployment rate held at 5� percent rather than dropping back as we had anticipated, following the increase of 0.5 percentage point in the previous month. The fraction of the labor force working part time for economic reasons had moved up sharply, and claims for unemployment insurance were trending up. The second major change in circumstance that we confronted was a secondquarter increase in real GDP that apparently continued to outpace our expectations. In last Wednesday's Greenbook, we projected growth at an annual rate of 2.7 percent in the second quarter, 1 percentage point stronger than in the June Greenbook. At that pace, GDP growth would have slightly exceeded our estimate of the rate of growth of potential output. The third major change was a financial sector that looked more hostile to economic activity, on balance, than at the time of the last meeting despite the improvement during the second half of the intermeeting period that Bill Dudley has just described. When we put the Greenbook to bed, the stock market was about 7 percent lower than we had expected as of June, a variety of spreads remained wide or had widened further since the previous Greenbook, and concerns had been heightened about some key institutions. In addition, the latest reading from the Senior Loan Officer Opinion Survey pointed to a remarkably widespread continued tightening of terms and standards for both households and businesses. These three factors--a weaker labor market, apparently stronger aggregate demand, and a more hostile financial environment--did not easily fit together. To resolve the situation, we began by ruling in favor of the profile presented by the labor market and heavily discounting the greater vigor being signaled by the spending indicators. In our judgment, the story being told by the labor market seemed by far the more credible one, what with housing prices continuing to decline at a rapid pace, consumer sentiment dropping into sub-basement levels, energy prices remaining high even after their recent partial reversal, loan officers reporting a pervasive tightening of credit terms and standards, and other measures of financial stress flashing at least amber. Moreover, while quarter-to-quarter discrepancies between GDP and IP are commonplace, the nearly 4 percent drop in manufacturing IP during the second quarter fueled our skepticism that the economy was on a fundamentally sound footing. As you know, for several Greenbooks our GDP projection has been substantially weaker than it would have been if we had kept in line with the advice from our forecasting models. We were motivated to impose this judgmental weakness partly in recognition of the possibility that we might be entering a recession, and recessions are times when spending tends to fall short of the level that would be indicated by the fundamentals. We also were motivated by the restraint that we think financial markets are imposing on real activity and which our models are ill-equipped to capture. In the current projection, we had to modify these assumptions in light of the changed circumstances. In effect, we interpreted the greater-than-expected strength of real GDP during the second quarter as reflecting an error of timing with respect to the judgmental weakness that we had built into the forecast but not a misjudgment about the overall magnitude of that weakness. Implementing that interpretation involved three steps. First, we responded to the unexpected strength in first-half GDP growth by shifting some judgmental weakness into the second half. Second, we deepened the overall amount of restraint that we imposed in light of the less favorable financial climate. Third, we stretched out the period of financial recuperation: Whereas previously we had financial market conditions essentially returning to normal by the middle of next year, in this projection we have the period of recuperation extending into 2010. These adjustments left our projection for real GDP growth 0.1 percentage point lower over the second half of this year and 0.2 lower next year, despite the offsets from lower oil prices and a slightly greater dose of fiscal stimulus, reflecting the introduction of extended unemployment insurance benefits. For the most part, the avalanche of information that we received since putting out the Greenbook last Wednesday has corroborated our projection. This year's revision of the national income and product accounts threw us no real curve balls. (Sorry for the baseball analogy.) [Laughter] The growth of real GDP was revised down by an average of 0.2 percentage point per year. The revisions to the PCE price indexes, both core and total, were very slight. While the BEA has given us some homework to do between now and the September meeting in folding these data into our thinking, any adjustments that we might be prompted to make, including to the supply side of our forecast, are likely to be slight. On the face of it, the advance estimate of real GDP growth in the second quarter of this year seemed to hold a bigger surprise. The BEA's estimate, at 1.9 percent, came in � percentage point below our estimate in the Greenbook. However, as best as we can tell--based on still-incomplete information--the miss was attributable to lower estimates by the BEA of farm inventory investment and of value added in the trading of used motor vehicles. Our preliminary reading is that neither of these errors carries any signal for the forward momentum of the economy moving into the second half of the year. Friday's employment report was likewise mercifully well behaved-- at least in the narrow sense of conforming to our expectation. Private payroll employment declined an estimated 76,000 in July; together with small downward revisions to May and June, that left the level of employment in July very close to our forecast. In addition, the unemployment rate came in only a few basis points higher than we had expected. The only real news since Greenbook publication came from the motor vehicle manufacturers. On Friday, they reported that sales of light vehicles in July were at an annual pace of 12.5 million units, much weaker than our already weak forecast of 13.3 million units. Moreover, they knocked their assembly schedules for the third quarter down from 9.4 million units to 8.9 million units. Taking their schedules on board would slice another � percentage point from our estimate of GDP growth in the third quarter. The manufacturers have already announced increases in incentives, but it remains to be seen how vigorously consumers will respond in the current environment and how great the financial wherewithal of the manufacturers will prove to be to sustain such moves. In any event, the drop in sales and production is certainly large enough to give renewed urgency to the question as to whether a broader retrenchment in spending might be in train. Turning to the inflation side of the projection, our forecast for core PCE prices over the remainder of this year is nearly unchanged from the June Greenbook. We still have core inflation stepping up from a little more than 2 percent during the first half of this year to a little more than 2� percent in the second half, as the surge in prices for imports, energy, and other commodities passes through to retail prices and as some components that saw unusually low readings earlier in the year accelerate to a more normal rate of increase. Next year, with the pressures from import, energy, and commodity prices diminishing and with slack in resource utilization becoming a little greater, we have core inflation dropping back to 2� percent. The projection for next year is also the same as in the June Greenbook, as the influences from lower energy prices and slightly greater economic slack are roughly offset by the passthrough of higher import prices. The more dramatic changes in our inflation outlook came in the noncore pieces. Not surprisingly, the plunge in oil prices since the June meeting caused us to whack our forecast for retail energy price inflation over the second half of this year. For next year, however, we marked up PCE energy price inflation a little, partly because natural gas futures prices have a more positive tilt than they did before and partly because gasoline margins will still have some recovering to do. At the same time, we have become more pessimistic about the outlook for food price inflation. The CPI for food in June came in at 0.8 percent, much higher than our forecast of 0.3 percent. Because we have mostly been surprised to the upside thus far this year, we decided to move closer to our food price model, which has been calling for larger increases than we were previously willing to write down. The net result, as you saw in the Greenbook, is an outlook with faster food price inflation despite the fact that futures curves for both livestock and crops have moved down since the last meeting. All told, we now have headline PCE inflation running at an average annual pace of 3� percent over the second half of this year, nearly 1 percentage point slower than in the June Greenbook. For next year, we have marked up total PCE inflation by a few tenths in light of our reassessment of the food price situation and the slightly greater rise in energy prices that we now see next year. With regard to the risks in the outlook, my sense is that the downside risks to economic activity have increased since the time of the June Greenbook. That view is informed by two main factors: First, while we have factored the more unsettled nature of the financial environment into our baseline outlook, the situation seems more fragile than before, and the implications for real activity of a sharp deterioration in financial conditions could be quite large. The first alternative scenario that we presented in the Greenbook--entitled ""severe financial stress""--updates our periodic attempt to assemble an integrated macroeconomic and financial scenario. Second, the deterioration in the motor vehicles sector now, to my eye, more convincingly takes on the profile of what we usually see in the course of a typical recession. During the intermeeting period, we will be on high alert for evidence suggesting that the weakness in vehicle sales is a harbinger of a broader shortfall in consumer spending. As for inflation, the upside risks have, in my view, diminished somewhat. Again, two factors inform this assessment. First, the downtick in the long-term inflation expectations measured in the Reuters/Michigan survey is somewhat reassuring. Second, the drop in oil prices is a welcome relief from the steady drumbeat of bad news from that sector and suggests a somewhat diminished probability that persistently high topline inflation will be reflected in a more serious erosion of household expectations, with all the adverse implications for monetary policy that would entail. To be sure, even with those favorable developments, upside risks remain. We illustrated one such risk in the scenario entitled ""inflationary spiral,"" in which we posited an initial shock to inflation expectations of 50 basis points followed by an adverse feedback loop that causes actual and expected inflation to chase each other up nearly 1 percentage point above baseline. Monetary policy eventually brings the process under control but only over a lengthy period of time, partly because the rule that we use in the simulations has policy responding to actual but not to expected inflation. Steve Kamin will now continue our presentation. " CHRG-111hhrg74855--56 Mr. Gensler," Chairman Markey, Ranking Member Upton, Chairman Waxman, it is good to be back here. I believe about 10 years ago I was in front of this committee or the full committee, and I thank you for inviting me to testify regarding regulation of the over-the-counter derivatives markets, particularly with respect to energy markets. If I might just before I turn to that discuss a little bit what the CFTC is and we do as an agency. We oversee, as you know, risk management contracts called futures. We regulate these markets to ensure market integrity, protect against fraud and manipulation, promote transparency of the price discovery function to help lower risk to the American public. We have broad surveillance and enforcement powers and regulate, of course, exchanges, clearinghouses and then the intermediaries that bring transactions there. The CFTC's exclusive jurisdictions over the futures markets coexist alongside other agencies' jurisdiction for underlying commodities. For instance, Department of Agriculture regulates marketing standards for corn and cash milk prices and the CFTC regulates corn and milk futures. The Treasury Department oversees the issuance of all Treasury Bills, Notes and Bonds while, of course, the CFTC oversees Treasury futures. And the Federal Energy Regulatory Commission oversees many elements of the energy markets that this committee is familiar with including natural gas pipelines and electricity markets while the CFTC oversees natural gas and electricity futures. So we live and coexist along other Federal regulators. The CFTC currently oversees futures trading in crude oil, natural gas, electricity and other energy products, gasoline and ore and so forth. Just to give an example, so far this year futures equivalent to 114 billion barrels of oil have traded with the notional amount of nearly $7 trillion this year on the futures exchanges that we oversee. Natural gas, a similar number would be nearly $1.6 trillion of notional amount of natural gas futures. Electricity actually has futures on the NYMEX, on ICE and on a small exchange you might not have heard of, the Nodal Exchange, outside of this RTO issue that again we oversee some of these futures markets and there, there is about 23 million contracts have traded. It is about 7 percent of the overall energy futures market is actually in electricity markets. Now, the over-the-counter derivatives market is that which is currently not regulated by FERC, by the CFTC, by any other Federal regulator and we believe that that is certainly part of the crisis last year, not the only part of the crisis but that we need broad reform in the over-the-counter derivatives market and it is currently out of sight of Federal regulators. As Congress considers this, I believe there are two principal goals, to lower risk to the American public and promote transparency to the American public, and statutory exemptions can undermine those two principal goals as we move forward and as we have seen sometimes in the past can lead to unintended consequences. In terms of transparency, four quick things, one, the administration has proposed that all standardized derivative transactions be moved to under regulated transparent exchanges. This allows for every treasurer, every assistant treasurer of a corporation to see where the real time trading is happening in standard contracts. Customized transactions should still be allowed but the dealers would be subject to comprehensive regulation. Two, all non-cleared transactions, those too customized to be on those exchanges should be in a trade repository and the regulators should be able to see those trades. Three, data on that over-the-counter derivatives market should be aggregated and made public as we do weekly in the futures market. And fourth, stringent recordkeeping and reporting should be established for the swap dealers in these markets. To lower risk in the market, to lower risk the administration has proposed first that the standard contracts be brought into centralized clearing. There is a very natural debate as to who that covers. Do some end users are they out of it or into it but I think that is separate from the transparency debate because everybody benefits from transparency. Secondly, swap dealers and major swap participants would explicitly have to have capital to back up what they are doing in their swap business. And third, the swap dealer should be required to post and collect margin for individual transactions. And lastly, the CFTC and SEC should be authorized to mandate robust business conduct standards to protect the market integrity, to protect against fraud and manipulation. Over-the-counter derivatives have traditionally not been something that have any protection against fraud, manipulation and importantly to this committee, position limit authority. We have proposed and the administration has proposed that the over-the-counter energy markets, oil, natural gas and the like, also have extended position limit authority aggregate position limit authority. We support that. I thank you for inviting me to testify today. I will be happy to answer any questions you may have. [The prepared statement of Mr. Gensler follows:] [GRAPHIC] [TIFF OMITTED] T4855A.007 FOMC20080805meeting--130 128,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Like the Greenbook, our modal forecast shows weaker real activity and slightly higher core inflation over the forecast period. Downside risks to growth remain substantial, in my view, and have probably increased relative to what we thought in June. Risks on the inflation front remain weighted to the upside, perhaps somewhat less than in June, but this is hard to know with confidence. The adverse growth risks are worse for several reasons. The labor market and labor income are weakening more quickly than expected. Although there were some tentative signs of stabilization of housing demand in the spring, demand seems to have fallen further since. Credit conditions are tighter and are expected to be tighter longer, and this seems likely to produce a further deterioration in overall demand--note, of course, the reduction in credit for autos, the rise in mortgage rates, and the more conservative lending standards for consumer and corporate credit. Growth outside the United States seems likely to slow further. Of course, fundamental to this dynamic, as has been true for 12 months, each shift in perceptions that the bottom in overall economic growth is further away produces additional stress for financial institutions and markets, adding to the intensity of prospective financial headwinds and to concerns about downside risks to growth. Now, the adverse tail on the inflation front remains significant. Many measures of underlying inflation suggest a broad-based, if limited to date, acceleration in the rate of underlying inflation. Market- and survey-based measures of long-term expectations are high. Surveys suggest that firms are able to pass on some part of the acceleration in energy and materials costs. On the more positive side, energy, commodity, and materials prices have declined significantly, principally it seems because of expectations of slower growth in global demand. Growth is moderating significantly around the world, and it's going to have to moderate further in the most populous parts of the world as central banks there get monetary policy tighter. The growth of unit labor costs has been and is expected to be very moderate here. Profit margins still show plenty of room to absorb cost increases, and as David reminded us, you can have a relatively benign outlook for the path of core inflation without margins narrowing very dramatically. Inflation expectations have not deteriorated meaningfully here, even with the flatter expected path of monetary policy in the United States. Of course, it's very important that inflation expectations and pricing power moderate from current levels. If some of the downside risks to growth materialize, this will happen, and inflation risks will moderate. If, however, the economy continues to prove to be resilient to these downside risks, then we will face higher inflation. On balance, the rate of growth in underlying inflation suggests that growth in demand in the United States will have to be below potential for a longer period of time if inflation expectations are to come down sufficiently. This means that we will have to tighten monetary policy relatively soon compared with our previous behavior in recoveries--perhaps before we see the actual bottom in house prices and the actual peak in unemployment. However, at this point, the risks to real growth remain critical. In my view, we need to have more confidence that we have substantially reduced the risks of a much sharper, more protracted decline in growth before we begin to tighten. I think it is unlikely that we will be able or will need to move before early next year. Short-term market expectations for monetary policy in the United States seem about right at present. I don't see a strong case for trying to alter those expectations in either direction at this point. To try to pull forward the expected tightening would risk adding to the downside risk to growth and magnifying the risk of a much more severe financial crisis. On the other hand, if we avoid some of these downside risks to growth, then policy will need to tighten more quickly, perhaps, than the expected path now priced in the markets. The evolution of monetary policy expectations and of inflation expectations since May illustrates how uncertain the markets are about what path of policy will be appropriate. But the pattern of changes in both of these measures of expectations suggests that the markets believe we will get this balance right--that we will do enough soon enough to keep underlying inflation expectations from eroding materially. Thank you. " FinancialCrisisReport--386 In late February, Goldman’s Operating Committee, a subcommittee of its Firmwide Risk Committee, became concerned about the size of the $10 billion net short position. The Firmwide Risk Committee was co-chaired by Mr. Viniar, and Messrs. Cohn and Blankfein regularly attended its meetings. 1560 The concern arose, in part, because the $10 billion net short position had dramatically increased the Mortgage Department’s Value-at-Risk or “VAR,” the primary measure Goldman used to compute its risk. The Committee ordered the Department to lock in its profits by “covering its shorts,” as explained above. The Mortgage Department complied by covering most, but not all, of the $10 billion net short and brought down its VAR. It then maintained a relatively lower risk profile from March through May 2007. Attempted Short Squeeze. In May 2007, the Mortgage Department’s Asset Backed Security (ABS) Trading Desk attempted a “short squeeze” of the CDS market that was intended to compel other market participants to sell their short positions at artificially low prices. 1561 Goldman’s ABS Desk was still in the process of covering the Mortgage Department’s shorts by offering CDS contracts in which Goldman took the long side. The ABS Desk devised a plan in which it would offer those CDS contracts to short parties at lower and lower prices, in an effort to drive down the overall market price of the shorts. As prices fell, Goldman’s expectation was that other short parties would begin to sell their short positions, in order to avoid having to sell at still lower prices. The ABS Desk planned to buy up those short positions at the artificially low prices it had caused, thereby rebuilding its own net short position at a lower cost. 1562 The ABS Desk initiated its plan, and during the same period Goldman customers protested the lower values assigned by Goldman to their short positions as out of line with the market. Despite the lower prices, the parties who already held short positions generally kept them and did not try to sell them. In June, after learning that two Bear Stearns hedge funds specializing in subprime mortgage assets might collapse, the ABS Desk abandoned its short squeeze effort and recommenced buying short positions at the prevailing market prices. The Big Short. In mid-June 2007, the two Bear Stearns hedge funds did collapse, triggering another steep decline in the value of subprime mortgage assets. In response, Goldman immediately went short again, to profit from the falling prices. Within two weeks, Goldman had massed a large number of CDS contracts shorting a variety of subprime mortgage assets. On 1558 3/10/2007 email to Daniel Sparks, “Mortgage Presentation to the board, ” GS M BS-E-013323395, Hearing Exhibit 4/27-17. 12/13/2006 Goldman email, “Subprime Mortgage Risk,” Hearing Exhibit 4/27-2. 1559 1560 8/23/2007 email from Tom Montag, “Current Outstanding Notional SN ames,” GS MBS-E-010621231. 11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined Comments, ” GS MBS-E-010135693-715 at 695). 1561 9/7/2007 Fixed Income, Currency and Commodities Annual Individual Review Book, Self-Review of Deeb Salem, GS-PSI-03157-80 at 72 (hereinafter “Salem 2007 Self-Review ”). 1562 Id. FOMC20061025meeting--49 47,MS. MINEHAN.," Thank you, Mr. Chairman. The New England District economy continues to grow at a moderate pace, pretty much as it was growing the last time we met, with job counts slowly increasing and business and consumer confidence relatively good about both current and future conditions. As I’ve noted before, income growth has been robust in the District, with regional income growing better than 7 percent from second quarter ’05 to second quarter ’06. Indeed, incomes in Massachusetts and Connecticut both rose about 9 percent. Reflecting this rise, the fiscal condition of the states in the region, while varied, remains positive. Regional corporate health is solid, and readings of regional stock indexes follow the positive pace of the nation’s financial markets. Contacts from a wide range of manufacturing industries reported positive trends; fewer cost pressures from commodity, energy, and interest rates; and a continuation of competitive pressures to restrain costs and keep prices stable. We regard this pressure as a return to business as usual. On the negative side, the slowdown in the housing sector becomes more apparent with each passing month. According to the overall OFHEO house-price indexes, year-over-year appreciation in the second quarter of ’06 for New England was about half of that for the nation. The change from the first to the second quarter in ’06 was virtually zero. The region now has the lowest rate of annual housing appreciation of any area of the country except the Midwest. This situation is not entirely unwelcome, as housing price levels in the region remain quite high relative to the nation, and there has been much hand-wringing locally about the effect high housing costs have on attracting skilled labor to the region. Of course, the cyclical effect of a sharp residential investment slowdown is of concern. Existing home sales volumes are down 12 percent from their 2005 peaks. New home construction is weakening significantly, and construction employment has declined in both Connecticut and Massachusetts since year-end 2005. Indeed, negative commentary from area business contacts revolved mostly around markets for products aimed at the residential housing industry. While there may be some light at the end of this tunnel, with recent lower mortgage interest rates and some sense of bottoming out, the usual seasonal slowdown in the real estate industry as winter approaches may make this improvement difficult to appreciate for some time. The effect of slowing residential investment remains one of the key uncertainties on the national scene as well. Combined with the negative effect of trade, housing trends have caused us to mark down our estimate of third-quarter GDP growth to about the level of the Greenbook. However, positive incoming data on employment, consumer spending, and corporate profits, spurred as they have been by favorable trends in energy prices, financial markets, and worldwide growth, support a modest rebound in overall activity in the fourth quarter and a forecast for 2007 and 2008 of just slightly less than potential. Indeed, I was pleased to see the upward revision to the Greenbook forecast for the fourth quarter of this year, as I had worried whether the earlier trajectory had increased the risk of a spiral downward into a recession. I don’t think that’s likely, and I realize that overall the second-half GDP projection remains about the same. But the upward revision to the fourth quarter in the Greenbook, which brings it closer to our Boston forecast, makes me somewhat more comfortable about the underlying trajectory of economic activity. We, like the Greenbook authors, have revised down slightly our estimate of potential, so our sense of any gap in resource usage remains about the same as it was at the last meeting. Thus, unemployment rises very slowly, to just about 5 percent in 2008, and inflation falls slowly as well, along the lines of the forecast at the last meeting. All in all, that is not a lot of change. I must admit, however, to some small amount of hope that we may be seeing the bottoming out of the housing market decline because of the mixture of the data that Dave referred to earlier. Moreover, other aspects of the current situation seem quite positive as well—in particular, the very accommodative nature of financial markets and the continuing profitability of the nation’s corporations. Thus, the risks to what continues to be in many ways a rather benign forecast seem to me to be a bit less on the downside than they seemed at our last meeting. Energy-driven inflation may be lower as well, but I remain concerned about the underlying pressures on resource utilization if the economy does not slow as much as we now expect. Corporate-driven productivity growth, though we haven’t seen it escalate recently, could come to the rescue here, but I think it’s hard to bet on that. Thus, I do see some continuing uncertainty as to whether inflation will be as well behaved as in either the Boston or the Greenbook forecast." FinancialCrisisReport--622 When asked about particular transactions, Goldman executives or traders often described them as examples, not of “proprietary trading,” but “principal trading” in which Goldman acted as a market maker. Goldman personnel told the Subcommittee that to fulfill the firm’s role as a market-maker, Goldman used its own capital to amass an inventory of assets in anticipation of customer demand, and acted as a “principal” when building that inventory. They indicated that the mortgage related assets were acquired for the purpose of accommodating existing or anticipated client buy and sell orders and not to produce proprietary profits for the firm. At the same time, several Goldman executives and traders told the Subcommittee that all of Goldman’s trading desks, including those in the Mortgage Department, were given discretion to trade some amount of the firm’s capital within certain limits. 2793 Daniel Sparks told the Subcommittee: “We told [the Firmwide Risk Committee] what we wanted to do, and they told us how much we could do.” 2794 Joshua Birnbaum said that the amount of proprietary trading that a desk was allowed to do depended upon certain risk limits, but could not recall a specific or typical dollar amount of any risk limit assigned to the Mortgage Department as a whole or to any of its trading desks for proprietary trading purposes. 2795 Goldman’s Chief Risk Officer Craig Broderick told the Subcommittee that the firm did not distinguish between “proprietary” versus other types of risk, because the aggregate risk levels would be the same. 2796 Mr. Broderick said that the firm’s proprietary trading, outside of GSPS, was “embedded” in the routine business conducted by various trading desks and was not specifically segregated as “proprietary.” 2797 Until enactment of the Dodd-Frank Act in 2010, federal securities law contained no statutory or regulatory definition of proprietary trading by banks and generally did not require firms to identify or monitor their proprietary investments. 2798 The Subcommittee investigation found that the terms “proprietary” and “prop” were commonly used in the financial services industry to describe business performed on behalf of, or for the benefit of, a financial firm itself, 2793 Subcommittee interviews of Mr. Sparks (4/15/2010); Mr. Birnbaum (4/22/2010); and Mr. Broderick (4/9/2010). See also 12/17/2007 email from Michael DuVally to Mr. Sparks, “WSJ Responses,” GS MBS-E-013821884 (“Some traders are allowed to express their own market views using the firm’s capital.”). 2794 Subcommittee interview of Daniel Sparks (4/15/2010). 2795 Subcommittee interview of Joshua Birnbaum (4/22/2010). 2796 Subcommittee interview of Craig Broderick (4/9/2010). 2797 Id. Goldman’s Chief Financial Officer David Viniar provided similar information in response to questions from the Financial Crisis Inquiry Commission, indicating that Goldman did not specifically “break out” its proprietary trading from its other business results. See FCIC Hearing, Testimony of David Viniar (7/2/2010), www.fcic.gov. 2798 The Dodd-Frank Act defines “proprietary trading” as “engaging as a principal for the trading account of [a] banking entity . . . in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative, or contract or any other security or financial instrument that the appropriate Federal banking agencies ... may, by rule ... determine.” 12 U.S.C. ' 1851(h)(4). The Act further defines “trading account” as one used for “near term” trading or for capturing profits from “short term price movements.” Section 1851(h)(6). These provisions are subject to further refinement through implementing regulations. while the term “flow” was used to refer to market-making transactions involving, or for the benefit of, the firm’s customers. 2799 FOMC20050809meeting--135 133,MR. FISHER.," Mr. Chairman, as reported in the Beige Book, activity in our District has picked up substantially. There’s a tremendous amount of activity in all but the manufacturing sector. And there’s an enormous surge in confidence, particularly in Texas, even though that may seem like a redundancy to talk about confident Texans! I’ll refer to just a couple of points very quickly as part of the broader discussion we’ve been having at this table. First, we’ve had a huge surge in housing starts. Houston now ranks second in the country year-to-date in terms of housing unit permits, and Dallas ranks third. First, by the way, is Atlanta. Moreover, permits are running at rates roughly three times what we see in New York City and roughly twice those in Miami or Orlando. But to illustrate the point that we discussed at our last meeting, in terms of price pressures, Dallas ranks 250 out of 265 MSAs [metropolitan statistical areas], which shows the geographic differential. In any event, we’ve had August 9, 2005 35 of 110 The second point, with regard to energy, is that Texas, Louisiana, and New Mexico account for two-thirds of the rig count in the United States. It’s a rather schizophrenic sector. One might say that schizophrenia beats dining alone, because we do get both sides of these arguments. [Laughter] We have a very excited group of people—the rig operators—now running at the tightest capacity rate in terms of rig utilization since December of 1985 in the case of Texas and since 1986 in the case of Louisiana. As evidence of the kind of pressure that’s occurring on the happy side, but also a testimony to globalization, we have the first case of a company—a small company that was not able to find rigs—importing a rig with workers from China to operate in a certain basin in Colorado. By the way, 70 percent of that rig content is constructed in China and 30 percent in the United States. This is the first such case that we’re aware of. On the opposite side, the depressive side, there is a constant fear of price collapse in the oil sector. One might describe it as a wild surmise, except that one of the most articulate and outspoken champions of the view that oil prices could fall dramatically happens to be Lee Raymond, the Chairman of Exxon and the Chairman of the National Petroleum Council. He likes to remind listeners, and he lectures me constantly, that in 1985 or 1986—I forget exactly when it was—we had a price collapse which took oil prices from $28 to $10 in two weeks. He is constantly warning his colleagues—noting that it is a minority view within the oil patch—that if we have a warm winter he expects that kind of price behavior in the oil market. And he certainly is a noteworthy proponent of that view. On the high-tech side, I’d note a couple of points based on conversations with Texas Instruments and Dell on the issues of capacity and capital expenditures. TI, having just August 9, 2005 36 of 110 area—says that they expect this to be one of their last full-bore production facilities for wafers. By the way, even with that large dollar investment, the factory will employ only 500 people. What they’re finding now is that they can buy what they call commodity wafers—which is about 60 percent of the content they need—from Chinese producers at ever-lower prices. Dell repeats the same kind of defiance of the laws of economic behavior, as they put it, in terms of what they’re able to source out of China, and they claim now to be the second largest operator of U.S. companies in China. Moreover, they report that with each passing day, as we’ve heard from retailers, somebody appears on their doorstep able to outbid any existing supplier at an ever- cheaper price. As far as the retail sector is concerned, again, with my colleague’s permission, I do talk to contacts from Wal-Mart occasionally—to the COO and to the President of Wal-Mart International. We hear the same kinds of reports, and there are substantial questions about Chinese accounting. And, Karen, the reason I asked the question about the assumptions regarding the Chinese yuan appreciation or the general depreciation of the dollar against the yuan—even though it’s obviously very volatile—is that the CEO of Wal-Mart International said that it makes absolutely no difference that China has revalued the renminbi at this juncture. They constantly find that people that will come in and underbid existing suppliers. The supposition, Mr. Chairman, is that the Chinese (a) don’t pay back principal, (b) don’t pay taxes, and (c) if they do pay taxes, they pay the tax collector rather than the government. All of that, of course, gives them a substantial advantage. This has always been the case, and we assume it will be not carried forward over time. But in terms of competition, there seems to be a voracious appetite to continue to supply—a variation of the old Communist model in which they produced August 9, 2005 37 of 110 retailers, our high-tech sector, and others, and now our energy sector—are taking advantage of that situation. Having said all of that, I want to indicate, as did Mr. Moskow, that with this strong economic activity, even though there may be a risk that we’re borrowing from the future, we, too, are concerned about inflationary pressures. So we would be in favor of further tightening to the degree that my former colleague as Deputy U.S. Trade Representative just mentioned. We’ll talk about the wording of the statement later. Thank you very much." fcic_final_report_full--247 GOLDMAN: “LET ’S BE AGGRESSIVE DISTRIBUTING THINGS ” In December , following the initial decline in ABX BBB indices and after  con- secutive days of trading losses on its mortgage desk, executives at Goldman Sachs de- cided to reduce the firm’s subprime exposure. Goldman marked down the value of its mortgage-related products to reflect the lower ABX prices, and began posting daily losses for this inventory.  Responding to the volatility in the subprime market, Goldman analysts delivered an internal report on December , , regarding “the major risk in the Mortgage business” to Chief Financial Officer David Viniar and Chief Risk Officer Craig Brod- erick.  The next day, executives determined that they would get “closer to home,” meaning that they wanted to reduce their mortgage exposure: sell what could be sold as is, repackage and sell everything else.  Kevin Gasvoda, the managing director for Goldman’s Fixed Income, Currency, and Commodities business line, instructed the sales team to sell asset-backed security and CDO positions, even at a loss: “Pls refo- cus on retained new issue bond positions and move them out. There will be big op- portunities the next several months and we don’t want to be hamstrung based on old inventory. Refocus efforts and move stuff out even if you have to take a small loss.”  In a December  email, Viniar described the strategy to Tom Montag, the co-head of global securities: “On ABX, the position is reasonably sensible but is just too big. Might have to spend a little to size it appropriately. On everything else my basic mes- sage was let’s be aggressive distributing things because there will be very good oppor- tunities as the market goes into what is likely to be even greater distress and we want to be in position to take advantage of them.”  Subsequent emails suggest that the “everything else” meant mortgage-related as- sets. On December , in an internal email with broad distribution, Goldman’s Stacy Bash-Polley, a partner and the co-head of fixed income sales, noted that the firm, un- like others, had been able to find buyers for the super-senior and equity tranches of CDOs, but the mezzanine tranches remained a challenge. The “best target,” she said, would be to put them in other CDOs: “We have been thinking collectively as a group about how to help move some of the risk. While we have made great progress moving the tail risks—[super-senior] and equity—we think it is critical to focus on the mezz risk that has been built up over the past few months. . . . Given some of the feedback we have received so far [from investors,] it seems that cdo’s maybe the best target for moving some of this risk but clearly in limited size (and timing right now not ideal).”  It was becoming harder to find buyers for these securities. Back in October, Gold- man Sachs traders had complained that they were being asked to “distribute junk that nobody was dumb enough to take first time around.”  Despite the first of Goldman’s business principles—that “our clients’ interests always come first”—documents indi- cate that the firm targeted less-sophisticated customers in its efforts to reduce sub- prime exposure. In a December  email discussing a list of customers to target for the year, Goldman’s Fabrice Tourre, then a vice president on the structured product correlation trading desk, said to “focus efforts” on “buy and hold rating-based buyers” rather than “sophisticated hedge funds” that “will be on the same side of the trade as we will.”  The “same of side of the trade” as Goldman was the selling or shorting side—those who expected the mortgage market to continue to decline. In January, Daniel Sparks, the head of Goldman’s mortgage department, extolled Goldman’s suc- cess in reducing its subprime inventory, writing that the team had “structured like mad and traveled the world, and worked their tails off to make some lemonade from some big old lemons.”  Tourre acknowledged that there was “more and more leverage in the system,” and—writing of himself in the third person—said he was “standing in middle of all these complex, highly levered, exotic trades he created without necessar- ily understanding all the implications of those monstrosities.”  FOMC20060808meeting--72 70,MR. KOHN.," Thank you, Mr. Chairman. As many of you have remarked, the inflation news over the intermeeting period was not favorable. Core consumer prices continued to run at an elevated level, and the CPI actually came in on the high side of expectations. The shortfall in the PCE that President Yellen referenced was, I think, more of those mysterious nonmarket components. Petroleum prices rose further, implying additional feed-through going forward. Prices of other commodities, as Karen remarked, were on average unchanged to somewhat higher, suggesting not only continuing cost pressures on producers but sustained strength in global demand. Early estimates of unit labor costs for the second half of last year and the first half of this year show a faster increase than had been estimated and anticipated. The compensation data for the early part of this year, in particular, are subject to very large revisions. Even the now-faster growth doesn’t necessarily indicate that the economy has been operating beyond its sustainable potential, given the likelihood of some catch-up with past productivity gains, the still quite elevated profit margins, and the moderate increase in the ECI. But at the very least, the unit labor cost story doesn’t provide as much comfort about future inflation as it did previously. Largely as a consequence, the staff revised up its inflation forecast for 2006 and 2007, and that response seems reasonable to me. At the same time, some developments over the intermeeting period help me feel a touch more comfortable, or perhaps a touch less uncomfortable, with the downward trajectory for inflation after the bulge. One of them that a number of you have mentioned from surveys is that the long-term inflation expectations in the market remained stable or even edged down a little despite higher energy prices and, importantly, despite downward revisions to the expected path of monetary policy. If I were forecasting today, I would forecast a slightly higher inflation rate, but I would also forecast a slightly higher unemployment rate than I did before. To be sure, output gaps, as you’ve mentioned, don’t play a large role in determining inflation, but certainly the growth of demand relative to potential has some effect on the competitive conditions that businesses are facing and on their ability to pass through costs. From the information that we received over the intermeeting period, growth slightly below the growth rate of the economy’s potential seems more likely than it seemed a month or so ago, and this would inhibit the pass-through of higher energy and labor costs. Weakness in the housing sector has deepened, and we have not yet seen the full implications of the rise in long-term and short-term interest rates over the first half of the year. This weakness seems to be having an effect on housing prices as well as on activity. The effects of a lower expected trajectory for housing wealth and the increase in interest rates this year haven’t begun to show through to consumption, judging from the minus 1½ percent saving rate. The energy-price increases of recent weeks will take something more out of consumption. Recent data are consistent with a below-trend track for the growth of economic activity: Private domestic final purchases increased at a rate of only 2 percent in the second quarter. The consumption and investment data for late months in the quarter don’t suggest an acceleration going into the third quarter. The growth of employment has been running slightly below what would be a steady-state pace if participation were to remain stable, and participation has edged higher. The greater increase than had been anticipated in inventories in the second quarter suggests little impetus or even a small drag from inventory accumulation in the third and fourth quarters. The growth of federal government spending seems to be dropping back a bit as Katrina-related expenditures top out. Moreover, the recent higher rates of core inflation, though they are puzzling to a considerable extent, must reflect some influences that are unlikely to be repeated indefinitely into the future. One of those is the rise in oil and energy prices. The recent rise clearly has been associated with escalating tension in the Mideast and other producing areas, as well as the recent cutback in supply from Alaska. At some point, the risks of supply disruptions, while remaining very high, should level out. As a consequence, so, too, should energy prices, which will reduce core inflation as the feed-through fades. Another factor boosting inflation in recent months was related to rising rents and, in particular, to an even greater increase in owners’ equivalent rent. The staff has assumed that owners’ equivalent rent will rise in line with other rents and that both will continue to increase fairly rapidly but less rapidly than they did. That seems reasonable to me, given the increased availability of houses and apartments on the market that would, at some point, seem to limit the rise in rents as well as house prices. So my conclusion is that the staff forecast of a gradual moderation of core inflation after the second quarter is a reasonable expectation, although I am very worried about upside risks to inflation. The inflation rate looks as though it will end up a tad higher than either the staff or I thought likely at the time of our June meeting. Thank you, Mr. Chairman." CHRG-111shrg53176--167 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM RICHARD BAKERQ.1. Does the concept of the sophisticated investor, which sets certain income and asset-size limitations on investors in hedge funds, need to be revisited? If so, how should it be revisited?A.1. The Managed Funds Association (MFA) strongly supports limiting investments in hedge funds to sophisticated investors. Rule 501 of Regulation D under the Securities Act of 1933 defines the term ``accredited investor'' as including: (5) Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000; (6) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year . . . The Commission adopted these standards in 1982. In May 2003, the SEC held a public roundtable meeting to discuss the hedge fund industry. In connection with that roundtable, MFA submitted its ``White Paper on Increasing Financial Eligibility Standards for Investors in Hedge Funds.'' \1\ In the White Paper, MFA proposed that the Commission could increase the dollar thresholds for the accredited investor definition to address concerns that, because of inflation, the thresholds no longer adequately ensured the sophistication of accredited investors. In 2007, the Securities and Exchange Commission proposed modifying the accredited investor definition to account for the effects of inflation on the thresholds. \2\ In its comment letter to the proposed rule change, MFA supported increasing these thresholds to account for the effects of inflation. \3\ MFA continues to support increasing the accredited investor threshold to ensure that hedge fund investors are sophisticated investors who are capable of understanding the risks associated with an investment in a hedge fund and who have the financial wherewithal to withstand the potential losses from an investment. MFA also supports adjusting, as appropriate, the accredited investor threshold to account for inflation on a going forward basis, to ensure that the threshold appropriately limits investing in hedge funds to sophisticated investors.--------------------------------------------------------------------------- \1\ Available at: http://www.sec.gov/spotlight/hedgefunds/hedge-mfa2.htm#wpaper2. \2\ Securities Act Release No. 8828 (August 3, 2007); 72 FR 45116 (August 10, 2007). The Commission has not adopted this proposal. \3\ Letter from John G. Gaine, President, MFA, October 19, 2007, available at: http://www.managedfunds.org/downloads/MFA%20Regulation%20D%20Comment%20Letter.pdf.--------------------------------------------------------------------------- The SEC has noted on several occasions that the objective income test in Regulation D strikes an appropriate balance between limiting private offerings to sophisticated investors only and promoting capital formation for companies. Prior to the SEC's adoption of Rule 242 under the Securities Act of 1933, which was replaced by the adoption of Regulation D under the Securities Act, issuers relying on the private offering exemption had to make a subjective determination of the sophistication of the investors to whom they offered or sold securities. The requirement to make this subjective determination, however, ``created uncertainty about whether the exemption was available and thus posed problems for issuers, primarily small issuers, about potential rescission liability should the exemption turn out to be unavailable.'' \4\ To address this concern, the SEC incorporated the objective standard for accredited investors in Regulation D. In its 2007 proposed rulemaking to amend the accredited investor standards, the Commission again recognized the appropriateness of objective thresholds,--------------------------------------------------------------------------- \4\ Securities Act Release No. 8041 (December 19, 2001); 66 FR 66841 (December 27, 2001). Before 1982, our rules generally required an issuer seeking to rely on section 4(2) to make a subjective determination that each offeree had sufficient knowledge and experience in financial and business matters to enable that offeree to evaluate the merits of the prospective investment or that such offeree was able to bear the economic risk of the investment. In part because of a degree of uncertainty as to the availability of the section 4(2) exemption, the Commission adopted Regulation D under the Securities Act in 1982 to establish nonexclusive ``safe harbor'' criteria for the section 4(2) private offering exemption. \5\--------------------------------------------------------------------------- \5\ Securities Act Release No. 8766 (December 27, 2006); 72 FR 403-404 (January 4, 2007) (footnote omitted). We recognize that asset and income tests do not necessarily guarantee the level of sophistication of investors, but we agree with the SEC that such tests do achieve an appropriate balance between investor protection and market certainty. Bright line, easy to understand thresholds promotes certainty, which is important to market participants and also promotes efficient and effective oversight by regulators. Investors who meet significant income or asset thresholds are more likely to have greater investment experience and sophistication, and therefore are better able to protect their interests than are retail investors. At the very least, these thresholds help ensure that investors who do not personally have such experience and sophistication have the means to engage fiduciaries who do have such experience to assist them in making investment decisions. Further, investors who meet such tests are likely to have the financial wherewithal to withstand losses that may arise from their investment decisions. As such, we believe that limiting hedge funds to investors who meet significant income or asset thresholds is an effective, if not perfect, means to ensure that only sophisticated investors invest in hedge funds. In 1996, Congress amended the Investment Company Act of 1940 to, among other things, introduce an additional, heightened sophisticated investor standard, the ``qualified purchaser'' \6\ standard, which is applicable to investors in certain kinds of hedge funds (so-called ``3(c)(7) hedge funds''). In practice, investors in 3(c)(7) hedge funds must meet both the accredited investor and qualified purchaser thresholds. Like the accredited investor test, the qualified purchaser test sets out an objective standard ($5,000,000 in investments for an individual). We believe that the qualified purchaser standard has worked well since its inception; however, Congress may want to consider whether it is appropriate to adjust the standard to account for inflation. If Congress does decide to make an adjustment to the qualified purchaser standard, it is important for the new standard to be objective, transparent and easy to understand.--------------------------------------------------------------------------- \6\ The term qualified purchaser is defined in section 2(a)(51) of the Investment Company Act of 1940 to mean: (A)(i) any natural person (including any person who holds a joint, community property, or other similar shared ownership interest in an issuer that is excepted under section 80a-3 (c)(7) of this title with that person's qualified purchaser spouse) who owns not less than $5,000,000 in investments, as defined by the Commission; (ii) any company that owns not less than $5,000,000 in investments and that is owned directly or indirectly by or for 2 or more natural persons who are related as siblings or spouse (including former spouses), or direct lineal descendants by birth or adoption, spouses of such persons, the estates of such persons, or foundations, charitable organizations, or trusts established by or for the benefit of such persons; (iii) any trust that is not covered by clause (ii) and that was not formed for the specific purpose of acquiring the securities offered, as to which the trustee or other person authorized to make decisions with respect to the trust, and each settlor or other person who has contributed assets to the trust, is a person described in clause (i), (ii), or (iv); or (iv) any person, acting for its own account or the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $25,000,000 in investments. (B) The Commission may adopt such rules and regulations applicable to the persons and trusts specified in clauses (i) through (iv) of subparagraph (A) as it determines are necessary or appropriate in the public interest or for the protection of investors. (C) The term ``qualified purchaser'' does not include a company that, but for the exceptions provided for in paragraph (1) or (7) of section 80a-3 (c) of this title, would be an investment company (hereafter in this paragraph referred to as an ``excepted investment company''), unless all beneficial owners of its outstanding securities (other than short-term paper), determined in accordance with section 80a-3 (c)(1)(A) of this title, that acquired such securities on or before April 30, 1996 (hereafter in this paragraph referred to as ``pre-amendment beneficial owners''), and all pre-amendment beneficial owners of the outstanding securities (other than short-term paper) of any excepted investment company that, directly or indirectly, owns any outstanding securities of such excepted investment company, have consented to its treatment as a qualified purchaser. Unanimous consent of all trustees, directors, or general partners of a company or trust referred to in clause (ii) or (iii) of subparagraph (A) shall constitute consent for purposes of this subparagraph.Q.2. What level of standardization of disclosures might help investors in hedge funds? What is the balance between disclosure for the protection of investors and the protection ---------------------------------------------------------------------------of hedge funds' intellectual property?A.2. MFA and its members strongly support hedge funds providing an appropriate level of disclosure to investors and potential investors in hedge funds, to allow those investors to make informed investment decisions. Hedge funds do disclose a significant amount of information to investors because of regulatory requirements and the requirements of investors. \7\ We believe that the appropriate balance between disclosure to investors and protection of intellectual property is best determined between sophisticated hedge fund investors and hedge fund managers. Investors who believe that they do not have sufficient information about a hedge fund should not make an investment in that fund. The balance between disclosure to investors and protection of intellectual property is, of course, set in the context of the anti-fraud provisions of the federal securities laws.--------------------------------------------------------------------------- \7\ To assist investors in their diligence process, MFA has published a model due diligence questionnaire, which illustrates the types of information commonly requested by investors prior to investing. MFA's model DDQ is available at: http://www.managedfunds.org/downloads/Due%20Dilligence%20Questionnaire.pdf.--------------------------------------------------------------------------- We believe that because the class of investors who can invest in hedge funds is limited to sophisticated investors only, those investors are able to request and receive any information they believe to be relevant to their investment decisions. Further, we believe that sophisticated investors are better able than regulators to determine what information they need and how they want that information to be presented. Any investor who fails to receive the information that it believes is material to an investment decision can choose not to make an investment. Because sophisticated investors are best able to determine what information they need, and they have the ability to request and receive that information (or not make an investment if they do not), we believe that it is neither necessary nor advisable to require standardized disclosures by hedge funds. While hedge funds provide a significant amount of information to investors, we do not believe that detailed public disclosure about hedge funds should be required. Public disclosure of such information could be misleading, as it would likely be incomplete data that would be viewed by the public outside of the proper context. Public investors may be inclined to take action based on this data without fully understanding the information, which could lead to adverse consequences for those public investors, for investors in the relevant hedge funds, and for the stability of the financial system as a whole. Public disclosure of proprietary information also harms the ability of market participants to establish and exit from investment positions in an economically viable manner. We believe that investors in hedge funds can receive the information they need to make informed investment decisions (and regulators can receive information reported on a confidential basis to allow them to fulfill their investor protection, oversight, monitoring and other regulatory functions) without the adverse consequences that would result from public disclosure of the intellectual property of hedge funds.Q.3. Is it reasonable that regulators could review detailed information such as trading positions of hedge funds overall to see where there might be concentrations, or is this level of analysis too difficult? If so, why?A.3. MFA supports the notion of a central systemic risk regulator (SRR) and believes that such a regulator should be responsible for oversight over the key elements of the entire financial system, across all relevant structures, classes of institutions and products of all financial system participants. \8\ Factors a SRR should consider in determining whether an entity is systemically important should include the amount of assets of an entity, the concentration of its activities, and an entity's interconnectivity to other market participants.--------------------------------------------------------------------------- \8\ See Testimony of the Honorable Richard H. Baker, President and Chief Executive Officer, Managed Funds Association, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, March 26, 2009; and Testimony of the Honorable Richard H. Baker, President and Chief Executive Officer, Managed Funds Association, before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, Committee on Financial Services, U.S. House of Representatives, March 5, 2009.--------------------------------------------------------------------------- While we acknowledge that at a minimum the hedge fund industry as a whole is of systemic relevance and, therefore, should be considered within the systemic risk regulatory framework; we believe that most hedge funds are not systemically significant entities and, thus, hedge funds, as a class, should not be singled out for greater scrutiny. A SRR should have the authority to request and receive, on a confidential basis, from those entities that it determines to be of systemic relevance, including any hedge funds, information that the regulator determines necessary or advisable to enable it to adequately assess potential risks to the financial system. We don't mind reporting information within reason if systemically relevant, provided that the SRR provides assurance of confidentiality. In this respect, we also believe a SRR should not equate systemically relevant entities with entities that are too big, or too interconnected, to fail. An entity that is perceived by the market to have a government guarantee, whether explicit or implicit, has an unfair competitive advantage over other market participants. We strongly believe that the systemic risk regulator should implement its authority in a way that avoids this possibility and also avoids the moral hazards that can result from a company having an ongoing government guarantee against its failure. With respect to whether a regulator could assess an entity's trade concentrations through reviewing trade positions, we provide the following example for comparison: The Commodity Futures Trading Commission currently performs analysis of the trading positions of market participants, including hedge funds, as part of its market surveillance program. For example, the CFTC operates a large-trader reporting system (LTRS) through which it collects daily market data and position information from clearing members, futures commissions merchants, and foreign brokers. \9\ In this way, the CFTC conducts real-time surveillance of market participants.--------------------------------------------------------------------------- \9\ Section 4g of the Commodity Exchange Act (CEA); 17 CFR Parts 15, 16, 17, 18, 19, and 21.--------------------------------------------------------------------------- We understand that the CFTC reviews the position information daily and will contact a market participant that exceeds an accountability level or position limit to conduct an inquiry (note: an accountability level is a soft limit and exceeding it is not per se illegal, whereas a position limit is a hard limit). If a market participant exceeds an accountability level, the CFTC will inquire into the market participant's positions, strategy or other rationale for exceeding the accountability level. If the CFTC is not satisfied with its finding, it may require the market participant to decrease its position. All of this is done quietly and privately to avoid alarming or putting other market participants on notice and creating a market impact. The CFTC provides the public with aggregated data of reported positions via its weekly Commitments of Traders reports. The Commodity Exchange Act protects market participants by prohibiting the CFTC from disclosing any person's positions, transactions, or trade secrets (except in limited circumstances). \10\--------------------------------------------------------------------------- \10\ Section 8 of the CEA.--------------------------------------------------------------------------- As provided in the above example, it is possible for regulators to review detailed information to assess position concentrations. Similar to the CFTC's market surveillance program, we believe it would be more meaningful for a SRR to review trading positions across all market participants that it deems systemically significant, rather than single out specific types of market participants, such as hedge funds. While we believe it is useful for the public to receive aggregated position information for specific markets (i.e., commodities), we strongly believe information reported to a systemic risk regulator by market participants should be kept confidential for the reasons discussed in our written testimony. A SRR is also likely to need sufficient authority and flexibility to adapt to changing conditions and take a forward-looking view toward risk regulation. Attempting to pre-determine what information a regulator would need would not provide sufficient flexibility and likely would be ineffective as a tool to address potential future risks. As a starting point, however, a SRR may consider collecting aggregated trade data from counterparties, such as banks, broker-dealers and exchanges. MFA and its members are actively engaged in an effort to identify the types of information and data that would be relevant to a SRR. While we don't have recommendations yet, we are committed to being constructive participants in the regulatory reform discussions and working with policy makers to develop smart regulation. A systemic risk regulator's challenge will be to understand the interplay and use of various financial instruments across classes of institutions to assess the soundness of the financial system. For this reason, we believe it is important that a systemic risk regulator's mandate should be focused on the protection of the financial system and that other regulatory entities should continue to focus on investor protection and market integrity. ------ fcic_final_report_full--93 This guidance applied only to regulated banks and thrifts, and even for them it would not be binding but merely laid out the criteria underlying regulators’ bank examina- tions. It explained that “recent turmoil in the equity and asset-backed securities mar- ket has caused some non-bank subprime specialists to exit the market, thus creating increased opportunities for financial institutions to enter, or expand their participa- tion in, the subprime lending business.”  The agencies then identified key features of subprime lending programs and the need for increased capital, risk management, and board and senior management oversight. They further noted concerns about various accounting issues, notably the valuation of any residual tranches held by the securitizing firm. The guidance went on to warn, “Institutions that originate or purchase subprime loans must take special care to avoid violating fair lending and consumer protection laws and regulations. Higher fees and interest rates combined with compensation incentives can foster predatory pricing. . . . An adequate compliance management program must identify, monitor and control the consumer protection hazards associated with subprime lending.”  In spring , in response to growing complaints about lending practices, and at the urging of members of Congress, HUD Secretary Andrew Cuomo and Treasury Secretary Lawrence Summers convened the joint National Predatory Lending Task Force. It included members of consumer advocacy groups; industry trade associa- tions representing mortgage lenders, brokers, and appraisers; local and state officials; and academics. As the Fed had done three years earlier, this new entity took to the field, conducting hearings in Atlanta, Los Angeles, New York, Baltimore, and Chicago. The task force found “patterns” of abusive practices, reporting “substantial evidence of too-frequent abuses in the subprime lending market.” Questionable prac- tices included loan flipping (repeated refinancing of borrowers’ loans in a short time), high fees and prepayment penalties that resulted in borrowers’ losing the eq- uity in their homes, and outright fraud and abuse involving deceptive or high-pres- sure sales tactics. The report cited testimony regarding incidents of forged signatures, falsification of incomes and appraisals, illegitimate fees, and bait-and-switch tactics. The investigation confirmed that subprime lenders often preyed on the elderly, mi- norities, and borrowers with lower incomes and less education, frequently targeting individuals who had “limited access to the mainstream financial sector”—meaning the banks, thrifts, and credit unions, which it viewed as subject to more extensive government oversight.  Consumer protection groups took the same message to public officials. In inter- views with and testimony to the FCIC, representatives of the National Consumer Law Center (NCLC), Nevada Fair Housing Center, Inc., and California Reinvestment Coalition each said they had contacted Congress and the four bank regulatory agen- cies multiple times about their concerns over unfair and deceptive lending prac- tices.  “It was apparent on the ground as early as ’ or ’ . . . that the market for low-income consumers was being flooded with inappropriate products,” Diane Thompson of the NCLC told the Commission.  The HUD-Treasury task force recommended a set of reforms aimed at protecting borrowers from the most egregious practices in the mortgage market, including bet- ter disclosure, improved financial literacy, strengthened enforcement, and new leg- islative protections. However, the report also recognized the downside of restricting the lending practices that offered many borrowers with less-than-prime credit a chance at homeownership. It was a dilemma. Gary Gensler, who worked on the re- port as a senior Treasury official and is currently the chairman of the Commodity Fu- tures Trading Commission, told the FCIC that the report’s recommendations “lasted on Capitol Hill a very short time. . . . There wasn’t much appetite or mood to take these recommendations.”  CHRG-111shrg53176--36 Chairman Dodd," Thank you very much. Senator Menendez. Senator Menendez. Thank you, Mr. Chairman. Madam Chairlady, I appreciate your statement, particularly where you said if there ever was a time when investors needed and deserved a strong voice and a forceful advocate in the Federal Government, that time is now. And you went on to make a series of positive statements that I think are very powerful, and I appreciate that. In pursuit of those statements and in pursuit of what I asked you during your confirmation process, could you tell me what since your confirmation--and I understand it has been about 2 months or so--what steps you have taken within the Securities and Exchange Commission to increase enforcement and investor protections? Ms. Schapiro. I am happy to do that. We have announced the appointment of a new enforcement Director who begins on Monday, a long-time Federal prosecutor who also ran the Commodities and Securities Task Force in the Southern District of New York. We have retained the Center for Enterprise Modernization to help us overhaul tips and complaints as they come into the agency so that we can have a better handle on and pursue those tips and complaints that are most likely to produce important investor protection enforcement cases for the agency. I ended the penalty pilot program which required that the Commission's enforcement staff pre-negotiate with the Commission before they could suggest a fine against a public company. We have speeded up dramatically the process which authorizes the staff to issue subpoenas in enforcement investigations. We have instituted new training programs. Our hiring now is focused on bringing in people with new skill sets that are in forensic accounting, financial analysis, and trading and operations. We are working on our technology. We have a long way to go there. And we have been very fortunate to have sufficient resources this year to actually do some hiring in the enforcement program, which had declined, as you may know, by about 5 or 6 percent over the last couple of years. So we have a new sense of urgency, and we have started to put into place tools that I think will really result in much more aggressive, much faster enforcement. Senator Menendez. Well, I appreciate that you were ready for my question. Ms. Schapiro. I remember the confirmation hearing. Senator Menendez. And I am happy to hear your answer, to be very honest with you, so I appreciate your progress there. You know, I have told some of those in the investor community that you have only been there 2 months and give it time. Some of them are worried that you will not take the tougher steps that are necessary, and particularly on proxy access. I saw that you mentioned that in your statement. I think Senator Schumer asked you a question on this, and I appreciate what you said. I just want to visit with you on that issue. Is this something that you still remain committed to offering investors, a path to nominate their own candidates for board seats on company proxy ballots? And if so, give us a sense of your timeline for addressing what is a very important investor issue. Ms. Schapiro. I remain very much committed to that, and it is my expectation that--I believe we are tentatively scheduled, the Commission, to consider this issue in May--if not May, June, but certainly in the first half of this year. Senator Menendez. Let me ask you one other question. Have you had the chance to look at the question that many in the Enforcement Division of the SEC move on to be employed by Wall Street firms? And there is some concern that there may be a conflict of interest there. Is that a revolving door, or is that something that you feel is OK? Ms. Schapiro. It is a revolving door. We talked about this at my confirmation hearing, and I made a commitment to talk with the bank regulators who actually have in place some limitations on their examination staff's ability to move freely from the agency to an entity that was otherwise examined by the agency. My counterbalancing concern is that I want to attract the best and the brightest people to the SEC, and if I make it too hard for them to leave, I may not get them in the first place. So from my perspective, it is a balancing act, but it is something that I continue to be committed to looking at and hopefully will get to before terribly long. Senator Menendez. Finally, let me ask you, in light of the recent intense pressure from financial services lobbyists on accounting standard setters over fair value accounting, what will you and the Commission do to ensure that accounting standard setters remain independent so that they can fulfill their mission of serving the needs of investors rather than the short-term interests of some of the industry? Ms. Schapiro. Well, I completely agree that that is a critical function for the SEC to help protect the independence of FASB and the accounting standard setters. And I understand there is tremendous emotion and concern about fair value accounting right now and any impact that it may be having. But our guiding light on this is that investors have told us that fair value accounting is important to them. It is important to their understanding of financial statements and their confidence in the honesty of those statements, and that is critical for them to make decisions about the allocation of capital. So we will continue to be vocal proponents of the independence of FASB. I think it is one of the tremendous strengths of our corporate disclosure system, which is unsurpassed in the world, and largely as a result of having an independent, highly expert body that sets accounting standards. Senator Menendez. All right. Well, so far so good. Thank you, Madam Chairlady. Thank you, Mr. Chairman. " FOMC20070628meeting--111 109,MR. FISHER.," Mr. Chairman, for the sake of consistency, I will refer to my report at the last two meetings on what I call the Goldilocks porridge classification system. I reported last that the international economy was hot, and it remains so as we saw in the excellent slide presentation. I reported that the domestic economy was cold. I believe it remains so, in contrast I think to the previous two interventions, at least from a growth perspective. I also reported that the Eleventh District, home of the NBA champions, vanquishers of the—shall I say “more cavalier”?—Fourth District, [laughter] was just right. It remained so in relative terms. I would say that it has weakened somewhat and cooled somewhat in absolute terms. I just want to comment quickly on the international side of the domestic economy, with the hopes of adding on the margin to the staff’s excellent work in the Greenbook, the Bluebook, and the presentations we had earlier. On the international side, I was pleased that for the first time, at least since I have been a member of this august body, the last minutes reported that the participants expressed “some concern that the strength of global demand could contribute to price pressures at home” and noted “heightened levels of capacity utilization in those countries.” We didn’t talk about capacity utilization in your excellent report. I just wanted to add that our work in Dallas and my CEO contacts continue to validate the phenomenon that we are getting closer to capacity constraints abroad. Research by the Dallas staff, imperfect as it is, confirmed continued growth overseas, resulting in a tightening of capacity around the world, as does the work of JPMorgan, one of the few places in the private sector that we find has spent a good deal of time contemplating this issue. Anecdotal reports from CEOs and CFOs confirm this trend. The rest of the world is reported to be offering more fertile soil for growth and investment, as I think President Moskow pointed out. Shippers tell me that tonnage demand for dry bulk is running at a rate significantly higher than last year, driven by underlying demand outside the United States and despite slower rates of growth of shipments to the United States. You also see this in ship charter rates remaining high. Freight rates, which don’t have a spot market and are much more difficult to measure, appear to be rising in terms of their volume expansion and in shipments to Europe from the Pacific—certainly at a faster rate than those shipments from the Pacific to the United States. One of the largest engineering logistics firms in the world reports that, with the exception of downstream oil and gas investments, power, and an as yet unannounced nuclear power plant that will be built in the United States, their bookings and substantial backlog are “all driven by non-U.S. demand, with cost escalation not only of commodity inputs but of the building blocks and their materials, such as compressors and pumps, and so on, despite the leveling-off of the price of steel.” On the cost side, the head of the United States’ largest importer of consumer goods—without mentioning the name of the retail company—[laughter] reports that cost pressures, as you indicated before in your presentation, coming from China are leading them to “aggressively seek to shift imports to other country sources; in certain sectors, China is becoming too pricey.” At home, business operators to whom I talked are more equivocal about growth prospects for the economy, Mr. Chairman, than I expected. The CEO of one of the largest rails describes the economy as “lethargic.” The CEO of one of the largest IT firms “doesn’t see much sequential growth.” The CEO of an airline, which is not Southwest Airlines, says that “domestically, the seasonally adjusted revenue for the industry line is flat.” A usually ebullient CEO of one of the nation’s largest broadcasters said that “while Q2 is always the slowest quarter, this one is slower than normal.” The CFO of one of the flagship express shippers reports that B2C is growing at 3 to 4 percent rates of volume expansion after several years of 7 to 8 percent rates of growth. But there has been no pickup in the second quarter over the first quarter seasonally adjusted, and “it just seems to be as flat as it can be across the board in all segments.” A leading restaurateur with thirty years in the business notes that he is experiencing a combination of soft top line and rising costs for the first time in his history of operating. For added measure, the CEO of a very large retailer describes demand as “flatter than a pancake.” He and retailers at the higher price points report that shoppers are moving away from the malls to closer-to-home retailers because of transportation costs and financial insecurity. They make fewer trips, and they buy larger volumes per trip. President Yellen, I won’t depress you with the soundings from the two largest public homebuilders. I only half jokingly recommended that they take all sharp objects off their desks and seal their windows. [Laughter] Their situation is reported to have gone from bad to worse. One of the interesting data points is that they represent 27 percent of the homebuilders. The remainder is in private developers’ hands. They suggest that the rapidity with which those private developers report their stress is certainly much less than the publicly held companies, in part because they are afraid of their lenders. Therefore, those shoes have yet to drop, which is not an encouraging sign. On the price front, I hear two common complaints across the board. First, labor remains tight and pricey except in the homebuilding sector, where there has been some relief for obvious reasons. Second—and I think very importantly—food prices driven by corn oil are creating significant cost pressures for all crops, including substitute crops. One of the most astute contacts I have—a leading banker, not a restaurateur or a food person—says that adding ethanol to what he called a tectonic shift in demand for corn, wheat, and other food stuffs stemming from the addition of two billion people—new consumers moving up the food chain (no pun intended)—may place corn at the center of the inflation paradigm in the new century. One commonly voiced concern might influence business investment in capital expenditures. I keep hearing from each CEO, “What are we going to do with our capital?” Reports are increasing of competition from rates on the longer end of the yield curve, above 5 percent. Boards of directors are reluctant to embrace the concept that eighteen months out the U.S. economy’s sun will shine more brightly than it is shining currently, and concerns linger about the costs and the availability of labor for domestic cap-ex purposes. In summary, Mr. Chairman, statistically we may have a second-quarter snapback driven by inventory adjustment as predicted by the Board staff and by my own staff. But my soundings with business leaders—again, no doubt imperfect—provide some cognitive dissonance. I didn’t hear a single one of twenty-six interlocutors who would agree with the baseline case as stated in the Greenbook. Most would agree with the alternative cases that were presented, which were quite thoughtful. I used the term “dyspeptic” in describing the mood of corporate leaders the last time we met. I would say the mood, Mr. Chairman, remains sour, and perhaps it has become more sour. I remain relatively pessimistic on growth and skeptical about inflation and the utility of reliance on the core measurement in guiding our deliberations. Thank you, Mr. Chairman." FOMC20060131meeting--89 87,MS. MINEHAN.," Thank you, Mr. Chairman. There’s not a lot new in New England. So I thought I’d just skip over my usual probably more-lengthy-than-necessary comments on the region. Let me just mention a couple of things, though. Employment growth is still slower, and income growth is still slower than that of the nation. Our regional unemployment rate went up rather than down over the past year, and we have seen some slowing in residential real estate markets. However, surprisingly enough, there seems to be a good deal of optimism in discussions we have had with people about business spending and about commercial real estate markets. So, for the first time in five or six years, we’ve actually had net absorption of space, both downtown and in the suburbs. That situation is making a big difference in the smiles on people’s faces around town. I hope it means that New England is getting back and moving along the same trajectory as the nation. Turning to the nation, we, like most observers, were surprised at the modest growth rate of the economy in the fourth quarter. But we, like almost everybody else, believe that the reduced pace of government spending and smaller-than-expected inventory investment that affected the fourth quarter are likely to be temporary and reflect issues of timing rather than overall economic strength. Thus, we, too, anticipate a slightly stronger first quarter this year than we had before. But our forecast takes the same basic trajectory over the balance of ’06 and ’07—that is, strength in the first half of ’06 and then moderation as the effect of tighter monetary policy, cooling housing markets, and less fiscal stimulus takes hold. This is the same trajectory as that in the Greenbook. However, as we look at GDP, our forecast for ’07 is slower—½ percent or a little bit less— than the forecast for ’06, reflecting an expected outright decline in housing investment. We also see inflation trending off both this year and next, with core PCE inflation never above 2 percent over the two-year period. I mean, not “never,” which is a strong word, but at the points we’re mapping. Some of this difference in price pressures is accounted for by a sense of a somewhat greater supply of labor resources, as reflected in a slightly lower NAIRU and a higher labor force participation rate. Looking at these forecasts and assessing all the data and anecdotal inputs I have received since the last meeting, I am struck by a couple of things. First, these forecasts, and the vast majority of those available from other sources, describe an almost ideal outcome. U.S. demand is strong but slowing, as consumers save more and borrow less. Fiscal stimulus diminishes, business spending remains solid, employment grows, inflation edges off, and foreign growth is spurred by domestic demand at last and acts to create some export growth, though we continue to have a widening current account deficit. If these forecasts were to be realized, it would truly be just about the best of outcomes, and I would agree with President Yellen—a major sweet spot as the Chairman hands over the reins. But that scenario sort of begs the question of risks, both large and small, and how they are balanced. We could certainly be surprised by new energy shocks or geopolitical events of such magnitude to cause financial turmoil and consumer and business retrenchment. We could also witness the turbulence that could accompany a sharp unwinding of the nation’s ever-growing external deficit. But you don’t have to focus on major upsets. Risks of a lesser proportion loom as well. We could very well be wrong about the remaining capacity in labor markets, and the resulting upward pressure on wages and salaries could create a more rapid pace of inflation, particularly given the solid pace of external growth and pressures on a range of commodity prices. To date, however, the growth of wages and salaries has been on the slow side, particularly relative to productivity, and there is little evidence that firms believe they have the pricing power to pass on much more than energy surcharges. Indeed, their profit margins suggest that they have a cushion against increases in input costs. Alternatively, the impact of a cooling housing market could take a larger bite out of consumption than we now expect and cause a greater-than-projected, though welcome, increase in personal saving. This would, of course, slow the economy from baseline and damp price pressures. We haven’t seen this yet either, but it could be just as likely as missing on the inflation side. Thus, as I look at both the upside and downside risks, they seem to me to be more balanced than they have been. As some evidence of this, both the Greenbook and the fed funds futures markets anticipate that policy is near a tipping point—move a bit more now and then retrench in late ’06 or early ’07. I also find myself beginning to wonder about the cost of being wrong. When policy was arguably much more accommodative, it seemed to me that letting inflation get out of hand might be harder to deal with and ultimately more damaging to the economy than if growth slipped a bit. That may still be true. But just as our credibility regarding price stability is important in setting market expectations so, too, is some sense that policy will be supportive of growth when the threat of rising inflation is less imminent. In short, we need to be credible about achieving both our goals. At this point, another nudge toward a policy rate that neither stimulates nor restrains the economy seems appropriate. But the need for further moves seems to me to be increasingly driven by the incoming data." CHRG-111hhrg53246--2 The Chairman," The hearing will begin. We are very happy today to have before us two Presidential appointees who head important agencies: the Chair of the SEC, Mary Schapiro; and the Chair of the Commodity Futures Trading Commission, Gary Gensler. I want to begin by saying I am very happy that both agency heads are here. I strongly believe that if we were starting from scratch, we would not have two separate agencies, with the extent to which they share a mission. But we do have the two separate agencies. There is no point in wasting energy in trying to consolidate them when there would be no chance of that happening. I am encouraged by the fact that the two Chairs here today have, from the beginning of their appointment, worked closely together to try and avoid friction. I have to say that in my view, jurisdictional fights--whether between congressional committees or among congressional committees or between or among Federal agencies--represent Washington at our worst, because the job getting done well ought to be the issue. And people who insist that--people's egos get too tied up with their positions. We are working hard to avoid that. I have also been working closely with Chairman Peterson of the Agriculture Committee because there is a shared jurisdiction here. And we have come to a very good agreement on substance. We had the hearing a week ago with the Secretary of the Treasury an unusual hearing with two major full committees. We intend to keep doing this. There will be some disagreements I believe at the edges--I am reluctant to say margins here because it will get too doubly interpreted--but at the edges, there may be some disagreements. They clearly are outweighed by the substantial agreement that we have. So one of the questions will be on derivatives. Another will be in our jurisdiction which, we should be clear, is primarily the SEC. I appreciate the fact that Mr. Gensler is here. This committee is not the committee of jurisdiction for him. Mr. Peterson, in the spirit of cooperation, understands that. If Mr. Peterson would ask Chair Schapiro to appear before Agriculture, I don't know if you have yet, but we would encourage that as well, because we don't want these jurisdictional issues to be there. With regard to derivatives, I will tell you the conceptual approach that Mr. Peterson and I have taken, Mr. Peterson's committee has the jurisdiction over those for whom hedging is a part of their business. That is, the Agriculture Committee are more the end users of this who have a product to sell and who hedge because they want to deal with price volatility. Our jurisdiction is more over the people who do some of the hedging and are in the financial area. The concept, it seems to me, we ought to be guided by here is what we ought to be thinking about with the financial institution in general. Their role is to be intermediaries, not to be ends in and of themselves. When there is a breakdown in the financial sector, we call it disintermediation. Their job is to be a very important, I was going to say bridge, but bridge understates the creativity involved. There is nothing passive about their role, but their job is to link up essentially people in the end of the economy who are producing goods and services of value and the people with money to invest in them. Their job is to help us in this society agglomerate investment funds so that they are made available to the end users. Obviously, people aren't going to do that unless they make a profit off it. That is a very important and sometimes complex business. People aren't going to make their money available unless they make a profit. But I do think that over the past couple of decades, there are some examples in the financial sector of the means becoming the ends. We have had people tell us that we should not restrict or regulate this or that because then certain entities would not be able to make money. Yes, it is important that they make money as a by-product of the intermediation function they perform. The fact that a given institution won't make money is, in itself, no reason to be opposed to this. And, in fact, activities whose major justification is that they make a profit for some entity unconnected to that intermediation function are not going to be well received by us. I will now add, finally, this is not just about derivatives, we have other issues, this committee has been very interested in the whole question of mark-to-market. The gentleman from Pennsylvania has played a major role there. And there is also continued interest in the question of short sale and corporate governance. I will say that two of our members, the gentleman from California, Mr. Campbell, and the gentleman from Michigan, Mr. Peters, in a bipartisan way, have a great interest in corporate governance issues. And I expect the committee will turn to them this fall after we have done some of the major regulatory stuff. But both of those issues are, particularly the short sale and the mark-to-market, are going to be before us today. The gentleman from New Jersey is recognized for 3 minutes. " FOMC20050920meeting--86 84,MS. MINEHAN.," Thank you very much, Mr. Chairman. For the past couple of meetings I’ve been reporting a lull in economic activity in New England, with little employment growth and muted readings on confidence. Perhaps it was the weather or the impact of the Pentagon’s base realignment and closure (BRAC) proposals on fragile labor markets such as those in Maine but, whatever it was, the region appeared to pull out of it in late July and make some further progress in August. The weather turned bright and sunny, tourists filled the beaches, and hopes for fall tourism rose. Employment surged by more than 13,000 jobs over the two months—that’s big in New England—with most broad industry categories showing gains. Consumer confidence rose, as did business confidence. And the BRAC Commission decided not to follow the September 20, 2005 55 of 117 With the exception of commercial real estate, which remains in the doldrums in Boston, the outlook turned positive overall, with most contacts expecting continued growth for the remainder of 2005 and into 2006. But, of course, this was pre-Katrina. Since that devastating disaster, we’ve tried hard to understand the impact on the region and the nation. Our small business advisory group met as scheduled the week after the hurricane hit, as did our board of directors. At that point things, indeed, seemed gloomy. But as the recovery effort got on a better footing, the underlying resilience of the U.S. economy began to show through. To capture a sense of this changing scene, we made calls late last week to large national retailers and manufacturers headquartered in the First District. Overall there were several common themes. First, most contacts believed the pace of underlying growth had been solid and was likely to stay that way, with some negative hurricane effects this quarter and next but some positive impact thereafter. Indeed, one of our directors whose company is a large manufacturer of semiconductor chips reported worldwide expansion on the heels of a major inventory drawdown during the first half of the year. He reported semiconductor plants everywhere working at an 85 to 90 percent capacity most recently, with strong demands for PCs and hand sets driving chip production. A major regional bank with offices throughout New England and the eastern Midwest and down to Philadelphia reported that given the yield curve, the banking business had been a bit tough, but most bank customers seemed to be doing great. This bank and other employers reported increasing problems in finding skilled labor, even people to fill teller positions. Second, while Katrina’s devastation was terrible, our contacts were especially concerned September 20, 2005 56 of 117 materials and on consumer pocketbooks. Consumer prices in the Boston area were on the rise prior to Katrina, with the region’s headline rate of inflation at 4 percent and core at 3 percent. The biggest area of price growth even then was for fuel and utilities, which rose almost twice as fast as nationwide over the 12 months from July ’04 to July ’05. Given the region’s lack of homegrown energy supplies, its reliance on oil for home heating purposes, and the fact that over half of its electrical generators are now fired by natural gas brought in from outside the region, it seems clear that Boston price growth, driven by energy costs, will continue to outstrip the nation at least through the winter months. Moreover, a pre-Katrina Federal Energy Regulatory Commission report, which I think I’ve talked about before, sees the region’s power supply at risk of widespread brownouts this winter if very cold weather puts stress on generators working at capacity. More broadly, contacts also reported that Katrina’s impact on energy costs may give them cover for price increases that prior to Katrina they’ve lacked the power to make stick. The third common theme related to the possible upside potential for reconstruction- related demand in 2006. Manufacturers of capital goods and consumer durables anticipate a hurricane-related uptick next year. Companies with stores and manufacturing or major distribution points in the hurricane area will have some losses, though most expect them to be covered by insurance. And one large retailer reported that while 7 to 10 out of its 120 stores in the region appeared to be total losses, business was extremely strong at stores just outside the devastated areas, such as in Baton Rouge. That company has been moving employees in the affected areas to stores in areas where business is booming. A supplier of capital goods to the September 20, 2005 57 of 117 other defense spending but they, on balance, thought the probability was that sales to the government and other major contractors might be delayed but not canceled. Finally, there was a theme of outreach and support to employees in the affected area and of helping with disaster recovery. Almost all contacts were doing whatever they could— supplying generators and giving out free medicine and other supplies at evacuation locations. In fact, one drugstore reported that on a daily basis they were handing out about $500,000 worth of free drugs. Supplying water purification equipment and technology to restore communications was also noted. Most companies have continued to pay their personnel and have made efforts to locate them all. Several have made grants to those who lost everything. They expect insurance to cover some of this and perhaps some government reimbursement, but the general attitude seemed to be to do as much as they could and to worry about how to cover the costs later. Just as within the Reserve Banks, the reported generosity of employees in areas beyond the hurricane was amazing, with one major company alone raising at least $17 million in donations to Katrina victims in the reconstruction efforts. So it’s not just government money that’s going into the area. There’s a lot of money from everywhere. In sum, the New England economy seems on a stronger footing than it was earlier in the summer, though the dark clouds of rising energy costs are almost certain to take a bite out of regional pocketbooks, especially if the winter is a cold one as is predicted. This likely would have been the case without Katrina, but the related energy supply shock has made the short-term outlook a bit worse. Aside from energy, the economic effect of Katrina seems likely to be small, September 20, 2005 58 of 117 the outlook could well be positive for the larger retailers and capital goods manufacturers in the region. Turning to the Greenbook, there is more than the usual amount of uncertainty clouding the very near-term outlook. We in Boston, probably like everybody else around the table and elsewhere, have tried our hand at estimating the impact of Katrina. But I can’t imagine that we’re any better at it than the Board staff is. In fact, despite the ups and downs in the quarter-to­ quarter projections, the Q4-over-Q4 GDP growth rates we see for both this year and next differ from the Greenbook only marginally. Our forecast for the unemployment rate is the same as the Greenbook’s and, given that we see a bit more excess labor capacity, we’re a little less pessimistic about increases in core inflation next year. So despite the near-term uncertainty, the medium-term outlook seems less in question. While it seemed impossible a couple of weeks ago, as we were all riveted to the horrifying scenes on national TV, Katrina’s effect on the economy is likely to be very short term—a slower pace now and a somewhat faster pace later as reconstruction takes place. The real issue is what was happening pre-Katrina and how that plays out going forward, and we have a somewhat greater sense of certainty about that picture—or, I should say, the same level of certainty we have about any forecast. Prior to Katrina most everything in the economy seemed to be running on all fours, though not without some causes for concern. Shipments data for July suggested some softness in P&E spending, and inventory rebuilding at the wholesale level was less than expected, but labor markets had shown solid progress. Financial markets had September 20, 2005 59 of 117 External growth was showing signs of life. A slowly closing output gap and higher energy costs raised concerns both about inflation down the road and possible negative effects on spending. Assuming the instant effect of Katrina on energy prices moderates, the broad economic picture seems about the same as it was before the hurricane. That is, the best guess is growth at around potential for the next year or so, lower unemployment as labor markets continue to tighten, and more rather than less pressure on prices. Additional fiscal stimulus from Katrina recovery efforts could be a bit of a wild card here, as there seems to be a growing tendency to throw money at the problem—money we can ill afford, given medium-term deficit expectations. Don’t get me wrong. I think the federal government should help in the rebuilding process, but it has to be done in the context of overall fiscal discipline, which at this point seems a bit lacking. There are surely risks to the forecast. On the downside, the higher energy prices that prevailed before Katrina might have a bigger impact on consumer spending and overall growth, particularly if the supply shock of the hurricane doesn’t ease off as expected. Pre-Katrina shipments and orders data may foretell a flattening rather than a rebound of capital spending. On the other hand, greater fiscal ease will certainly be an additional stimulant, and the hurricane could provide additional cover for more widespread pricing power. Productivity growth has slowed, and we hear reports of labor being hard to find. Combine these reports with the slowly falling unemployment rate, and a surge in wage and salary growth as measured by the ECI, which we haven’t seen yet, may not be far off the mark. As a matter of risk management, it seems to me for now that appearing to be complacent about simultaneous energy demand and supply shocks and diminishing excess capacity might September 20, 2005 60 of 117 greater downside effects if they were to emerge. Those effects could be addressed in a timely way by pausing, but at this point I don’t see a need to take that step. Thus, I’m in favor of continuing our process of removing policy accommodation at this meeting. Incoming economic data could well convince us of the need to stay put some time soon, or we might find it necessary to continue our upward trek longer or at a faster pace than we now are expecting. But at this point, continuing to remove policy accommodation at the “measured pace” we’ve been doing seems about right." FOMC20071211meeting--104 102,MR. HOENIG.," Thank you, Mr. Chairman. I’ll start on the local level. Overall our District economy continues to perform generally well, with ongoing weakness in the housing sector being offset by strength in agriculture, energy, and manufacturing. We have seen some slowing in employment growth over the past few months, but this appears in part to be a supply consideration. Our directors and business contacts continue to report that the labor markets are, in fact, tight across much of the District with shortages of both skilled and unskilled labor and rising wage pressures. There is some reduction in employment, obviously in the housing sector, but that is being offset by these other considerations. I would also note that manufacturing activity remains basically solid, with manufacturers reporting strong export orders. The District’s manufacturing index moved upward in November and still points to moderate growth. In addition, District manufacturers’ capital spending plans actually rose but remained below most of last year’s readings on balance. Turning to spending, general retailers reported a rebound in sales in the latter part of October and early November. Automobile dealers, on the other hand, did report weaker sales and have also become more pessimistic on future sales. Travel and tourism continues to expand in our region, with District airline traffic figures solid, particularly in the Denver area. Likewise, hotel occupancy figures have continued to increase from already strong levels in the region. As has been true for some time, housing activity, as I said, remains soft. For example, the value of residential contracts dropped again in October, and the rate of decline in residential permits steepened again in the past few months in our region. Offsetting this weakness in housing, though, is considerable strength in agriculture and energy. District energy producers continue to expand their capital investments as they are relatively confident that oil and gas prices will remain firm over the longer term. In fact, their capital expenditures have been slowed by a continuing shortage of labor and access to some equipment. Our larger regional banks are still reporting fairly good conditions. The deal flows seem to be coming through, although they are looking at those carefully, just given the environment that they find themselves in on a national level. Finally, price pressures remain mixed. Most businesses report rising input costs, both labor and materials, but differ in their ability to pass those costs on at this point. In transportation, input costs are passed through one for one through customer surcharges. Other businesses continue to find it a little more difficult to pass through the higher costs, but they are beginning to push harder on that as we talk to them. Let me turn to the national outlook. Weakness in incoming data and continuing stress in financial markets obviously are noteworthy, and others have noted that here today. Compared with the Greenbook, however, I see stronger growth in both the short run and the longer run. I expect fourth-quarter growth to be closer to 1 percent, not the zero percent in the Greenbook, and the economy to strengthen slowly through a good part of 2008, starting out slowly obviously and then picking up as we go through the year. Comparing my views with those in Greenbook, the basic difference appears to be largely in some of the judgmental adjustments in the Greenbook concerning spillovers from the housing and financial stress to consumer spending. The current Greenbook forecast, as others have noted, is similar to the Blue Chip Bottom Ten forecast, which suggests to me that it might be better seen as the downside risk outlook not necessarily the most likely outlook at this point. The first half of 2008, as I said, is likely to be somewhat slower than I previously projected because of the high energy prices and continued drag from housing. However, I expect that growth will gradually strengthen as we move toward the end of 2008 and then remain there through the rest of the forecast period. Having said this, I realize that the downside risk to economic activity does remain elevated. The housing slowdown could be deeper and last longer, and continuing financial turmoil could further affect consumer and business spending. However, while financial factors remain a risk to the outlook, in my view the economy, though it will grow below its potential, can weather these forces and is being supported by the policy actions that we have taken in the past two meetings. Against this outlook for economic growth, let me turn now to the inflation outlook. Year- over-year overall and core inflation rates have risen. In addition, Greenbook’s 2008 forecast for overall and core PCE inflation has increased since our last meeting. While below-trend growth in the near term may exert some downward pressure on inflation, the combination of higher prices for oil, commodities, and some services and dollar depreciation should place upward pressure on both overall and core inflation going forward. Over the past several years, the pass-through of dollar depreciation and higher oil prices to inflation has been limited in part because of longer-term inflation expectations remaining, as we said, anchored. My concern is that, if we continue to lower the fed funds rate into a rising inflation environment and the dollar continues to depreciate, these expectations may become unhinged perhaps more quickly than we would like to think. In this environment, I think we should not lose sight of not just the downside risk to the real economy but also some very serious upside risk to inflation. Thank you." FOMC20080430meeting--97 95,MR. LOCKHART.," Thank you, Mr. Chairman. Our high-level view of current circumstances is that the real economy is quite weak, with weakness widespread. The financial markets are turning optimistic, and elevated prices and inflation remain a serious concern. Reports from our directors and District business contacts were broadly similar to the incoming national data and information from other Districts reported in the Beige Book. Observations from such District input support themes in the national data--for example, employment growth is quite weak. In this round of director reports and conversations, I heard an increasing number of reports of holds on hiring and expansion plans. One representative of a major retailer of home improvement goods reported that hiring for seasonal employees will be down 40 percent this spring. This translates to approximately 45,000 jobs. Nonresidential real estate development continues to slow in the District, especially in Florida and Georgia. Of the 18 commercial contractors contacted in April, 15 expect that commercial construction will be weaker for the rest of 2008 than for the same period in 2007, with several predicting even more pronounced weakness in 2009. On the brighter side, Florida Realtors are anticipating that sales over the next few months will exceed year-ago levels, and builders are signaling less weakness than in recent reports. This is a level of optimism we have not heard from Florida for some time. However, housing markets in the rest of the District continue to weaken. We heard several complaints that obtaining financing is a serious problem for commercial and residential developers and consumer homebuyers. In sum, the information from the Sixth District seems to confirm what I believe is the continuing story of the national real economy captured in the Greenbook--that is, shrinking net job creation, developing weakness in nonresidential construction, and a bottom in the housing market still not in sight. In contrast, conditions in the financial markets appear to have improved substantially. As has been my practice, I had several conversations with contacts in a variety of financial firms. There was a consistent tone suggesting that financial markets are likely to have seen the worst. This does not mean that no concerns were expressed. Some contacts had concerns about European banks and credit markets, and concern about the value of the dollar, notwithstanding the recent rally, is coming up in more contexts. Concern was expressed about the dollar's disruptive effect on commodity markets, in turn affecting the general price level--in particular, the effect of high energy prices on a wide spectrum of businesses' consumer products and even on crime rates in rural and far suburban areas related to the theft of copper wiring and piping from vacant homes and air conditioning units. I worry that a narrative is developing along the lines that the ECB is concerned about inflation and the Fed not so much. This narrative encourages a dollar carry trade mentioned, again, by some financial contacts that puts downside pressure on the dollar that potentially undermines both growth and inflation objectives. I remain concerned about the vulnerability of financial markets to a shock or surprise, but overall, my contacts express the belief that conditions are improving. The Atlanta forecast submission sees flat real GDP growth in the first half of 2008, with gradual improvement in the second half. We continue to believe that the drag on economic activity from the problems in the housing and credit markets will persist into 2009. On the inflation front, I am still projecting a decline in the rate of inflation over this year. I've submitted forecasts of declining headline inflation in 2009 and 2010, but I should note that my staff's current projections suggest that improvement to the degree I would like to see may require some rises in the federal funds rate. It is my current judgment that, with an additional 25 basis point reduction in the fed funds rate target, policy will be appropriately calibrated to the gradual recovery of growth and the lowering of the inflation level envisioned in our forecast. This judgment is based on the view that, with a negative real funds rate by some measures, policy is in stimulative territory; that a lower cost of borrowing in support of growth depends more on market-driven tightening of credit spreads than a lower policy rate; that further cuts may contribute to unhelpful movements in the dollar exchange rate; and that extension of the four liquidity facilities may allow us to decouple liquidity actions from the fed funds rate target. In my view, we are in a zone of diminishing returns from further funds rate cuts beyond a possible quarter in this meeting. That said, as stated in the Greenbook, uncertainty surrounding the outlook for the real economy is very high, and the Committee needs, in my view, to preserve flexibility to deal with unanticipated developments. Thank you, Mr. Chairman. " FinancialCrisisReport--17 II. BACKGROUND Understanding the recent financial crisis requires examining how U.S. financial markets have changed in fundamental ways over the past 15 years. The following provides a brief historical overview of some of those changes; explains some of the new financial products and trading strategies in the mortgage area; and provides background on credit ratings, investment banks, government sponsored enterprises, and financial regulators. It also provides a brief timeline of key events in the financial crisis. Two recurrent themes are the increasing amount of risk and conflicts of interest in U.S. financial markets. A. Rise of Too-Big-To-Fail U.S. Financial Institutions Until relatively recently, federal and state laws limited federally-chartered banks from branching across state lines. 2 Instead, as late as the 1990s, U.S. banking consisted primarily of thousands of modest-sized banks tied to local communities. Since 1990, the United States has witnessed the number of regional and local banks and thrifts shrink from just over 15,000 to approximately 8,000 by 2009, 3 while at the same time nearly 13,000 regional and local credit unions have been reduced to 7,500. 4 This broad-based approach meant that when a bank suffered losses, the United States could quickly close its doors, protect its depositors, and avoid significant damage to the U.S. banking system or economy. Decentralized banking also promoted competition, diffused credit in the marketplace, and prevented undue concentrations of financial power. In the mid 1990s, the United States initiated substantial changes to the banking industry, some of which relaxed the rules under which banks operated, while others imposed new regulations, and still others encouraged increased risk-taking. In 1994, for the first time, Congress explicitly authorized interstate banking, which allowed federally-chartered banks to open branches nationwide more easily than before. 5 In 1999, Congress repealed the Glass- Steagall Act of 1933, which had generally required banks, investment banks, securities firms, and insurance companies to operate separately, 6 and instead allowed them to openly merge operations. 7 The same law also eliminated the Glass-Steagall prohibition on banks engaging in proprietary trading 8 and exempted investment bank holding companies from direct federal 2 See McFadden Act of 1927, P.L. 69-639 (prohibiting national banks from owning branches in multiple states); Bank Holding Company Act of 1956, P.L. 84-511 (prohibiting banking company companies from owning branches in multiple states). See also “Going Interstate: A New Dawn for U.S. Banking,” The Regional Economist , a publication of the Federal Reserve Bank of St. Louis (7/1994). 3 See U.S. Census Bureau, “Statistical Abstract of the United States 2011,” at 735, http://www.census.gov/compendia/statab/2011/tables/11s1175.pdf. 4 1/3/2011 chart, “Insurance Fund Ten-Year Trends,” supplied by the National Credit Union Administration (showing that, as of 12/31/1993, the United States had 12,317 federal and state credit unions). 5 Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, P.L. 103-328 (repealing statutory prohibitions on interstate banking). 6 Glass-Steagall Act of 1933, also known as the Banking Act, P.L. 73-66. 7 Gramm-Leach-Bliley Act of 1999, also known as the Financial Services Modernization Act, P.L. 106-102. Some banks had already begun to engage in securities and insurance activities, with the most prominent example at the time being Citicorp’s 1998 merger with the Travelers insurance group. 8 Glass-Steagall Act, Section 16. regulation. 9 In 2000, Congress enacted the Commodity Futures Modernization Act which barred federal regulation of swaps and the trillion-dollar swap markets, and which allowed U.S. banks, broker-dealers, and other financial institutions to develop, market, and trade these unregulated financial products, including credit default swaps, foreign currency swaps, interest rate swaps, energy swaps, total return swaps, and more. 10 CHRG-111hhrg51698--313 Mr. Morelle," Good morning, Chairman Peterson, Ranking Member Lucas, my good friend who hails from Monroe County, Congressman Massa, and Members of the Committee. Thank you for allowing me to testify on a matter key to the stability and well-being of our Nation's financial system. I am New York State Assemblyman Joseph Morelle, testifying on behalf of the National Conference of Insurance Legislators, or NCOIL. I chair the New York State Assembly Committee on Insurance, and serve as Chairman of NCOIL's Financial Services Committee. NCOIL is a multi-state organization comprised of legislators whose main area of public policy concerns insurance. I am pleased to be here today on behalf of NCOIL to discuss the provision of the draft legislation that relates to credit default swaps, and the question of whether and how to regulate this vast and yet somewhat obscure marketplace. On a point of interest, this is the third hearing in which I have participated regarding CDSs. I chaired the first two, one in my capacity as Chairman of the Assembly's Insurance Committee and the other as Chairman of NCOIL's Financial Services Committee. I congratulate the Committee for its commitment to gain and provide a greater understanding of the importance of credit default swaps. Frankly, this discussion is not only appropriate but overdue. It is a discussion with broad implications that go to the fundamental notions of how to effectively regulate and strengthen the free market system. In recognition of this, NCOIL has, like the Committee, turned its attention to the critical questions surrounding CDSs: namely, what manner of financial instrument are they; and, once defined, how shall they be subject to the safeguards that are a fact of life for the buyers and sellers of other similar financial instruments? On behalf of NCOIL, I would like to spend the time that I have been allotted to address these questions and make the following points: CDSs are, in fact, a species of insurance, and naked swaps are more akin to gaming than insurance since they lack insurable interest. The states are best suited to regulate this type of financial guaranty. Relative to the question of whether CDSs are a species of insurance, I point to New York insurance law, section 1101. Insurance contract means any agreement or other transaction whereby one party is obligated to confer benefit or pecuniary value upon another party dependent upon the happening of a fortuitous event in which the insured or beneficiary has or is expected to have at the time of such happening a material interest which will be adversely affected by the happening of such event. Or, as defined in a letter dated February 23rd, 2006, by the GAO, insurance is a contract whereby one undertakes to indemnify another or pay a specified amount upon determinable contingencies. What is a credit default swap? Simply put, it is a financial guaranty against a negative credit event. A negative credit event triggering a CDS payment clearly meets the definition of a fortuitous event, one occurring by chance. In recognition of these facts, the NCOIL Financial Services Committee approved a 2009 committee charge to explore the role of CDSs. And, as I mentioned, NCOIL held a public hearing on January 24th regarding proper marketplace regulation and the role of states in that regulation. NCOIL was represented by legislators from Connecticut, Kentucky, Mexico, North Dakota, and New York. While NCOIL took no formal action at the hearing, members generally agreed on a few broad principles: Credit default swaps are a form of insurance; naked swaps lack insurable interest and more closely resemble directional bets than insurance; state legislators and regulators should be responsible for regulating this market; and the CFMA played an unexpected and negative role in the proper and necessary regulation of swaps. The Financial Services Committee will chart a formal policy course for the organization later this month. The third point, in reference to state primacy in insurance regulation, is rooted in decades of established law. From the McCarran-Ferguson Act of 1945 established state preeminence in the area of insurance legislation and regulation. If we conclude that CDSs are a species of insurance, than regulatory authority must accrue to the states. It is our position that state regulators, with their extensive experience at regulating insurance products, are uniquely qualified to regulate covered CDSs as insurance. They are best able to ensure that the standards set for the insurance industry, such as insurable interest, reserving requirements, and insolvency tests are met by CDS providers. Respectfully, it is our position that Congress erred by preempting the states from regulating CDSs when it passed the CFMA. I would note parenthetically that state regulation of insurance is not to blame for the difficulties at AIG. State subsidiaries of AIG remain solvent and robust. The problem with CDS is deregulation by CFMA. That Act permitted so-called naked swaps, contracts that are speculative in nature and are merely directional bets on market outcomes, to proliferate to the point where it is estimated they now constitute 80 percent of the market. Let me state clearly that, as a matter of philosophy, that we believe that the Committee is on the right track in banning naked swaps. We believe naked CDSs pose a threat to global financial stability. Section 16 of the draft bill makes it a violation of the Commodity Exchange Act to enter into a naked CDS. The language establishes that a party could not enter into such contract unless it had direct exposure to financial loss should the referenced credit event occurred. Furthermore, it defines the term of a contract which ensures a party to the contract against the risk that an entity may experience a loss of value as a result of an event specified in the contract, such as a default or downgrade. We agree that they are insurance, and with the direction and spirit of the legislation now before you, even as we again, respectfully, aver that the implementation of a CDS regulator mechanism should be at the state level. Speaking for myself, however, I would respectfully suggest a broadening of the definition of covered swaps to include those that provide a legitimate hedge against negative credit events. In the domain of naked swaps, there is a critical need to delineate between those that are purely speculative and those in which some direct or indirect exposure ties the buyer to the insured asset. For example, an owner or investor of Ford dealerships may want to hedge their exposure to a negative credit event by purchasing a CDS on Ford. The point of demarcation is not so much one of clothed versus naked, but rather hedge versus speculative. Although CDSs used for hedging activity may not contain as direct an exposure as owning an underlying bond, they may contain an indirect exposure or insurable interest. Such activity can be identified through GAAP accounting, which requires derivative transactions be disclosed as either hedging or speculative. Thus, any prohibition on speculative CDS contracts, in my view, must make this distinction between the clear differences that exist in the inherent interest and nature of contracts that are purely speculative, and those in which there is a demonstrable exposure, direct or indirect, related to the contract buyer. In closing, NCOIL urges that the Committee and Congress consider the question of whether the goals of this draft bill would be best realized and enacted by the states; whether the CFMA was overbroad in its intent and application; and whether the powers removed from state government in relation to the Act might be restored as an avenue to establish what President Obama in his inaugural address called the watchful eye of oversight necessary to ensure that freedom in the financial markets does not degenerate into simple and destructive anarchy. It has been my pleasure, privilege and distinct honor to appear before you today on behalf of NCOIL. I look forward to working with you and the Committee as it moves forward in its review of CDS regulation. Thank you. [The prepared statement of Mr. Morelle follows:]Prepared Statement of Hon. Joseph D. Morelle, Assemblyman and Chairman, Standing Committee on Insurance, New York Assembly; Chairman, Financial Services and Investment Products Committee, National Conference of Insurance Legislators, Troy, NYIntroduction Good afternoon Chairman Peterson, Ranking Member Lucas, and Members of the Committee. Thank you for inviting me to testify before the Committee on a matter key to the stability and well-being not only of our nation's financial system, but, as we have learned, the U.S. economy as a whole. I am New York State Assemblyman Joseph D. Morelle, testifying this morning on behalf of the National Conference of Insurance Legislators (NCOIL). I chair the New York State Assembly's Standing Committee on Insurance and serve as Chairman of NCOIL's Financial Services & Investment Products Committee. NCOIL is a multi-state organization comprising legislators whose main area of public policy concern is insurance. NCOIL legislators chair or serve on committees responsible for insurance legislation in their respective state houses. I am pleased to be here today on behalf of NCOIL to discuss draft legislation titled the ``Derivatives Markets Transparency and Accountability Act of 2009,'' and the greater question of whether and how to regulate this vast and yet somewhat obscure marketplace. On a point of interest, this is the third hearing in which I have participated regarding credit default swaps; I chaired the first two, one in my capacity as Chairman of the Assembly's Insurance Committee and the other as Chairman of NCOIL's Financial Services and Investment Products Committee.Credit Default Swaps as Insurance I greatly appreciate the opportunity to offer testimony in this instance, and heartily congratulate the Committee for its commitment to gain and provide a greater understanding of the importance of credit default swaps. Frankly, this discussion is not only appropriate but, perhaps, sadly overdue. It is a discussion with implications beyond even the very broad horizons of its specific subject matter, for it relates to our fundamental notions of the free market system, a system that has produced wealth more prodigiously than any other but which, absent oversight, can result in the rapid destruction of institutional and personal assets and reverse the hard-won achievements of a generation of Americans. In recognition of this, and particularly in the wake of the near collapse of American International Group, Inc. last September, NCOIL has turned its attention more closely than ever to the critical questions surrounding credit default swaps: namely, what manner of financial instrument are they and, once defined, how shall they be subject to the safeguards that are a fact of life for the buyers and sellers of other similar financial instruments? Why NCOIL? Primarily because of a rising conviction on the part of many observers that credit default swaps constitute a species of insurance, and should be regulated as such. Certainly, I have come to strongly believe that they do indeed meet the standing definition of insurance, and therefore, are best left to the regulatory purview of the states, whether acting collectively or individually. On behalf of NCOIL, I would like to spend the few minutes that I have been allotted to make the following points: (1) credit default swaps are a species of insurance; (2) naked swaps are more akin to gaming than insurance since they lack ``insurable interest''; and (3) that the states are best suited to regulate this type of financial guaranty. Under New York State Insurance Law, 1101: ``Insurance contract'' means any agreement or other transaction whereby one party, the ``insurer,'' is obligated to confer benefit of pecuniary value upon another party, the ``insured'' or ``beneficiary,'' dependent upon the happening of a fortuitous event in which the insured or beneficiary has, or is expected to have at the time of such happening, a material interest which will be adversely affected by the happening of such event. What is a credit default swap? Simply put, a credit default swap is a financial guaranty against a negative credit event. A negative credit event triggering a credit default swap payment certainly meets the definition of a ``fortuitous'' event, one occurring by chance, under New York statute.The NCOIL Process In recognition of these facts, the NCOIL Financial Services and Investment Products Committee last November approved a 2009 Committee charge to ``explore the role of credit default swaps and other financial instruments, develop a position, and communicate to legislative colleagues regarding their public policy implications.'' And as I alluded to earlier in these remarks, the NCOIL Steering--Officers, Chairs, and Past Presidents--and Financial Services Committees convened a public hearing in New York City on January 24th to receive testimony from interested parties regarding proper marketplace regulation and the role of state lawmakers and NCOIL in that regulation. NCOIL was represented by legislators from Connecticut, Kentucky, New Mexico, North Dakota, and New York. New York State Insurance Superintendent Eric Dinallo, and representatives of the International Swaps and Derivatives Association (ISDA), Assured Guaranty and the Association of Financial Guaranty Insurers (AFGI), AARP, the National Association of Mutual Insurance Companies (NAMIC), and the American Academy of Actuaries, among others, testified at the hearing. For your reference, electronic testimony is available on the NCOIL web site at www.ncoil.org. While NCOIL took no formal action at the hearing--the Financial Services Committee will chart a policy course for the organization during the NCOIL Spring Meeting, which will be held here later this month--members generally agreed on a few broad principles, including that: credit default swaps have many of the characteristics of insurance transactions. so-called ``covered'' swaps closely resemble financial guaranty insurance. ``naked'' swaps are very troubling because they lack insurable interest and more closely resemble directional bets than insurance. state legislators and regulators should be responsible for regulating the credit default swap market. by preventing states from enforcing long-standing regulatory statutes, the Commodity Futures Modernization Act played an unexpected and negative role in the proper and necessary regulation of swaps.States as Insurance Regulators This final point, in reference to state primacy in insurance regulation, is rooted in decades of established law. As the distinguished Members of the Committee know, the McCarran-Ferguson Act of 1945 established the state preeminence in the area of insurance regulation. If we conclude that credit default swaps are a species of insurance, and I would strongly argue that they are, then authority in relation to CDS must accrue to state legislatures and state insurance regulators. It is NCOIL's position that state regulators, with their extensive experience at regulating insurance products, are extremely qualified to regulate covered CDS as insurance products. They are best able to ensure that the standards set for the insurance industry at large--such as identification of insurable interests, institutional solvency and the other elements essential to indemnification--are met by CDS providers as well. Thus, respectfully, it is also NCOIL's position that Congress erred when it preempted the states from regulating CDS under our gaming and bucket shop laws when it passed the Commodities Futures Modernization Act of 2000 (CFMA). The CFMA permitted so-called ``naked swaps''--those CDS contracts that are speculative in nature and are merely directional bets on market outcomes--to proliferate to the point where they now constitute 80 percent of the CDS market, which has a notional value of around $54 trillion, with no regulatory framework. Let me state clearly that as a matter of philosophy, the members of NCOIL believe that this Committee is on the right track in banning ``naked'' swaps. We believe that naked CDS pose a dangerous threat to global financial stability.Defining Naked Swaps Section 16 of the draft bill makes it a violation of the Commodity Exchange Act to enter into a ``naked'' credit default swap. The language establishes that a party could not enter into such a contract unless it has a direct exposure to financial loss should the referenced credit event occur. Furthermore, it defines the term ``credit default swap'' as a contract which insures a party to the contract against the risk that an entity may experience a loss of value as a result of an event specified in the contract, such as a default or credit downgrade. Again, NCOIL agrees that credit default swaps are insurance, and with the direction and spirit of the legislation now before you, even as we again, respectfully, aver that the actual implementation of CDS regulatory mechanism should be at the state rather than Federal level. Speaking for myself, however, I would respectfully suggest a broadening of the definition of clothed or covered swaps to include those that provide a legitimate hedge against negative credit events. In the domain of naked swaps, there is a critical need to delineate between those that are purely speculative and those in which some ``stream of commerce'' ties the buyer to the insured asset. In other words, if a CDS were used for hedging rather than speculative purposes, we should consider that the economic utility of such transactions as more than mere speculative activity. For example, an owner or investor of Ford dealerships may want to hedge their exposure to a negative credit event by purchasing a credit default swap on Ford. The point of demarcation, then, is not so much one of ``clothed'' versus ``naked'' swaps, but rather ``speculative'' versus ``hedged.'' Although CDS used for hedging activity may not contain as direct an exposure as owning an underlying bond covered by a CDS, an insurable interest exists which can be identified through GAAP accounting--which requires that CDS be listed as used for hedging or speculative purposes. Thus, any prohibition of speculative CDS contracts, in my view, must make this distinction between the clear differences that exist in the inherent intent and nature of contracts that are purely speculative and those in which there is an arguable ``stream of commerce'' related to the contract buyer and, therefore, whether legitimate and beneficial economic stimulus is derived by permitting such contracts to occur.Conclusion In closing, NCOIL urges that the Committee and Congress consider the question of whether the goals of the transparency and accountability draft would be best realized and enacted by the states; whether the CFMA of 2000 was overbroad in its intent and application; and whether the powers removed from state government in relation to that Act might be restored as an avenue to establish what President Obama in his inaugural address called the ``watchful eye'' of oversight, necessary to ensure that freedom in the financial markets does not degenerate into simple and destructive anarchy. It has been my pleasure, privilege and distinct honor to appear before you today on behalf of NCOIL and all those whose interests are impacted by this Committee's deliberations. We look forward to working with the Committee as it proceeds in its review of credit default swap regulation. I certainly stand ready at this time to answer any questions you may have. Thank you. " CHRG-111hhrg74855--250 Mr. Markey," We are going to hold you to 5 minutes each of you in this round so please be aware of that just because of the roll calls that are pending out on the House floor and our need to be able to telescope this process in order to make sure that all of the members get a chance to ask questions so none of that came out of your time, Ms. Moler, please begin. Ms. Moler. Thank you very much, Mr. Chairman, Mr. Upton and members of the subcommittee. It is, believe it or not, a pleasure to be back. I guess it is like a moth in the flame. Exelon is an electric and gas public utility holding company headquartered in Chicago. Our subsidiary is Con-Ed in Chicago and PECO Energy in Philadelphia, serve 5.4 million customers or about 12 million people, more than any other company. Our competitive generation affiliate, Exelon Generation, owns, operates or controls about 30,000 megawatts of generation. Our nuclear fleet is the largest in the country and the third largest in the world. I am testifying today on behalf of Edison Electric Institute. EEI, as you know, is the trade association of U.S. shareholder-owned electric companies. My testimony today details why utilities use over-the-counter derivatives products, examines the costs to consumers of duplicative regulation of OTC derivatives transactions and encourages the subcommittee to support amendments to H.R. 3795 to clarify that FERC has and should remain exclusive, should retain, excuse me, exclusive jurisdiction over organized electricity markets and transactions. We look at H.R. 3795 from the perspective of our customers who are electric and natural gas consumers. We support the goal of regulatory reform but do not support the current version of the bill. It would result in costly, duplicative and overlapping regulation over organized energy markets and higher costs for our customers. In our view, subjecting OTC transactions to additional regulations, two regulators is simply not warranted because they do not involve or cause the type of systemic risk that the legislation is theoretically designed to deal with. EEI, EPSA, American Gas Association and 69 other organizations have sent a letter to the members articulating what we believe would be an effective approach to regulating OTC products. In short, the energy industry is united in our belief that this legislation should recognize the clear authority of FERC or the Public Utility Commission of Texas in the case of ERCOT and exempt all Regional Transmission Organizations or Independent System Operators, products and services from regulation by the CFTC. Why? It is simple. Subjecting these types of transactions to additional layers of regulation would be a duplication of effort, impose potential conflicts and gender additional litigation where you have two agencies looking at the same types of transactions and both of them trying to assert jurisdiction over them, and most importantly cost our customers billions of dollars in higher rates. Your invitation asked me to focus on organized energy markets, the RTOs. Over 65 percent of Americans, 134 million customers live in regions served by RTOs and ISOs. It is not a trivial problem. These independent entities operate the electric road and operate markets. We need to make sure that FERC retains effective authority to regulate RTOs and ISOs. I do not believe that the legislation is clear on this subject. It gives under the Commodities Exchange Act where the CFTC has authority over things they maintain, ``exclusive authority.'' I don't see how you can have two exclusive bosses in this area. Nor, I might add, do I believe that it can be dealt with by a Memorandum of Understanding between the two agencies because if CFTC has the exclusive authority over these types of transactions, that would at least arguably trump the FERC's jurisdiction. I think that can only be sorted out by statute. We believe that these transactions such as FTRs, swaps, excuse me, and other types of transactions that routinely entered into as part of RTOs are important consumer protection mechanisms. They reduce electricity costs to our customers and the authority of the FERC to regulate them should not be in doubt. We believe that any proposed legislation should clarify that FERC is the sole regulatory authority governing the organized RTO or ISO markets and the transactions entered therein. I appreciate very much your offer to have me testify today and would be happy to try to answer any questions. [The prepared statement of Ms. Moler follows:] [GRAPHIC] [TIFF OMITTED] T4855A.019 FOMC20071031meeting--37 35,MR. HOENIG.," Thank you, Mr. Chairman. I will talk a little about the District this time. It continues to perform well, with ongoing weakness in the housing sector offset by strength in agriculture and energy. As has been true for a while, construction activity remains mixed, with weakness in residential construction offset by continued strength in commercial construction. In terms of residential construction, both the number of single-family permits and the value of residential construction contracts declined in September, and home inventories rose with slower home sales, as is happening elsewhere. However, District home prices measured by the OFHEO index edged up in the second quarter and remain stronger than in the nation as a whole. On the commercial side, after a robust spring, construction activity has slowed but has remained solid. Energy regions, such as Wyoming, report strong activity. But even in the non-energy regions, activity remains solid. Office vacancy rates were stable, and absorption rates declined. In addition, developers reported more-stringent credit standards, and they expected credit availability to remain tight. Consumer spending softened in September. Mall traffic was flat, and retailers reported that sales were down slightly. In addition, auto dealers reported that sales fell further in September as high gasoline prices cut demand for our SUV sales and for vans. In other areas, though, activity appears to remain at least moderate. For example, travel and tourism remain healthy. In addition, manufacturing activity picked up slightly in October. Solid increases among producers of durable goods offset a weakening among producers of food, chemical, and other nondurable goods. Even so, purchasing managers remain optimistic about future activity, as most forward-looking indexes strengthened or held steady. Finally, we continue to see strength in agriculture and energy. District producers are selling a bumper crop at high prices as poor crop conditions in the rest of the world trimmed global inventories and boosted export demand. In addition, robust meat demand kept cattle and hog prices above breakeven levels. The sharp rise in farm income led to a surge in farm capital spending in the third quarter and is expected to rise further in the fourth quarter. Turning to the national economy, my outlook for growth is basically unchanged from our last meeting. Generally speaking, economic indicators have been a bit stronger over the intermeeting period, as described here, but financial markets continue, obviously, to exhibit some stress. The senior loan officer survey suggested moderate tightening of credit conditions. That is consistent with our estimates of slower growth in the current quarter. As before, though, I remain more optimistic than the Greenbook about both the near-term outlook and the longer-run growth potential for the economy. Specifically, I think growth over the forecast period will average about 2½ percent. My forecast is based on maintaining the fed funds rate at its current level of 4¾ percent through the middle of next year before reducing it to its more neutral level late next year or early 2009. With regard to trend growth, I continue to expect a decline in potential growth from about 2¾ percent to 2½ percent by 2010. Disappointing housing data have led me to mark down my near-term forecast for residential investment. I continue to expect that residential investment will decline through the first part of next year before turning up in the second half. Also, after strong growth in the first half of this year, nonresidential construction is likely, perhaps, to slow significantly over the next year and a half. Supporting growth in the near term will be moderate growth in consumer and government spending along with strength in exports driven by the lower dollar and robust foreign growth. Turning to the risks to the outlook, I believe they remain on the downside as far as real output but have not worsened noticeably since our last meeting, especially with that action. I believe that construction, both residential and nonresidential, and slower consumer spending from higher energy prices constitute the main risks to the outlook. With regard to the inflation outlook, recent data on core inflation continue to be, as noted here, favorable. I expect core PCE inflation to average about 1.8 percent over the forecast period—remember, assuming no change in the fed funds rate—but I also expect that overall PCE inflation next year will moderate as the effects of higher food and energy prices wear off. However, I do remain concerned about the upside risk to inflation as well. Greater dollar depreciation and higher energy and commodity prices, along with greater pass-through from all three, could push inflation higher for a period of time. In addition, I am also concerned about the implications of the gradual upcreep in the TIPS measures of expected inflation for the long-run path, and I am receiving more anecdotal information, in discussions with individuals in our region, about a change in expectations about inflation as they continue to deal with some rising prices in materials and other goods. Thank you, Mr. Chairman." FinancialCrisisReport--37 Some investors purchased large numbers of these CDS contracts in a concerted strategy to profit from mortgage backed securities they believed would fail. Some investment banks took the CDS approach a step further. In 2006, a consortium of investment banks led by Goldman Sachs and Deutsche Bank launched the ABX Index, which created five indices that tracked the aggregate performance of a basket of 20 designated subprime RMBS securitizations. 63 Borrowing from longstanding practice in commodities markets, investors could buy and sell contracts linked to the value of one of the ABX indices. Each contract consisted of a credit default swap agreement in which the parties could essentially wager on the rise or fall of the index value. According to a Goldman Sachs employee, the ABX Index “introduced a standardized tool that allow[ed] clients to quickly gain exposure to the asset class,” in this case subprime RMBS securities. An investor – or investment bank – taking a short position in an ABX contract was, in effect, placing a bet that the basket of subprime RMBS securities would lose value. Synthetic CDOs provided still another vehicle for shorting the mortgage market. In this approach, an investment bank created a synthetic CDO that referenced a variety of RMBS securities. One or more investors could take the “short” position by paying premiums to the CDO in exchange for a promise that the CDO would pay a specified amount if the referenced assets incurred a negative credit event, such as a default or credit rating downgrade. If that event took place, the CDO would have to pay an agreed-upon amount to the short investors to cover the loss, removing income from the CDO and causing losses for the long investors. Synthetic CDOs became a way for investors to short multiple specific RMBS securities that they expected would incur losses. Proprietary Trading. Financial institutions also built increasingly large proprietary holdings of mortgage related assets. Numerous financial firms, including investment banks, bought RMBS and CDO securities, and retained these securities in their investment portfolios. Others retained these securities in their trading accounts to be used as inventory for short term trading activity, market making on behalf of clients, hedging, providing collateral for short term loans, or maintaining lower capital requirements. Deutsche Bank’s RMBS Group in New York, for example, built up a $102 billion portfolio of RMBS and CDO securities, while the portfolio at an affiliated hedge fund, Winchester Capital, exceeded $8 billion. 64 Other financial firms, including Bear Stearns, Citibank, JPMorgan Chase, Lehman Brothers, Merrill Lynch, Morgan Stanley, and UBS also accumulated enormous propriety holdings in mortgage related products. When the value of these holdings dropped, some of these financial institutions lost tens of 63 Each of the five indices tracked a different tranche of securities from the designated 20 subprime RMBS securitizations. One index tracked AAA rated securities from the 20 subprime RMBS securities; the second tracked AA rated securities from the 20 RMBS securitizations; and the remaining indices tracked baskets of A, BBB, and BBB rated RMBS securities. Every six months, a new set of RMBS securitizations was selected for a new ABX index. See 3/2008 “Understanding the Securitization of Subprime Mortgage Credit,” prepared by Federal Reserve Bank of New York, Report No. 318, at 26. Markit Group Ltd. administered the ABX Index which issued indices in 2006 and 2007, but has not issued any new indices since then. 64 For more information, see Chapter VI, section discussing Deutsche Bank. billions of dollars, 65 and either declared bankruptcy, were sold off, 66 or were bailed out by U.S. taxpayers seeking to avoid damage to the U.S. economy as a whole. 67 CHRG-111shrg52619--211 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM GEORGE REYNOLDSQ.1. It is clear that our current regulatory structure is in need of reform. At my subcommittee hearing on risk management, March 18, 2009, GAO pointed out that regulators often did not move swiftly enough to address problems they had identified in the risk management systems of large, complex financial institutions. Chair Bair's written testimony for today's hearing put it very well: `` . . . the success of any effort at reform will ultimately rely on the willingness of regulators to use their authorities more effectively and aggressively.'' My questions may be difficult, but please answer the following: If this lack of action is a persistent problem among the regulators, to what extent will changing the structure of our regulatory system really get at the issue?A.1. We do not perceive that lack of action is a problem among the state credit union regulators. In fact, the authority given to state regulators by state legislatures allows state regulators to move quickly to mitigate problems and address risk in their state-chartered credit unions. NASCUS \1\ believes that the dual chartering structure which allows for both a strong state and federal regulator is an effective regulatory structure for credit unions.--------------------------------------------------------------------------- \1\ NASCUS is the professional association of state credit union regulatory agencies that charter, examine and supervise the nation's 3,100 state-chartered credit unions. The NASCUS mission is to enhance state credit union supervision and advocate for a safe and sound credit union system.--------------------------------------------------------------------------- State and federal credit union regulators regularly exchange information about the credit unions they supervise; it is a cooperative relationship. The Federal Credit Union Act (FCUA) provides that ``examinations conducted by State regulatory agencies shall be utilized by the Board for such purposes to the maximum extent feasible.'' \2\ Further, Congress has recognized and affirmed the distinct roles played by state and federal regulatory agencies in the FCUA by providing a system of consultation and cooperation between state and federal regulators. \3\ It is important that all statutes and regulations written in the future include provisions that require consultation and cooperation between state and federal credit union regulators to prevent regulatory and legal barriers to the comprehensive information sharing. This cooperation helps regulators identify and act on issues before they become a problem.--------------------------------------------------------------------------- \2\ 12 U.S. Code 1781(b)(1). \3\ The ``Consultation and Cooperation With State Credit Union Supervisors'' provision contained in The Federal Credit Union Act, 12 U.S. Code 1757a(e) and 12 U.S. Code 1790d(l).--------------------------------------------------------------------------- State regulators play an important role in protecting the safety and soundness of the state credit union system. It is imperative that any regulatory structure preserve state regulators role in overseeing and writing regulations for state credit unions. In addition, it is critical that state regulators and National Credit Union Administration (NCUA) have parity and comparable systemic risk authority with the Federal Deposit Insurance Corporation (FDIC).Q.2. Along with changing the regulatory structure, how can Congress best ensure that regulators have clear responsibilities and authorities, and that they are accountable for exercising them ``effectively and aggressively''?A.2. To ensure a comprehensive regulatory system, Congress should consider the current dual chartering system as a regulatory model. Dual chartering and the value offered to consumers by the state and federal systems provide the components that make a comprehensive regulatory system. Dual chartering also reduces the likelihood of gaps in financial regulation because there are two interested regulators. Often, states are in the first and best position to identify current trends that need to be regulated and this structure allows the party with the most information to act to curtail a situation before it becomes problematic. Dual chartering should continue. This system provides accountability and the needed structure for effective and aggressive regulatory enforcement. The dual chartering system has provided comprehensive regulation for 140 years. Dual chartering remains viable in the financial marketplace because of the distinct benefits provided by each charter, state and federal. This system allows each financial institution to select the charter that benefits its members or consumers the most. Ideally, for any system, the best elements of each charter should be recognized and enhanced to allow for competition in the marketplace so that everyone benefits. In addition, the dual chartering system allows for the checks and balances between state and federal government necessary for comprehensive regulation. Any regulatory system should recognize the value of the dual chartering system and how it contributes to a comprehensive regulatory structure. Regulators should evaluate products and services based on safety and soundness and consumer protection criterion. This will maintain the public's confidence.Q.3. How do we overcome the problem that in the boom times no one wants to be the one stepping in to tell firms they have to limit their concentrations of risk or not trade certain risky products? What thought has been put into overcoming this problem for regulators overseeing the firms? Is this an issue that can be addressed through regulatory restructure efforts?A.3. The current credit union regulatory structure appropriately provides state credit union regulators rulemaking and enforcement authority. This authority helps state regulators respond to problems and trends at state-chartered credit unions and it places them in a position to help state credit unions manage risks on their balance sheets. It is sometimes difficult, particularly during a period of economic expansion to motivate financial institutions to reduce concentration risk when institutions are strongly capitalized and have robust earnings. This is, nevertheless, the appropriate role of a regulator and it is not really a factor that can be addressed through regulatory restructuring. It can only be impacted by having effective, experienced and well trained examiners that are supported in consistent manner by experienced supervisory management.Q.4. As Mr. Tarullo and Mrs. Bair noted in their testimony, some financial institution failures emanated from institutions that were under federal regulation. While I agree that we need additional oversight over and information on unregulated financial institutions, I think we need to understand why so many regulated firms failed. Why is it the case that so many regulated entities failed, and many still remain struggling, if our regulators in fact stand as a safety net to rein in dangerous amounts of risk-taking?A.4. The current economic crisis and resulting destabilization of portions of the financial services system has revealed certain gaps and lapses in overall regulatory oversight. Currently, state and federal regulators are assessing those lapses, identifying gaps, and working diligently to address weaknesses in the system. As part of this process, it is also important to recognize regulatory oversight that worked, whether preventing failure, or identifying undue risk in a manner that allowed for an orderly unwinding of a going concern. To the extent that regulators miscalculated a calibration of acceptable risk, as opposed to undue risk, it may be safe to conclude that undue reliance was placed on underlying market assumptions that failed upon severe market dislocation.Q.5. While we know that certain hedge funds, for example, have failed, have any of them contributed to systemic risk?A.5. NASCUS members do not regulate hedge funds. The answers provided by NASCUS focus solely on issues related to our expertise regulating state credit unions and issues concerning the state credit union system.Q.6. Given that some of the federal banking regulators have examiners on-site at banks, how did they not identify some of these problems we are facing today?A.6. Given NASCUS members regulatory scope, this question does not apply. The answers provided by NASCUS focus solely on issues related to our expertise regulating state credit unions and issues concerning the state credit union system. NASCUS background: The NASCUS, \4\ mission is to enhance state credit union supervision and advocate for a safe and sound credit union system. NASCUS represents the interests of state agencies before Congress and is the liaison to federal agencies, including the National Credit Union Administration (NCUA). NCUA is the chartering authority for federal credit unions and the administrator of the National Credit Union Share Insurance Fund (NCUSIF), the insurer of most state-chartered credit unions.--------------------------------------------------------------------------- \4\ NASCUS is the professional association of state credit union regulatory agencies that charter, examine and supervise the nation's 3,100 state-chartered credit unions.--------------------------------------------------------------------------- Credit unions in this country are structured in three tiers. The first tier consists of 8,088 natural-person credit unions \5\ that provide services to consumer members. Approximately 3,100 of these institutions are state-chartered credit unions and are regulated by state regulatory agencies. There are 27 \6\ retail corporate credit unions, which provide investment, liquidity and payment system services to credit unions; corporate credit unions do not serve consumers. The final tier of the credit union system is a federal wholesale corporate that acts as a liquidity and payment systems provider to the corporate system and indirectly to the consumer credit unions.--------------------------------------------------------------------------- \5\ Credit Union Report, Year-End 2008, Credit Union National Association. \6\ There are 14 state-chartered retail corporate credit unions and 13 federally chartered corporate credit unions.--------------------------------------------------------------------------- ------ FOMC20060328meeting--92 90,MR. GUYNN.," Thank you, Mr. Chairman. I share the view of most that the slow growth in the fourth quarter of last year was, in fact, a temporary aberration that will be offset by strong first- quarter growth in the neighborhood of 4½ to 5 percent. Auto sales have already bounced back, and defense spending is unlikely to continue declining. And business investment spending looks to be strong. Like most outside forecasters and the Greenbook, our Atlanta BVAR and DSGE models are projecting that GDP growth will be around 3¼ percent or so in the second half of 2006 and into 2007. Our models also have core PCE inflation holding between 1¾ and 2 percent and the fed funds target rate peaking at about 5 percent. Although I would characterize this outlook as solid, and even encouraging, some significant uncertainties and risks surround the outlook. I’d like to comment on several of those risks and, in doing so, include some observations from our region’s experience and contacts that seem to be relevant. The first set of uncertainties in my own mind revolves around how the residential real estate adjustment will unfold—something Dave and Janet have already talked about. Although the decline in construction and sales and the slowing in price appreciation seem to be orderly so far, there clearly could be a more disruptive set of changes that we do not now foresee. As I reported at our last meeting, we are now seeing some significant downward price adjustments and cancellation of some major condominium projects in our red-hot, speculation-driven coastal Florida markets. At the same time, other markets are seeing more-modest adjustments, and it appears that builders are cutting back in response to demand signals. I don’t mean to imply that a major pullback in real estate would cause a precipitous drop in economic growth—that would be inconsistent with most of our simulations and analyses. Yet growth in that sector could slow even more than we now expect, especially if mortgage rates should continue to increase. Adding to the unknowns with regard to residential construction is the timing of the kick that will be associated with Hurricane Katrina rebuilding. The Greenbook has built in a measurable near-term contribution from that reconstruction, but I continue to believe that we’re going to be surprised at how protracted that rebuilding is going to turn out to be. That brings me to a second concern—our admitted uneasiness with how well we can explain the behavior of long-term interest rates in this cycle, something we talked about earlier but have not done so much recently. Despite the new academic look that I’m working on, [laughter] I don’t think I can add any genius to the possible explanations already offered by the current and the past Chairmen, Vice Chairman Geithner, and others. But I was here at the FOMC table for the heyday of the so-called new economy, when we thought for quite a while that we could explain some significantly different behavior, some important elements of our economy, only to learn in hindsight that some of those phenomena turned out to revert to past relationships and past experience. Clearly, an unexpected uptick in the long-term rates, including mortgage rates, would not come as a complete surprise. It would affect both household and business spending. I see it as a risk that we should be careful not to dismiss too quickly. The two uncertainties I’ve just talked about represent downside risks to output. There’s another development that I think tends to offset those downside worries. Job growth has been strong; in fact, in our region we are hearing more and more reports of shortages of new workers in a number of industries and with certain job skills. At the same time, much has been made of stagnant wages for some workers. My staff has analyzed data on the wages and on the types of jobs being created relative to those being destroyed and has found that, although the wage dynamics did deteriorate between 2001 and 2003, wage relationships have since returned to historical norms. Moreover, business surveys from both the National Association for Business Economics and the National Federation of Independent Businesses suggest that, although firms put a lid on wage increases during the 2001-04 period, the net projection of firms that are raising wages has become more widespread, and it is now about the same as it was during the 1990s. This rebound suggests to me that wage growth from net job creation is now lending more support to spending than it has in the recent past, taking some of the pressure off other sources of funding, such as home equity extraction. As our recent post-FOMC meeting statements have indicated, upside inflation risks also remain. It’s still not clear to me that we’ve seen the full long-term adjustment by households and businesses to elevated energy prices. I continue to hear reports of more energy and other commodity cost pass-throughs that people would like to make, and reports of rollbacks of earlier energy surcharges are few and far between. Although I’m not a proponent of the NAIRU way of thinking about the relationship between unemployment and expected pressure on inflation—a relationship that is hard to see in any recent empirical data—we do need to watch more carefully than ever for new bottlenecks and price pressures in a solid expansion that is now four years old. In fact, even though I see that the risk at our current and expected policy setting is getting close to balance, as a good central banker I remain at least a bit more concerned about the potential for inflation to edge somewhat higher. I will not argue tomorrow for a significantly tighter policy to help push the inflation rate moderately down, within the range most of us have said we view as our objective. But I do not think we want to risk a higher level of inflation at this point and risk having inflation expectations begin to deteriorate. I believe the kinds of uncertainty that I’ve just talked about demonstrate that our reading on the path of policy and the proper policy setting over the period ahead has become more difficult to get just right and more difficult to explain. And I think that suggesting that future policy action will be determined by the evolution of the economic outlook lends credence to the spirit of the recent post-meeting statements. Thank you, Mr. Chairman, and welcome back." FinancialCrisisReport--625 A third factor indicating the net short positions were proprietary in nature was how long Goldman held onto them. For example, the Mortgage Department maintained a $9 billion ABX AAA short for six to nine months in 2007. While that short was initially used to hedge certain long positions held by various Mortgage Department desks, it was retained even after those long positions were sold off or written down. Mr. Sparks later described the ABX AAA short as “disaster insurance” in case the subprime market collapsed. 2809 The Subcommittee found no evidence indicating that the $9 billion short was maintained over such a long period of time to accommodate client demand. A fourth factor indicating Goldman’s net short positions were proprietary in nature was the Mortgage Department’s affirmative effort to solicit clients to buy RMBS and CDO assets in its inventory. 2810 The Subcommittee saw no evidence that this sales activity was undertaken to accommodate client demand; to the contrary, the documents show that the Mortgage Department’s sales efforts took place amid a deteriorating mortgage market and waning investor interest in mortgage related products. 2811 Still another indicator that the Mortgage Department’s net shorts were proprietary was that, when clients expressed interest in acquiring certain short positions, Goldman at times refused to accommodate their requests. For example, in June 2007, when Goldman began building its second large net short position, its Mortgage Department refused client requests to purchase the short side of CDS contracts with Goldman: “Really don = t want to offer any [shorts to customers]” and “too late!” 2812 On another occasion in March 2007, a Goldman employee 2808 These totals include Goldman’s net shorts from both its mortgage trading and CDO securitization activities. 2809 Subcommittee interview of Daniel Sparks (4/15/2010). 2810 See, e.g., documents cited in Section C(4)(b) (sales efforts to reduce Goldman’s $6 billion long position) and Section C(5)(a)(iii) (sales efforts to reduce Goldman-originated RMBS and CDO securities), above. 2811 See, e.g., emails noting difficult sales environment. 1/31/2007 email from Mr. Sparks to Mr. Montag, “MTModel,” Hearing Exhibit 4/27-91 (making “lemonade out of some big old lemons”); 3/9/2007 email from Mr. Sparks to Mr. Schwartz and others, GS MBS-E-010643213, Hearing Exhibit 4/27-76 (“team is working incredibly hard and is stretched”); 3/27/2007 email from Mr. Ostrem to Mr. Bieber, GS MBS-E-000907935, Hearing Exhibit 4/27-172 (congratulating Mr. Bieber for “an excellent job pushing to closure these deals in a period of extreme difficulty”); 6/11/2007 email from Mr. Montag, GS MBS-E-001866144 (after a sale of Timberwolf securities, telling the sales team they had done an “incredible job B just incredible”). 2812 6/10/2007 email from Michael Swenson, “CDS on CDOs,” GS MBS-E-012568089; 6/13/2007 email from sales, “CDO protection,” GS MBS-E-012445931. See also 9/7/2007 Fixed Income, Currency and Commodities Annual Individual Review Book, Salem 2007 Self-Review, GS-PSI-03157 at 71 (in his self-evaluation Mr. Salem told Goldman’s Chief Risk Officer Mr. Broderick that the Mortgage Department was no longer buying subprime assets: “Just fyi not for the memo, my understanding is that desk is no longer buying subprime. (We are low balling on bids.).” 2813 Refusing client requests and lowballing bids to avoid purchases indicate that the Goldman Mortgage Department was not acting as a market maker to accommodate client demand. FOMC20080430meeting--110 108,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. In terms of markets, Fed credibility, and negative surprises on the data relative to our forecasts, I think this has been the best intermeeting period in a long time. The markets reflect increased confidence that policy will be effective in mitigating the risks both of a systemic financial crisis and of a very deep, protracted recession. We have seen a substantial upward movement in the expected path of the fed funds rate and in real forward rates, significant diminution in the negative skewness in fed funds rate expectations, and a significant move down in a range of different measures of credit risk premiums, and markets have been pretty robust despite bad news over the past few weeks or so. Medium- and long-term expectations in TIPS have moved down, and we have had a very important and substantial additional wave of inflow of equity into the financial system. Our forecast, though, is roughly the same as it was in March, and it is broadly similar to the path outlined in the Greenbook. We expect economic activity to follow a path somewhere between the last downturn--a relatively mild downturn--and that of 1990. We expect underlying inflation to moderate somewhat over the forecast period to something below 2 percent. We see the risks to the growth forecast still skewed to the downside, though somewhat less so than in March, and we see the risks to the inflation outlook as broadly balanced. Uncertainty around both paths, though, is unusually high. I want to make four points. First, on economic growth, again, I still think we face substantial risk in this adverse self-reinforcing interaction among falling house prices, slower spending, and financial headwinds. Even with the very substantial adjustment in housing construction that has already occurred and even if demand for housing stays stable at these levels, we still have several quarters ahead of us before the decline in housing prices starts to moderate. A further falloff in aggregate demand during this period would raise the prospect of a much larger peak-to-trough decline in housing prices, with higher risk of larger collateral damage to confidence, spending, credit supply, et cetera. Weakness, as the Chairman has reminded us several times over the past few years, tends to cumulate and spread in these conditions, and weakness may only just be beginning outside of housing. The saving rate here may have to rise substantially further. The world is behind us in this cycle, and it is likely to slow further, diminishing potential help from net exports going forward. Second, financial conditions are, I think, still very fragile. The financial system as a whole still looks as though it is short of the capital necessary to support growth in lending to creditworthy households and borrowers. Parts of the system still need to bring leverage down significantly. Liquidity conditions in some markets are still impaired; securitization markets are still essentially shut. I think the markets now reflect too much confidence in our willingness and ability to prevent large and small financial failures. We are going to disappoint them on the small ones, which may increase the probability they attach to the large. At least I hope we disappoint them on the small ones. Third, I think the inflation outlook, as many of you have said, still has this very uncomfortable feel to it--very high headline inflation, very high readings on the Michigan survey, and the dollar occasionally showing the spiral of feeding energy and commodity prices and vice versa. I sat next to Paul Volcker when he gave his speech in New York the other day, and he said that the world today feels as it did in the 1970s. I was alive in the 1970s, but only just. [Laughter] But I think it is better than that. It has to be better than that. Core has come in below expectations. David is not going to explain all of that away by these temporary, reversible factors. You have all acknowledged that there is somewhat of an improvement in inflation expectations at medium-term horizon. It is very important that you have not seen any material pressure in broad measures of labor compensation. Profit margins are coming down, but they are still unusually high. The path of output relative to potential, both here and around the rest of the world, is going to significantly diminish pressure on resource utilization going forward even if you have other forces that push up demand for energy and food secularly. I think it is worth remembering that we had a very, very large sustained relative price shock in the years preceding this downturn, with very little pass-through to core inflation. In fact, in many ways, core inflation moderated over that period with output to potential much tighter. Fourth, on monetary policy, it seems to me that we are very close to a level that should put us in a good position to navigate these conflicting pressures ahead. What matters for the outlook is the relationship between the real fed funds rate and our estimates of equilibrium. Although we can't measure the latter with any precision, those estimates of equilibrium have to be substantially lower than normal because of what is happening in financial markets. The Greenbook and Bluebook presentations suggest that the real fed funds rate now is about at equilibrium. You can look at it through a number of prisms and see some accommodation--see the real fed funds rate somewhat below equilibrium now. We won't know the answer until this is long over. I think that we are probably now within the zone where we are providing some insurance against the risk of a very bad macroeconomic financial outcome without creating too much risk of an inflation spiral. We should try for an outcome tomorrow in our action and in our statement that is pretty close to market neutral. One final point about the future. What strikes me as most implausible in our forecast in New York, and I think in the average of our submissions, is the speed with which we expect to return to growth rates that are close to estimates of long-term potential. A more prudent assumption might be for a more protracted period of below-trend growth for a bunch of familiar reasons. I don't know if that is the most likely outcome, but it is a plausible and realistic outcome. I don't think we should be directing policy at trying to induce an unrealistically quick return to what might be considered more-normal growth rates over time. Thank you. " CHRG-111hhrg52397--230 Mr. Duffy," Thank you, Chairman Kanjorski, for this opportunity to present our views on effective regulation of the OTC derivatives market. Treasury Secretary Geithner's May 9, 2009, letter to Senator Harry Reid outlined the Administration's plan for regulatory reform of the financial services sector. His plan proposed increased regulation of credit default swaps and other OTC derivatives. This committee posed seven questions for our consideration this morning. We agree with many of Secretary Geithner's proposals. For example, we support position reporting for OTC derivatives and agree that enhanced price transparency across the entire market is essential to quantify and control risk. We believe, however, that the measure chosen to achieve these ends should be fine-tuned to avoid adverse consequences for U.S. markets. We are concerned that legislation mandating the clearing of all OTC transactions could well induce certain market participants to transfer this business offshore, resulting in significant loss of U.S. futures business. By reducing liquidity on U.S. exchanges, this would undermine the Congress' attempt to establish greater transparency, price discovery, and risk management of U.S. markets. We applaud the Administration's efforts to enhance transparency, stability, integrity, efficiency, and fairness in all markets, but we believe that with slight modifications to the proposal outlined by Secretary Geithner, and the inclusion of a few additional measures would complement the Administration's efforts. We have responded to your specific questions at length in our written testimony. Let me offer a brief summary of our responses: First, we agree with the informed consensus that the financial crisis was attributable in part to the lack of regulation in the over-the-counter market, which was not subject to appropriate disclosure and risk management techniques. Second, clearing should be offered to the OTC market in a form that makes a compelling alternative to the current model. Central counterparty clearing offers a well-tested method to monitor and collateralize risk on a current basis, reducing systemic risk and enhancing fairness for all participants. Third, we are not in favor of government-mandated clearing even though we are strong proponents of the benefits of central counterparty clearing. Central counterparty clearing serves as an effective means to collect and provide timely information to regulators. It also reduces systemic risk imposed on the financial system by unregulated, bilateral OTC transactions. Nevertheless, rather than compel clearing of all OTC transactions, we believe appropriate incentives should be put in place. The incentives could be in the form of reporting and capital charges for uncleared OTC positions and reduce capital charges for cleared OTC positions. We believe they would contribute both to the transparency and the reduction of systemic risks. Fourth, obviously, we are strong proponents of the benefits of exchange trading of derivatives, but we are also realists on the issue of whether exchanges can generate sufficient liquidity to make exchange trading efficient and economical for our customers. We are concerned that government-mandated exchange trading will be a massive waste of resources and capital. Fifth, in our view, electronic trading offers many benefits. It levels the playing field. It enhances price transparency and liquidity. It speeds execution and strengthens processing and eliminates any classes of errors of unmatched trades. Overall, it is an enormous benefit to the market and to our customers. Electronic trading when coupled with our intelligent audit and compliance programs allows us to better monitor our markets for fraud and manipulation. It also gives us the tools to effectively prosecute anyone foolish enough to engage in misconduct in a forum with a perfect audit trail and a highly skilled enforcement staff. Sixth, we believe that there is an appropriate balance between price discovery and liquidity that is effectively controlled by the current procedures to police excessive speculation. Regulated future markets and the CFTC have the means and the will to limit speculation that distorts prices or the movement of commodities in interstate commerce. Seventh, we operate trading systems in a clearinghouse in which every bid and offer, as well as every completed transaction, is instantaneously documented. In addition, those records are preserved for an extended period of time. We hope that our views on regulating the OTC market will be given significant weight based on our record and experience, and I look forward to answering your questions. Thank you, sir. [The prepared statement of Mr. Duffy can be found on page 132 of the appendix.] " FOMC20051213meeting--86 84,MR. KOHN.," Thank you, Mr. Chairman. The news over the intermeeting period has suggested some shift in the nature of the inflation risks faced by the economy. Low and stable core December 13, 2005 53 of 100 of inflation expectations seem to imply a reduced threat from near-term feed-through of energy prices to expectations or to core inflation. At the same time, however, information on output and demand indicate that the economy remains on a growth track which is expanding a little more quickly than potential supply. And this is a trajectory that would increase pressure on resources at a time when those resources are already being fairly well employed. The reasons for the greater-than-expected momentum in output are unclear. Some of the strength may represent a more muted response to hurricane disruptions or energy prices than anticipated, but much would seem to be related to underlying strength in aggregate demand. The upward surprises in demand in the third quarter were global, not just in the United States. Increases in industrial commodity prices and sizable gains in equity prices around the world evidence widespread economic strength and expectations that it will persist. Added demand and rising equity prices have provoked little, if any, offsetting tightening in financial conditions in credit markets. Long-term interest rates globally were little changed on balance over the intermeeting period, and risk spreads out the yield curve and across risk categories continue to be low, reflecting the basically optimistic outlook of investors. Perhaps the resilience of the global economy to oil price increases and persistent expansion in global GDP, including in such laggards as Japan, are slowly increasing the confidence of non- financial businesses as well. In the United States, the growth of business investment has come into line with past relationships with the cost of capital and changes in output, though the level of investment still remains a bit lower than might be expected. As a consequence of this strength, one question is whether the current constellation of interest rates and asset prices, including expectations of the funds rate topping out in the 4½ to 4¾ percent December 13, 2005 54 of 100 neighborhood of its potential and to keep inflation stable. In the staff forecast and in the markets, such a rise in the funds rate is seen as sufficient to contain inflation, and that strikes me as a reasonable estimate, pending further information. Although long-term rates haven’t changed much for several quarters, short- and intermediate- term rates have increased quite a lot and will continue to move higher as we firm policy. These higher rates should exert increasing restraint on spending, especially for households that have been relying on borrowing at low short-term rates to short-circuit liquidity and income constraints when buying durables or houses. The slowing in consumer credit growth and mortgage loan applications in recent months may, indeed, indicate that higher short- and intermediate-term rates are beginning to bite. Moreover, perhaps as a consequence of the rise in borrowing costs, we do see some signs of a cooling in housing markets, as many of you remarked. Certainly the perceptions about housing markets of both builders and buyers have deteriorated noticeably in recent months, and the shift in attitudes may be particularly important when a significant portion of the activity in this market has been linked to investment demand. Based on these indicators and others, a slowing of house price appreciation and a moderation in construction activity next year seem to be a reasonable expectation. Such a slowing is a critical element behind the moderation in growth next year in the staff forecast, and I suspect in the market’s assessment as well. Still, we need to see more concrete evidence that this channel is working as anticipated, both in prices and in activity, before we can be confident that demand is likely to moderate. Nonetheless, the incoming information also reinforces the notion that we can afford to retain the gradual path of policy tightening as we look for signs that moderation is coming. With the upward revision to December 13, 2005 55 of 100 growth of potential. In addition, the better productivity and the downward revision to compensation data show the increase in business costs being held in check better than had been evident. And the higher rate of growth of structural productivity should help to hold down that increase in costs going forward. Moreover, the markups of price over unit labor costs have risen appreciably in the last two quarters for both nonfarm business as a whole and, within that category, for nonfinancial corporations. And those markups are close to the record highs of the mid-1990s, suggesting that businesses have some room and incentive to absorb some of the increases in labor costs that might be coming. As a consequence of these developments, I think we can be a little less concerned about the immediate threat of higher inflation, though we still need to focus on forestalling the potential for supply-demand imbalances to develop over the medium run. Thank you, Mr. Chairman." FOMC20051101meeting--115 113,MR. FISHER.," Mr. Chairman, growth in the Eleventh District, if anything, has been accelerating in recent months—picking up steam. We appear to be the beneficiary of the natural disasters that have taken place on the Gulf Coast, and that continued, incidentally, through Wilma. A small example is that the grapefruit growers have definitely benefited from the destruction of grapefruit crops in Florida, which was nearly total. If I were to paraphrase Yogi Berra, who said the future isn’t what it used to be, I think I would be on the mark because we’re now much more confident. One of the most articulate, smartest, and at the same time conservative, bankers in our District, Dick Evans of Cullen/Frost, says that building contacts are reporting the busiest business activity in 30 or 40 years in our state. At the very front end, which is site work for land development, one of his clients, an engineer, reported that in his entire business career he’s never been busier. So we are proceeding on all pistons, and we’re beginning to see it reflected particularly in real estate prices. The market has gone from a buyer’s market to a seller’s market almost overnight. In the Gulf area of Padre Island, for example, record prices are now suddenly appearing overnight. So in summary, the bankers and the business community in the Eleventh District, as I reported at the last session, are still frisky, Mr. Chairman. Indeed, their tails are wagging at an accelerated November 1, 2005 32 of 114 that history doesn’t repeat itself here. But we certainly have a much more enthusiastic business community. I want to turn now to a broader perspective, based on our calls to headquarters of companies that operate throughout the nation as well as in our District. At the last FOMC meeting, Mr. Chairman, you mentioned gasoline prices having a very visible impact as one of the few commodities that consumers look at for price comparisons. In talking to our retailers, that is clearly the case. In sharing with President Poole our contacts with Wal-Mart, I talked to the new CEO of U.S. Wal-Mart yesterday, and he noted that while October same-store sales were up 4.2 percent, the consumption pattern had shifted. Because of gasoline prices, people are making fewer trips to the stores but they’re buying larger amounts. And we have a leading indicator ourselves in Harvey Rosenblum, who is the wine connoisseur amongst our research leaders in Dallas. I’ve noticed that he, since he lives in a dry district of Dallas —we still have prohibition in parts of Texas—is making less frequent trips to the wine store but is buying in greater volume. Perhaps that’s because of the questions we’re asking him! [Laughter] Wal-Mart, 7-Eleven, and Dollar General all report that heavier items transported by truck— dog food and bottled water are just two examples—are under tremendous price pressure due to rising fuel costs. And these higher prices are being passed on, although sometimes offset by consumers substituting private label items for brand name products. American Airlines is passing on their fuel costs. They managed to raise their average fare 8 percent in the third quarter. Once again we hear them talking about $25 attachments to confirmation fees for standby passengers. Hovnanian and Centex, two of the largest builders, report rising costs of locally sourced materials delivered by truck, adding to price pressures of labor and materials for roofing, siding, and November 1, 2005 33 of 114 on by the express companies. UPS reports—and I don’t think this is public information—that they’re targeting rate increases, pre-fuel charge, of 4 percent to be set in early November, knowing that the U.S. Postal Service will be pricing in an increase of 5 percent plus at the beginning of the new year. There are some potential mitigating factors here. 7-Eleven, Exxon, Wal-Mart’s Sam’s Club stores, and other gas retailers report that the margin they are retaining on their gas sales—and 53 percent of 7-Eleven’s revenue comes from gasoline sales now—is still running 30 cents versus 13 to 14 cents normally. They expect to hold these margins as long as they can, or at least until volatility is dampened; but as gas prices ease, this could possibly be a cushion that will provide some relief for retailers. And the correlation is quite direct. At 7-Eleven, for example, they can walk you through, week by week, the effect on sales of each downward movement in the price of gasoline. Three weeks ago they had an increase in sales volume of 2 percent; two weeks ago, 4 percent; and this last week, 6 percent. So we may have a little bit of relief coming from the reduction of margins that might occur as the margins go from 30 to 13 to 14 cents. It’s still clear from our discussions with business operators that price pressures are building. A rising percentage of companies are experiencing price increases for what they sell as well as for what they buy, along the lines that President Moskow mentioned. We see it particularly in chemicals, as he mentioned. Caustic soda, formerly priced at $450 a dry ton, is now $800 a dry ton. Polyethylene, formerly priced at 38 cents a pound, is now priced at 55 cents a pound. I hope this is expunged later, but Exxon’s CEO told me that they will take every measure they can to pass through, and I quote, “sizable increases” on that front in every place that they can. Perhaps the best indicator of what’s happening in the chemical industry is Pioneer Core Alkaline Company, which November 1, 2005 34 of 114 to pass along price increases for all resin-based products, such as garden chairs and outdoor tables, in the spring. The rails appear to be planning, according to BNSF’s CEO, a price increase of 5 to 6 percent before fuel surcharges next year. And of interest in all of our discussions is that we’re hearing what President Moskow is hearing, which is that there are pressures on the wage front. To be sure, they are mitigated by Delphi, Northwest Airlines, and also GM. But the numbers we’re hearing from the rails, from the Belo Corporation, a large broadcaster, and others on labor prices are negotiation targets of about 3 percent, with a heavy focus on health care running in the 9 to 10 percent range. I think probably the best summary, Mr. Chairman, came from the CEO of Wal-Mart U.S. He said that “previously we were deflating and we can still offset a little bit through China, although to a lesser degree than before.” He said “we will early-discount like all retailers, moving our discount season, largely in terms of announcements, up to November 1. But at best we hope to ‘hold the line’ on prices.” That’s a direct quote. So I feel that the heightened inflationary pressures that we talked about last time are lurking. Against that background, I favor further tightening to contain inflationary impulses and expectations. I have some comments on the statement, but we can speak about that later. The bottom line is that one can sense, even though we don’t see it in the data, inflation pressures creeping up like little cat’s feet. Thank you." FOMC20060328meeting--159 157,MR. WARSH.," Thank you, Mr. Chairman, and thank you to everyone around the table. I think Governor Kroszner and I share the view that people have been incredibly kind and supportive in teaching us the ways of this institution in the past weeks. So we certainly appreciate that. I know I do. The only advice that I was given last night that I will not take is that they say that Governors at their first meeting should sing their opening remarks. [Laughter] I thought it was a joke, but I guess that we’ll test it here. [Laughter] Allow me to offer just a few perspectives consistent, I think, with a lot of the discussion yesterday and maybe some particular focus on business investment. As was discussed, the economy appears to be stronger, but as I think about the economy today versus over the last several periods, what strikes me is how much more well balanced it is than it was over recent periods. The equity markets, the credit markets, and certainly the anecdotal information that I’ve gleaned in my several weeks here and before, all tend to confirm that view. And although there are meaningful risks to the economy, my own view is that there is a greater upside potential for growth than expressed in the Greenbook. A few notes about the consumer before I spend the balance of my time on business investment. First, the consumer appears to be strong, as we discussed yesterday. And my own sense is that, while there may well be softening in the residential market, staggered repricing of adjustable-rate mortgages and perhaps potential sales of a very novel, new housing product—the thirty-year fixed-rate mortgage—[laughter] may simplify things, particularly if the shape of the curve keeps its current trajectory. Second, I would expect there to be, as I think the Greenbook referenced, accelerating household income growth and perhaps new job creation more robust even than was described in the Greenbook, particularly if some of the productivity gains that we have seen over the past several years tend to moderate. Let me spend a few more moments now on the business capital expenditure side. My own view is that the strength of business capital expenditure in property, plant, and equipment may well surprise to the upside. I think what we saw earlier in this recovery, both anecdotally as well as in the data, was a growth in cap-ex by a lot of the small and medium-sized businesses. And as one CEO said to me a couple of weeks ago, big company CEOs have now gotten that memo. Opportunities to drive profit margins through productivity improvements appear to be diminishing somewhat, and so there appears to be a tendency, a greater willingness, to go back to the well and to get cap-ex back up to speed. Two obvious indicia of greater cap-ex—which we’ve seen for some time and that would have suggested to many of us, including me, that business cap-ex would have ramped up sooner—are, of course, the strong corporate profits and these corporate balance sheets that are in remarkable shape. What I would like to spend a little time on is, well, what is new? What is going to make cap-ex grow over 2006 above and beyond the projections to this point? And so, as I talk about two other catalysts, I would suggest that they are not really reflected in the data yet. But my own sense is that we should see them or at least there is a greater probability of seeing them in the balance of the year. Of course, current regulatory and enforcement issues are still consuming significant CEO time and significant director and officer time, and that does tend to cast a rather deep shadow over these cap-ex budgets. What we are going to find in this proxy season is an occupation or preoccupation, both in the business press and in some boardrooms, with the ongoing fight over majority election of directors. There will be fights in boardrooms, fights by institutional shareholders, and a whole range of op-ed pieces about how these directors get put on boards and whether the system should be reformed. Obviously, the current environment and the fight over shareholder democracy still tend to cast a bit of a shadow. So I guess the question really is, what’s different now? I would note two catalysts. One is CEO confidence. I think Governor Bies yesterday referred to this in a couple of the surveys. CEO confidence—that look in their eyes, their view of the animal spirits—appears to be back in stronger measure than I at least have heard in some time. What then happens when CEOs go into the boardroom, as I think most of my colleagues around the table know, is that they tend to generate some excitement by directors themselves. Directors are really starting, in some regard, to go back to basics. One CEO said to me about a week ago, “Being a board member is starting to be fun again,” and that is not something this particular CEO, who is on a lot of large-cap boards, would have said a year ago. I don’t think he was referring to the days of going to the golf course in the middle of the board meeting. What he meant by the board’s being fun again is that board members are focused on where the company should be going. How should they be growing their business? Should they be more vested on the mergers and acquisition side? Should they be more focused on capital expenditures? And so from that CEO and from many others, we are hearing far fewer complaints about Sarbanes–Oxley. It does not mean that the complaints are not there, but my sense is that most of these companies have now been able, at least, to put a box around their compliance burdens. They have been able to check that box, go through their 404 controls once or twice, and though they still do not like it, the burden is no longer consuming their minds when they come to the boardroom. I think what we are going to see in the balance of 2006 are board members coming back to boards as “strategic advisers,” with a somewhat diminished role for board members as “compliance officers.” And that is a good thing with respect to cap-ex because the more they are focused on their businesses, the more they are focused on helping companies grow. I think that such focus is probably incrementally quite positive to a decision about investing the next billion dollars in property, plant, and equipment. So looking outward, I sense that companies are seeing bigger and bolder opportunities, and that situation is a necessary precursor to understanding whether or not these cap-ex numbers increase. The second catalyst that I note may be a touch more controversial—how outsiders are looking at companies. I guess the way I would say it is not that the barbarians are back at the gates but that they are gathering. When you look at the private equity world, the leveraged buyout world, and the emerging hedge fund world, the “outsiders” are now looking at each other in a series of alliances and are starting to look with a keener eye toward corporate America. They probably have seen the excess cash and, frankly, the conservatism of boardrooms and the conservatism of companies borne in the past five years and are willing to “think the unthinkable” and take greater advantage of that opportunity. I think Governor Olson made reference to the IPO market, which is really telling us many of the same things—whether a company that is public has, all of a sudden, a new interest in going private or an IPO candidate is saying, “Really, what is in it for me? Why should I enter the capital markets? Might we make better use of our time and attention by staying private, by growing cash flow that way?” Another reason that the IPO market is not as robust as perhaps it would have been in previous periods like this relates to research. You have to be a very big and very bold company to be getting large, bulge-bracket firms writing equity research and explaining your company to a greater pool of shareholders. For an IPO candidate or even for a public company that has been around awhile with a few billion dollar market cap, getting that kind of research and that sort of investor base is much harder to do than it was in the years before Sarbanes–Oxley. Another item I have considered is merger and acquisition backlogs. The backlogs that are on file by the largest investment banks and merger advisers are bigger now than they have been in the past six years and maybe even before that. The difference in the backlogs this time versus in previous years, I think, is how much is really private equity. It looks as though, in broad numbers, about a quarter to a third are private equity investors, LBO investors that are looking at companies that, because of size or background, they would frankly not have spent as much time looking at in years past. You have a range of LBO players that are now back, and they are now describing themselves as shareholder activists and corporate governance experts. But twenty years ago they were there, and they were focused much as they are now on shareholder value. So both the signs—from companies that are internally evaluating their own boardroom dynamics and from investment companies that are looking to come to the gates and to take a couple of these companies private—remind us that companies have a perspective about their own cash that is either use it or lose it. And it would not surprise me to find some very large “blue chip” companies that feel either under attack or on the precipice of being attacked tending to be bolder in their capital expenditure budgets. What’s likely to happen in the capital markets should that all come to pass? One thing that may happen, and may be a first casualty, in the investment-grade capital market is that some very large-cap “blue chip” companies with exceptional investment-grade ratings will all of a sudden find that they are in play by some LBO buyers and private equity participants. As you all well know, generally in the investment-grade market there has not been much of a change-of-control premium in investment-grade credit, unlike in the high-yield market. But should a couple of large transactions occur either here in the United States or in Europe, where a double-A credit one day ends up looking more like a high-yield credit the next, we might find that investment-grade investors are asking for a greater premium in those markets. I think all of this is a possibility as we think about ’06 and ’07—not a promise but a real possibility that we should continue to keep a keen eye on and evaluate. As that dynamic goes forward, we will have an early signal telling us whether the cap-ex numbers will come in larger than expected. Finally, with respect to inflation, I would add to some of the comments that the Vice Chairman made yesterday by noting that long-term inflation expectations as calculated in the TIPS markets, while contained, are higher than ideal. And the market expectations of potentially higher commodity prices and other material inputs might also cause further pressure on inflation. As we as a Committee approach our last step or our penultimate step in possibly moving rates, the markets will be more and more focused on our own vigilance with respect to those inflation expectations. With that, I have finished." FOMC20070509meeting--53 51,MR. FISHER.," Mr. Chairman, last time I reported a sense that the international economy was hot, that our domestic economy was cold, and that the regional economy of the Eleventh District was just about right. I concluded my comments by saying that we were in treacherous waters in terms of the U.S. economy, navigating between the Scylla of inflation and the Charybdis of a slowdown in growth. Like President Yellen, I don’t have much change to report, but I do want to comment in very brief order on a couple of aspects that my two predecessors commented on. As far as the international economy is concerned, we see continued expectations for higher growth and a different mindset beginning to set in. You saw that, I believe, in the French elections. Even Italian consumer and business confidence is at a ten-year high, or six-year high depending on which measurement you use. You also see it reflected in various measures of port congestion, charter rates for ships, and profit contributions to U.S. multinationals. By the way, the contacts that we talk to, Bill, are making a real effort to ferret it out and have a sense that there should be more push or oomph from abroad than they are getting domestically. You still have to prune those reports carefully. You see it in commodity prices. The bottom line from the standpoint of the Dallas Fed is that we’re seeing a tightening of capacity utilization in the rest of the world, which is somewhat vexing for U.S. operators because it limits our firms’ abilities to cut costs by shipping production abroad. Nonetheless, the rest of the world economy remains hot. I have just a couple of comments about the United States. When I talk to the rails, the airlines, the express delivery logistic companies, the middle-income consumption sectors such as retailers, or those that sell into those sectors, I am hearing increasing reports of weaker demand and lower expectations than I was hearing at the last meeting in all but one sector, which is the entertainment sector. Advertising revenues for the networks continue to stay high, and by the way, visits to theme parks are at a record high, driven largely by wealthy foreigners who are finding them to be a tremendous bargain. On the housing front, I have been bearish—more bearish than anybody at this table. I remain so, and like President Yellen and, I believe, President Moskow, I am more concerned than I was before. We can go through the numbers, but I think it is best expressed by the CEO of one of the five big builders, who said that in March he was arguing internally with his board that the headlines were worse than reality and now reality is worse than the headlines. There is significant inventory, and the qualification of buyers is becoming a very vexing issue. I suspect that this situation has yet to run its course. I am also hearing continued reports, despite layoffs and a slowing economy, of continued tightness of highly skilled labor and continued price pressure on that front. Finally in terms of the domestic economy, we are benefiting from a weaker dollar in terms of tourism flows and also the high-end retailers, most of which are in President Geithner’s District and one—Neiman Marcus—in my own District. Other than that, I have nothing to add on the U.S. economy. I want to talk about inflation for a minute. The data—whether core PCE or overall, core CPI, or even the trimmed mean, which we focus on in Dallas—seem to be indicating a tempering of pressures. So we have some meat on the bones of our expectation, or I should say our hope, that some deceleration of inflation pressures would manifest itself. But in talking to my business contacts, I would say—if you will forgive a terrible reversal of biblical scripture—that, though the flesh may be willing, the spirit is weak. What I mean is that even though they would like to believe the numbers, in terms of their own behavioral patterns and the way they are positioning their management, they feel enormous threats to their margins coming from slow volume growth and coming from increasing cost pressures in that they allocate tasks globally. And their first reaction is to see how they could change the pricing structure domestically. Chemicals are reporting that a 3 to 5 percent price action that was taken at the beginning of the year is sticking. My contact from a large producer of food products said that they are shifting their overall model away from focusing on unit-volume expansion to pricing, and even a ubiquitous brand like Starbucks is moving away from the number of transactions to figure out how to price more aggressively or to restructure the size of their containers, as are many food product producers. The large consumer paper products reported that they were budgeting zero percent price inflation at the beginning of the year and have redone their budget to price at 3 to 4 percent. If I had to pick a word, Mr. Chairman, in terms of the mood of our companies regarding the U.S. economy, I would say that it’s somewhat dyspeptic. It’s not a very pleasant mood. They feel a little indigestion because of the margin pressure that they’re getting and limited relief in terms of what they’re able to pull out in volume expansion. I am in an unusual position of coming from what I believe, reading the Beige Book and looking at the data, is a District that continues to significantly outperform the rest of the economy, although we have slowed somewhat; yet when you look at the histograms, I have the lowest forecast for GDP for this year. So I am the most pessimistic at the table in terms of short-term economic growth, and on the inflation front I would just resort to a Ronald Reaganism, which is that we need to trust but verify. In short, I would not be surprised to see disappointing growth in the second quarter, much more disappointing than in the Greenbook’s forecast, nor would I be surprised to see higher core PCE inflation sustaining itself than I am hearing from some of my colleagues and from the staff. Thank you, Mr. Chairman." FOMC20071211meeting--94 92,MR. EVANS.," Thank you, Mr. Chairman. Coming out of our October meeting, I expected a period of subpar growth stretching into the middle of 2008. Since I was anticipating some soft data, it was not obvious to me that the outlook had worsened until later in the intermeeting period. A lot of the data that we have cited are financial items that are difficult to assess and are somewhat unusual for the current period. But the incoming information has caused us to mark down our outlook further, although we don’t see growth declining as far below potential as in the Greenbook baseline forecast. Although housing continues to weaken, that by itself did not cause a substantial revision to our outlook. The bigger factor was a noticeable weakening of consumption. PCE was basically flat in September and October—I guess dead on arrival. The financial headlines are taking their toll on consumer sentiment, and higher energy prices are lowering real incomes. It is not clear, however, that we are seeing a major sustained pullback in consumption; but, of course, that is arguable. The limited information we have about November—motor vehicle sales and the chain store data—suggest at least modest gains in consumer expenditures. I realize that the chain store sales could be a bit artificial. I was talking to one of my business contacts who has a significant presence in retail, and I am accustomed to hearing that, “Well, the Christmas season is a bit short this year, so that could be a problem.” But I actually caught him this time saying, “Gee, it’s so long this time that people seem to be losing interest.” [Laughter] On balance, I think the fundamentals for consumption are still reasonably good. Importantly, although they may be somewhat lagging, the payroll numbers are still consistent with decent growth in wage income, and the unemployment rate remains low. Elsewhere, foreign growth remains good, which along with the lower dollar should support continued growth in exports. We have seen some softening in capital spending as well, but the usual indicators still point to moderate gains in investment. These developments seem reasonably consistent with what I heard from business contacts. Most of them think that growth is slowing, and they are more cautious, but I would summarize their views as guarded and not alarmist. Furthermore, many say that their improved inventory control methods are preventing an inventory cycle from exacerbating the current situation, and they bring this up without my prompting. So to me their comments do not yet suggest a sharp curtailment in real economic activity. Of course, the financial markets continue to weigh negatively on the outlook. In my view, the biggest concerns are the large markdowns on structured securities and the volume of assets that may be returning to banks’ balance sheets. These effects appear to be larger than the banks had planned for as of October and could have a significant impact on lending capacity. This is an important downside risk to the real economy, as the Greenbook highlights in many places. That said, when I talk with my business contacts, there continues to be a disconnect between the credit conditions they report facing and the turbulence we see in money and credit markets. Outside of lending for residential and nonresidential construction, my CEO contacts at nonfinancial firms do not report much change in credit costs or availability. We have heard this from a number of sources. For example, two of the larger banks in our District said they have not changed terms to borrowers, and they expressed relatively sanguine views of lending conditions overall. For the time being, some lenders report offsetting a portion of their higher funding costs by taking a hit on their interest margins. Credit conditions for construction-related industries are another matter. A major shopping center developer who has been one of the largest issuers of commercial mortgage- backed securities indicated that this market has dried up completely. However, the developer has been able to obtain financing from other traditional sources, such as life insurance companies. He is paying similar interest rates, he says, but the terms include lower loan-to-value ratios. So there is some credit effect, but he still has access for the moment. That is a bit like what President Lacker was suggesting. He said the switch is not a big deal for him currently, but if it continues for too long—say, for more than six months or so—it would then weigh more heavily on his business activity. The evolution of such developments will obviously be an important thing to watch over the next few meetings. I would just note that I don’t often look at the Duke University survey of CFOs. But as I looked at it—and I don’t have a great deal of experience— it did seem to indicate that they had higher spending plans on average from their September survey for capital expenditures and technology spending. It wasn’t a great bit, but given all the negative headlines associated with the credit conditions—which are unweighted, whereas these spending plans are weighted—that was a bit of a surprise. Putting all of this together, we have marked down our current quarter and 2008 real GDP forecasts 0.4 percentage point, which is pretty significant. We now have growth next year of 2¼ percent. We expect growth to improve to our assessment of potential thereafter, namely about 2½ percent. This forecast assumes two policy easings, similar to but sooner than the Greenbook, and it is shaded toward the “stronger domestic demand” alternative scenario, which has less financial restraint on PCE and business fixed investment than in the Greenbook baseline. Turning to inflation, our forecast is for PCE inflation to settle in at 1.8 percent. This continued favorable projection for inflation is important for my policy views now. We think resource utilization likely will be about neutral for inflation over this forecast period. Our GDP projection does not result in appreciable resource slack over the forecast period. Even under the weaker Greenbook scenario, the GDP gap remains less than ½ percentage point. But there are upside risks. The most recent data on core prices have been a bit higher. The lower dollar could put pressure on prices, and my business contacts remain concerned about the cost of energy and other commodities. Finally, at least by the Board staff calculations, five-year forward TIPS inflation compensation has moved up to the range that it was in during the spring of 2006, a period when we were more concerned about the inflation outlook. I wouldn’t put too much weight on this particular inflation expectation development at the moment, but it may be looming ahead. So I continue to see upside risk to inflation, which if realized would complicate our policy reaction to developments on the growth and employment side of the ledger. Thank you, Mr. Chairman." FOMC20070321meeting--236 234,CHAIRMAN BERNANKE.,"Chairman Bernanke Yes Vice Chairman Geithner Yes President Hoenig Yes Governor Kohn Yes Governor Kroszner Yes President Minehan Yes Governor Mishkin Yes President Moskow Yes President Poole Yes Governor Warsh Yes Thank you. Michelle, could you work with Debbie to get a printed version of the statement that we’ll circulate after the break so everybody can at least familiarize themselves with what we’re saying here today? [Laughter] All right. Why don’t we take a coffee break for fifteen minutes? Thank you. [Coffee break]" CHRG-111shrg50815--11 Mr. Levitin," Good morning, Mr. Chairman, Ranking Member Shelby, and members of the Committee. I am pleased to testify today in support of the Chairman's Credit Card Accountability, Responsibility, and Disclosure Act and other legislation that would create a more efficient and fair credit card market and would encourage greater consumer responsibility in the use of credit. Credit cards are an important financial product. They offer many benefits and conveniences to consumers. But credit cards are also much more complicated than any other consumer financial product, and unnecessarily so. Auto loans, student loans, closed-end bank loans, and all but the most exotic mortgages are relatively simple. They have one or two price terms that are fixed or vary according to an index. Not so with credit cards. Credit cards have annual fees, merchant fees, teaser interest rates, purchase interest rates, balance transfer interest rates, cash advance interest rates, overdraft advance interest rates, default or penalty interest rates, late fees, over-limit fees, balance transfer fees, cash advance fees, international transaction fees, telephone payment fees, and probably several other fees of which I am unaware. In addition to these explicit price points, there are also numerous hidden fees in the form of credit card billing practices. The card industry has been ingenious in creating tricks and traps to squeeze extra revenue out of unsuspecting consumers. These billing tricks cost American families over $12 billion a year. Credit card billing tricks make cards appear to be much cheaper than they actually are, and that leads consumers to use cards too much and to use the wrong cards. By disguising the cost of using cards through billing practices, card issuers are able to maintain uncompetitively high interest rates and to generate greater use of cards. That produces additional revenue from interchange fees for the issuers as well as over-limit fees, late fees, and penalty fee revenue. The complexity of credit card pricing makes it impossible for consumers to accurately gauge the price of any particular credit card, and unless consumers can gauge the cost of using a card, they cannot use it efficiently and responsibly. Markets cannot function without transparent pricing because demand is a function of price. The lack of transparency in credit card pricing has resulted in inefficient and irresponsible use of credit, and that has resulted in dangerously over-leveraged consumers, who are paying too much for what should be a commodity product with razor-thin profit margins rather than one with a return on assets that is several multiples of other banking activities. Consumer over-leverage is a factor that should concern all of us, especially today. There is nearly a trillion dollars of credit card debt outstanding. The average carded household owed almost $11,000 in credit card debt last year. That is a drop in the bucket compared with household mortgage debt, but even the most exorbitant subprime mortgage rate is rarely over 10 percent annually, whereas the effective APR on many credit cards--the effective APR--can easily be five times as high. And the harm to families is palpable. A single repricing due to a billing trick can cost a family between an eighth and a quarter of its discretionary income. These levels of credit card debt are not sustainable. Dollar for dollar, a consumer with credit card debt is more likely to file for bankruptcy than a consumer with any other type of debt. And to the extent that consumers are servicing high-interest-rate credit card debt, that is money they cannot use to purchase new goods and services from merchants. The money siphoned off by credit card billing practices does not create value. It cannot be spent in the real economy. The card industry's arguments that Congress should not interfere with their finely calibrated risk-based pricing are malarkey. Only a very small component of credit card pricing reflects risk. Almost all credit card pricing is a function of the cost of funds, the cost of operations, and the ability-to-opportunity price, not the function of risk. Moreover, to the extent that credit card prices reflect a risk premium, it is a pool-based premium. It is not an individualized risk premium. The card industry is not capable of pricing for risk on an individual basis. The technology is not there. This means that there is inevitably subsidization of riskier consumers by more creditworthy ones. Nor is there any evidence that connects the so-called risk-based pricing to lower costs of credit for creditworthy consumers. While it is true that base interest rates have fallen, that is almost entirely a function of the lower cost of funds, and the decline in base interest rates has been offset by increases in other credit card prices. According to the GAO, for 1990 to 2005, late fees have risen an average of 160 percent, and over-limit fees have risen an average of 115 percent. Since the 1990s, credit card pricing has been a game of three-card monte. Pricing has been shifted away from the up-front, attention grabbing price points, like annual fees and base interest rates, and shifted to back-end fees that consumers are likely to ignore or underestimate. The card industry's risk-based pricing story simply doesn't hold up on the evidence and is not a reason to refrain from much-needed regulation of unfair and abusive credit card billing and pricing practices that have had a deleterious impact on the economy and society. Legislation like the Credit Card Accountability, Responsibility, and Disclosure Act is a crucial step in restoring transparency and fairness to the credit card market and to letting American consumers responsibly enjoy the benefits of credit cards. Thank you. Senator Johnson. Thank you, Mr. Levitin. The panel should know that we will limit your remarks to 5 minutes in order to have a proper question and answer period. Mr. Clayton? STATEMENT OF KENNETH J. CLAYTON, SENIOR VICE PRESIDENT AND FOMC20081029meeting--211 209,MR. LACKER.," Thank you, Mr. Chairman. Business and consumer sentiment in the Fifth District has deteriorated markedly. Even though economic conditions were already decelerating heading into our September meeting, a discrete shift in outlook seems to have occurred. It seems to me to have originated during the week of September 15 or shortly thereafter. Our business contacts express anxiety about the national economy, and they express uncertainty about the meaning for their firms' prospects of the astonishing sequence of events that began unfolding that week. Both consumers and firms have been increasingly unwilling to make long-term commitments and engage in discretionary expenditures. Consumers are delaying large and discretionary expenditures. Firms have adopted a wait-and-see attitude on investments. Our regional survey released this morning shows a substantial drop in business conditions as well. Our business survey respondents report that obtaining business loans is more difficult than three months ago, and there are widespread reports of lenders tightening credit terms and seeking to reduce exposures. Most respondents, however, also indicated that they would still be able to satisfy their borrowing needs. When you listen to bankers, they will tell you that they are tightening standards, but they also report that they are still extending credit to solid borrowers with high-quality deals. I find it difficult right now to pin down the real effects of the financial market turmoil of the last few weeks. As the Greenbook notes, assessing such effects ""poses significant identification challenges."" Specifically, it is hard to disentangle the effects of the increased cost of bank capital from those of the deterioration in the economic environment facing borrowers. Personally, I suspect the latter are playing the more prominent role in the tightening of credit terms right now. Looking on the bright side, the near-term inflation picture has eased noticeably since our September meeting, mainly because of the decline in oil and other commodity prices. The Greenbook carries this moderation into its long-term forecast, where PCE inflation now converges to 1 percent in 2013. I did a double-take when I saw that--it had me wondering whether the Greenbook was ghost-written this month by President Plosser. [Laughter] Whoever's forecast it is, the longer-term projected moderation in inflation relies heavily on the opening-up of a large and persistent output gap. In the current circumstances, I am not sure how plausible that story is. In particular, I have been struggling with how to think about the effect of credit market disruptions on the concept of potential output. To the extent that we think of these disruptions as analogous to shocks to intermediation technology--and that is what the models of these kinds of credit channel effects generally tell you to do--it seems to me that we should see them as pulling down potential as well as actual output. I believe this point has been made at previous meetings. We have also talked before about the tenuous nature of the Phillips curve relationship, and it is difficult to forecast. The slope is sort of flat. We had been scheduled to discuss inflation dynamics, and we postponed that, for good reasons I believe. I hope we can get back to it soon because I think it's going to be relevant to how we see our way through this. In any event, I think we should be careful not to be overly optimistic about the forecast of an inflation decline driven by a large output gap. The shift in the Greenbook's long-term inflation projection is noteworthy for another reason, I believe. We are getting closer to a 1 percent target federal funds rate, and we may actually reach 1 percent at some meeting soon. The last time this happened it sparked a widespread discussion of and concern about the zero lower bound on nominal interest rates. I want to make a couple of related observations. First, a key to conducting monetary policy at the zero bound is being able to keep inflation expectations from falling and thereby increasing real interest rates. From this perspective, the revision of the Greenbook's forecast from 1.7 percent one meeting ago to 1.0 percent for five-year-ahead inflation implies that we run a monetary policy regime in which five-year-ahead expected inflation varies pretty significantly in response to contemporaneous shocks. I don't think that variability in long-run inflation projections can help our ability to manage inflation expectations at the zero bound. We'd be better if we ran a policy in which long-run expected inflation was more anchored, more stable. You can tell where I'm going with this, I'm sure. This highlights the value of an explicit inflation objective as well as the value of being able to communicate clearly about how we view the functioning of monetary policy at the zero bound. Second, I will just note briefly that the economics of monetary policy at the zero bound are closely related to the economics of paying interest on reserves at close to the target rate. In fact, if I'm not mistaken, they are virtually identical. I think progress on both fronts would be useful right now. Finally, let me just comment on financial market conditions. My sense is that what the public has seen--the large failures, the variety of resolution techniques, the deliberations leading up to the Congress's adoption of the bill it adopted--taken together have added up to significant pessimism on people's parts and have altered optimal strategy for a lot of financial institutions. So I think that is altering how people allocate portfolios and has led to further volatility in certain markets. It has led some institutions to adopt a wait-and-see attitude, to see how particular programs are going to be implemented. I think that we are seeing at least some dead-weight loss associated with the burdens of shifting financial flows between things that are covered and things that aren't and we are seeing a good deal of rent-seeking behavior as well. What we are seeing is going to have the effect of masking the evolution of underlying fundamentals. It is going to make it harder to see our way through this and understand just what is happening. I think that is going to be a thicket that we will need to cut through in the months ahead. That concludes my comments, Mr. Chairman. " FOMC20080430meeting--114 112,MR. WARSH.," Thank you, Mr. Chairman. As has been described by most around the table, official data on the real economy suggest weakness but haven't materially changed since we met in mid-March. Others have talked in more detail about weakening labor markets, poor consumer sentiment, and worrying trends in consumer spending. Certainly the reports through March that I have received are that consumer spending in March was as bad as anyone who was in the business of retail or credit card spending could have envisioned. That is certainly disappointing. Oddly, there are at least some preliminary data through the first few weeks of April of some improvement, but I don't take much signal from them. Also, obviously, as others around the table have said, the tone, trading, and expectations of financial market participants have improved markedly. If only I were as confident. Whereas market participants only some weeks ago saw fear, they now perceive promise. Whether that is the triumph of hope over experience only time will tell, but I am skeptical. Let me talk for a few moments about a couple of positive factors that should be helping and four or so negative factors. First, on the positive side, I want to give voice to the capitalraising that a couple of others around the table have referred to. We and the Treasury have been calling for some months for capital-raising across all types of financial institutions. The questions then were whether financial institutions were willing to take the dilution and go raise capital. At least equally as important was whether there would be sufficient investor demand. I think the answer to both of those questions appears to be ""yes."" Investor demand from nearly all sources--including sovereign wealth funds, hedge funds, and traditional long-only managers-- has funded virtually all classes of financial institutions--that is, investment banks, money center banks, regional banks, and community banks--across the capital structure--equities, convertibles, and preferred debt--in a huge range of distressed and more-stable situations. I think that is invariably a very encouraging sign, and we should only be so lucky that those markets remain wide open. Is this improvement likely to be enduring? This strikes me as pretty consequential as to whether or not we see the economy respond as favorably in the second half of this year as the Greenbook suggests. Is the improvement in equity markets, in leveraged loans, and in high-yield markets and the narrowing of CDS spreads sustainable, or is there more bad news to come that is not priced into the market? My own view is that balance sheets are on the road to repair but that income statements for these financial institutions remain highly challenged. March was a terrible month for financial institutions' profitability, which should make it harder for credit to expand, as would be hoped for with any sort of V-shaped or Ushaped recovery. The second positive factor, building on the increase in capital, is really what is going on among the Fortune 2000, particularly the nonfinancial Fortune 2000. Earnings look pretty stubborn and solid. Though they have come off their peaks, corporate profit levels are quite remarkable for all of the things that are wrong in this economy, and they look to me to be anachronistic with previous periods of recession. The balance sheets of those Fortune 2000 companies look excellent. The investment-grade markets remain wide open. I think the question is whether those Fortune 2000 will be hiring workers during the next two or three years in the United States, and on that front, I am probably reasonably skeptical. So if those are the positive factors, let me turn to the negative. First, consumer weakness seems to be spreading. The largest credit card providers report that credit card spend is deteriorating--again, absent a couple of odd noises in April--and that the strains showing up as delinquency, which were once only in states where housing issues were predominant, now seem to be in other states as well. Second, credit availability for small business seems under remarkable pressure. Not only has the Senior Loan Officer Opinion Survey continued to be disappointing, large money center banks appear to be pulling back from some segments of the small business markets entirely. Third, interbank funding market problems, as others have discussed, seem inconsistent with the broader improvement in credit markets. It is a troubling sign that all might not be as well as it appears in this curative process. A fourth and final negative factor is inflation. The Greenbook, which has a much more benign forecast for inflation than I do, revised up the forecast for core and headline inflation in the second half of 2008, as David said. I am still more worried about inflation prospects. As for inflation expectations and possible second- and third-order effects of these changes in prices, trading and anecdotes over the last several weeks and months continued to be troubling. I have spent less time in my remarks on inflation than on growth but only because I suppose there is less to say. The trends are troubling. The relationships among our policy actions, the foreign exchange value of the dollar, and commodity prices are worth further scrutiny. In summary, although we should be pleased with the official data on the economy as not deteriorating in the intermeeting period and with financial markets that have certainly exceeded my own expectations for improvement, I remain quite concerned about pressures on both sides of the dual mandate--a discussion that we will take up more in the next round. Thank you, Mr. Chairman. " FOMC20070628meeting--132 130,MR. KOHN.," Thank you, Mr. Chairman. My projection was closely in line with that of the Greenbook, modestly below-trend growth for a few quarters, held down by a prolonged weakness in housing. As that drag abates, the economy picks up to potential and is held back from overshooting that potential by various factors, including the rise in the saving rate and slightly lower growth of government spending. Under these circumstances, core PCE inflation holds in the neighborhood of 2 percent. I do not really see much to push it one way or another at this point. The economy is producing very near its potential, as close as we can figure. Inflation expectations have been moving in a narrow range. Some of the transitory factors, such as owners’ equivalent rent, that we’re expecting to come down to reduce inflation have already done that to a considerable extent. So I don’t see them, moving forward, as having a big effect. Given the limited pass-through of energy and commodity prices into core prices, I would not expect much downward pressure on inflation from a leveling-out of those prices. I think that we are around 2 percent and that we will probably stay there, at least for a little while. In terms of risks, the recent data on capital goods, orders and shipments, and manufacturing activity suggest, as many have remarked, some reduced downside risk from business attitudes on spending. They do not suggest a great deal of strength in business capital spending, however. The fundamentals are less favorable than they were a couple of years ago, and the most recent data, which we received today, suggest a pretty flat or a modest upward tilt to capital spending in the second quarter. The data weren’t that strong, but they do suggest that what I feared in May—that we were in the midst of a cyclical adjustment that was going to make capital spending much weaker—has certainly abated. I agree with many others around the table that housing is a significant downside risk to the forecast, given the high level of inventories despite a major reduction in starts over the past year and the price-to-rent ratio being as high as it is. The further slide in housing may be gentle, as President Lacker said, but I do not think we’ve seen the bottom yet. You can go a long way at a gentle slope. [Laughter] We also have not yet really seen the full effects of the tightening in subprime credit terms or, obviously, of the recent increase in mortgage rates. I also see a big downside risk from consumption. The Greenbook has the growth of consumption sustained despite an increase in saving rates as the growth in disposable income exceeds the growth in GDP—and that is with the labor share recovering and the business profit share declining. I see two downside risks to that. One is that the saving rate will rise faster as the housing weakness feeds through both in terms of wealth effects and in terms of reduced availability of credit as terms tighten and there is less equity to borrow against, particularly for liquidity-constrained households. I also continue to see a downside risk to equity prices, although I have certainly been wrong so far. Nellie’s table presenting the difference between the staff’s forecast of profits and the market’s forecast of profits showed a huge difference for next year. So though I think the basic outlook is fine, I still see some downside risk on that side. On the inflation front, I, like others, see the better-than-expected core inflation as a hopeful sign; but it is recent and may be affected by temporary factors, and I do not think we need to get too enthusiastic about it. I do see several upside risks to inflation: the high level of total headline inflation, which could erode inflation expectations; business resistance to any erosion of profit margins as unit labor costs pick up; the high levels of resource utilization in the United States; and the tighter global conditions of demand on potential supply that others of you have mentioned. Let me say a word or two about my year-three projections. I projected output growth at 2½ percent, the unemployment rate at 4¾ percent, and core PCE inflation at 1.9 percent. I certainly saw my output and employment projections as a sense of what the steady state was. On the unemployment rate, I do think the odds are better that the NAIRU is lower than that it is higher than the staff’s 5 percent assumption. This judgment is partly based on the very moderate pickup in the employment cost index, and average hourly earnings growth has actually been coming off recently. On the behavior of core inflation, I don’t see much evidence that we are significantly beyond potential now, although I recognize that, with a very flat Phillips curve, it could be a long time before one figures that out. But I had growth of potential at 2½ percent, which is below what I infer to be the central tendency of the Committee. Regarding my reading of the decline in productivity growth, productivity over the past five quarters has been growing significantly below the staff’s estimate of 2½ percent. Some of it is cyclical. There could be a revision, as Presidents Plosser and Yellen have suggested. I confess to having asked David Wilcox about this at the break, and he said that the data are kind of ambiguous here and that it is much too early to predict a significant downward revision to employment. But I hope you are right. Now, some of the recent slowdown certainly must be cyclical, though I would have thought that labor hoarding and things like that would be much less in today’s flexible labor markets, with so much more use of temporary workers than there has been in the past. I would think that the cyclical effects on productivity would be muted, that businesses would move pretty promptly to adjust their labor forces to output. So I wonder how much cyclicality there is. The big uncertainty is in the construction industry and in the fact that construction employment hasn’t come down. We don’t quite understand why it hasn’t come down more. So perhaps productivity will pick up. But I still would look at the staff’s 2½ percent as having even just a little more downside than upside risk to it, given the fact that we have had more like 1 to 1½ percent in the past four or five quarters. So I stuck with the staff’s forecast of 2½ percent potential GDP. In some sense, our view of what the potential growth rate is isn’t all that important for monetary policy. We ought to be looking at the gap. We ought to be looking at the pressure of the level of production on the level of potential GDP. But I don’t think it’s quite that easy. We don’t know what that gap is. We have seen that the surprises over the past year or two have been in the behavior of the unemployment rate and capacity utilization relative to growth. So we do tend to look at our estimates of potential growth and the actuals coming in relative to those estimates and pass judgment on what’s happening to the output gap even when the unemployment rate doesn’t move. We just need to remember that potential growth is an entirely estimated number that we will never observe, and we need to be aware that it might not be quite as high as the central tendency indicates that my colleagues on the Committee apparently think it is. Thank you, Mr. Chairman." CHRG-111hhrg51698--18 Mr. Gooch," Thank you. I am Michael Gooch, Chairman and CEO of GFI Group Inc. Thank you, Chairman Peterson and Ranking Member Lucas, for inviting us here to testify today. I began my career in financial brokerage in London in 1978, emigrated to the U.S. in 1979, and eventually became a naturalized U.S. citizen. I founded GFI Group in 1987 with $300,000 of capital. The firm is now one of five major global inter-dealer brokers, or IDBs, with approximately 1,700 employees on six continents and with $500 million in shareholder equity. GFI Group is a U.S. public company listed on NASDAQ under the symbol GFIG. GFI Group and other inter-dealer brokers operate neutral marketplaces in a broad spectrum of credit, financial, equity, and commodity markets, both in cash instruments and derivatives. We are transaction agents to the markets we serve and do not trade for our own accounts. GFI is also a leading provider of electronic trading platforms to many global exchanges and competing IDBs. GFI has been ranked as the number one broker of credit derivatives since the market began over 11 years ago, which provides us with far more experience with the product than any exchange. The leading IDBs offer sophisticated electronic trading technology that has been widely adopted in Europe and Asia. These European markets have functioned well in the wake of the credit crisis. The electronic ATS trading environment for inter-dealer OTC-CDS that is operating successfully in Europe and Asia could be replicated in the U.S. immediately. Most, if not all, of GFI's individual brokers of credit derivatives in the U.S. are licensed, registered representatives, regulated by FINRA. GFI supports this Committee's initiatives for greater transparency, central counterparty clearing, and effective regulatory oversight. However, the matter of central counterparty clearing is not a simple one. Any clearing mechanism is only as good as its members in the event that its initial clearing funds are exhausted. It is my opinion, and I believe it is shared by many in the financial community, that in the event major global investment banks had failed last September, then the clearinghouses of the various futures exchanges would have failed, too. Sixty percent of the inter-bank volume in credit derivatives is transacted outside of the United States. To successfully achieve OTC clearing, large inter-bank dealer and global cooperation will be required. Notwithstanding the complexities of central clearing a global OTC credit derivatives market, it is my view that the listed exchanges can play an important role in introducing simple vanilla futures contracts on the most liquid indexes and single names. Both cleared and uncleared OTC and listed futures can co-exist as they do in most other financial markets. I would like to specifically address two sections of the proposed legislation: section 14 and section 16. We support the extension of CFTC regulation to the market for carbon offset credits and emissions allowances under section 14 of the bill. As a major broker of European emissions credits, we are very familiar with the importance of an orderly, efficient, and well-regulated marketplace. Therefore, we do not see a reason why the proposed legislation requires all trades to be done on a designated contract market and not also allowed on a CFTC-regulated DTEF. We believe that the limitation of transactions to DCMs needlessly stifles competition, leading to greater costs that are ultimately passed along to the consumer. With regard to section 16, we are very concerned that the elimination of naked interest will kill the CDS market and significantly inhibit the liquidity of credit markets, including the market for corporate bonds and bank loans. Just as third-party liquidity providers and risk takers are willing to buy and sell futures and options in agricultural products, providing much-needed liquidity for businesses in agriculture to hedge and offset risk, so do such risk takers enhance liquidity in credit markets. There is plenty of capital on the sidelines today willing to take risk in credit without becoming direct lenders. This source of credit will not be available if the buying of credit derivatives is limited to those with a direct interest in the underlying instruments. That is because risk takers need to take risk on both sides of the market in order for there to be a liquid market. New issuance of corporate debt cannot happen without a liquid, functioning bond market; and since credit derivatives are often more liquid than the market for the underlying bonds, it is clear that a functioning credit derivatives market is paramount for the unfreezing of credit markets. Killing the CDS market will contribute to an extended period of tight lending markets, where credit will only be available to the most secure borrowers, which will extend and deepen the current recession we are experiencing. Thank you for this opportunity to address you today. I will be happy to answer any questions you may have. [The prepared statement of Mr. Gooch follows:]Prepared Statement of Michael A. Gooch, Chairman of the Board and CEO, GFI Group, Inc., New York, NY I am Michael Gooch, Chairman and CEO of GFI Group, Inc. Thank you Chairman Peterson and Ranking Member Lucas for inviting us to testify today. About GFI Group: I began my career in financial brokerage in London in 1978, emigrated to the U.S. in 1979 and became a naturalized U.S. citizen. I founded GFI Group in 1987 with $300,000 of capital. The firm is now one of five major global ``inter-dealer brokers'' with approximately 1,700 employees on six continents and with 500 million dollars in shareholder equity. GFI Group is a U.S. public company listed on the NASDAQ under the symbol ``GFIG''. GFI Group and the other inter-dealer brokers operate neutral market places in a broad spectrum of credit, financial, equity and commodity markets both in cash instruments and derivatives. GFI group has a strong presence in many over-the-counter (or ``OTC'') and listed derivative markets and has a reputation as being the leader globally in Credit Derivatives. We function as an intermediary on behalf of our brokerage clients by matching their trading needs with counterparties having reciprocal interests. We are transaction agents to the markets we serve and do not trade for our own account. We offer our clients a hybrid brokerage approach, combining a range of telephonic and electronic trade execution services, depending on the needs of the individual markets. We complement our hybrid brokerage capabilities with decision-support service, such as value-added data and analytics products and post-transaction services including straight-through processing (or ``STP'') and transaction confirmations. We earn revenues for our brokerage services and charge fees for certain of our data and analytics products. We are also a leading provider of electronic trading software through our Trayport subsidiary, which licenses critical transaction technology in numerous product markets from energy to equities that is used by institutional market participants, such as futures exchanges and competing IDBs. GFI is a global leader in numerous OTC derivatives markets. We have ranked as the number one broker for credit derivative since the market began over 11 years ago. In that time, GFI Group has brokered billions of dollars of credit derivative transactions that provides us with far more experience with the product than any exchange. In 2008, GFI was ranked as both the Number One Credit Derivative Broker and the Number One Commodity Broker.About Inter-Dealer Brokerage: I would like to take a moment to describe the market role played by inter-dealer brokers such as GFI. Inter-dealer Brokers (or ``IDBS'' as they are known) are an established part of the global, financial landscape. GFI and its competitors, aggregate liquidity and facilitate transactions in both OTC and exchange transactions between major financial and non-financial institutions around the world. IDBs cross transactions over-the-counter in listed futures in equities, energy and financial markets and post them to recognized exchanges within stringent regulator-mandated reporting time frames. The leading IDBs offer sophisticated electronic trading technology that has been widely adopted in Europe and Asia. These European markets have functioned well in the wake of the credit crisis. In the credit derivatives market, for example, millions of electronic messages are recorded and processed by IDBs in real time every business day. With the most sophisticated IDBs that handle the bulk of the inter-dealer business in Europe, Asia and the U.S., the technology is connected via API to the Depository Trust Clearing Corporation (DTCC) the main central warehouse for CDS trades with Straight through Processing (STP) to all the major credit derivatives dealers. The electronic ATS trading environment for inter-dealer OTC-CDS that is operating successfully in Europe and Asia could be replicated in the U.S. immediately. At least four global regulated inter-dealer brokers have the ATS technology in place to achieve this now. Most, if not all, of GFI's individual brokers of credit derivatives in the U.S. are licensed, registered representatives regulated by the Financial Industry Regulatory Authority (FINRA). Such IDBs with FINRA registered representatives keep electronic copies of all communications supporting each credit derivatives transaction they cross and the bids and offers leading up to those trades. Trading data, in some cases, goes back as far as 1996.About the Proposed Legislation: As a major aggregator of liquidity in OTC derivatives, GFI supports this Committee's initiatives for greater transparency, central counterparty clearing and effective regulatory oversight. We believe that enhancing transparency and eliminating counterparty risk will be a major improvement in the CDS market structure that will ensure its role as a credit transfer tool for investors. We commend the Committee for its efforts to achieve these goals. We also support its efforts to provide the CFTC with greater regulatory oversight. We have a deep appreciation for the work of the CFTC. Our experience is that they are dedicated, competent, and hard working and have done an excellent job. Nevertheless, the matter of central counterparty clearing is not a simple one. A central clearing mechanism requires a degree of standardization and price transparency not available for all instruments and all credits. Any clearing mechanism is only as good as its members in the event its initial clearing funds are exhausted. It is my opinion and I believe it is shared by many in the financial community that in the event certain major, global investment banks had failed last September, then the clearing houses of the various futures exchanges would have failed too. The large banks and prime brokers represent the bulk of the open interest on the various futures exchanges and the gapping of markets that would have occurred overnight in such an outcome would have led to a call on the capital of the very firms that may have failed. To have illiquid credits in such clearing mechanisms would only have exacerbated the problem. Since the large banks and prime brokers represent the bulk of the clearing capital at risk, it makes sense that a clearing solution provided by those banks with a high degree of transparency on pricing and mark to market makes the most sense. We believe that the credit derivatives market could certainly benefit from a central counterparty. It would be a mistake, however, to presuppose that the entire market for credit derivatives operates only in the U.S. and that a single vertical clearing and execution venue can be designated for the entire global market. Sixty (60%) percent of the inter-bank volume in credit derivatives is transacted outside of the United States. Central counterparty clearing in CDS is a complex issue that is under-estimated by those that propose or believe it can be achieved almost overnight. To successfully achieve OTC clearing, large inter-bank dealer and global co-operation will be required. Notwithstanding the complexities of centrally clearing a global OTC credit derivative market, it is my view that the listed exchanges can play an important role in introducing simple vanilla futures contracts on the most liquid indexes and single names. Both cleared and un-cleared OTC and listed futures can co-exist as they do in most other financial markets.Issues Raised by the Proposed Legislation I would like to specifically address two sections of the proposed legislation: section 14 and section 16. We support the extension of CFTC regulation to the market for carbon offset credits and emission allowances under section 14 of the bill. As a major broker of European emissions credits, we are very familiar with the importance of an orderly, efficient and well regulated marketplace. Therefore, we do not see a reason why the proposed legislation requires all trades to be done on a Designated Contract Market (or ``DCM'') and not also on a CFTC-regulated ``Derivatives Transaction Execution Facility'' (or ``DTEF''). We believe that the limitation of transactions to DCMs needlessly stifles competition leading to greater costs that are ultimately passed along to the consumer. With regard to section 16, we are very concerned that limiting participation in the Credit Derivatives market to entities with a direct interest in the credit being protected, i.e., elimination of naked interest, will kill the CDS market and significantly inhibit the liquidity of the credit markets, including the market for debt instruments such as corporate fixed income and bank loans. Just as third party liquidity providers and risk takers are willing to buy and sell futures and options in agricultural products providing much needed liquidity for businesses in agriculture to hedge and offset risk, so do such risk takers enhance liquidity in credit markets. There is plenty of capital on the side lines today willing to take risk in credit without becoming direct lenders. This source of credit will not be available if the buying of credit derivatives is limited to those with a direct interest in the underlying instruments. That is because risk takers need to take risk on both sides of the market in order for there to be a liquid market. Without question, new issuance of corporate debt cannot happen without a liquid, functioning bond market and, since credit derivatives are often more liquid than the market for the underlying bonds, it is clear that a functioning credit derivatives market is paramount for the unfreezing of credit markets. Killing the CDS market will contribute to an extended period of tight lending markets where credit will only be available to the most secure borrowers. CDS has become so integral to the functioning of credit markets that killing it will extend and deepen the current recession we are experiencing. In conclusion, let me just say that the global market for credit derivatives is not murky or unregulated as some would have us believe. Rather, it is highly liquid and, potentially, quite transparent. It is today functioning well and will play an important role in the unfreezing of the credit markets and the recovery of the global economy. That critical role could be jeopardized if we do not sort out the half-truths and misperceptions surrounding credit derivatives and their market structure. It is only then that the discussion of improving the credit derivatives market through central clearing and electronic trading can be put in proper context. Thank you for this opportunity to address you today. I will be happy to answer any questions you may have. " CHRG-111hhrg52397--236 Mr. Sprecher," Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee, my name is Jeff Sprecher, and I am the chairman and chief executive officer of IntercontinentalExchange, which is also known by our New York Stock Exchange ticker symbol as ICE. I very much appreciate the opportunity to appear before you today to testify on the over-the-counter derivatives regulation. And, Congressman Scott, thank you for your kind introduction earlier today. In the mid-1990's, I was a power plant developer in California, and I witnessed the State's challenge in launching a market for electricity. Problems arose from a complex market design and partial deregulation, and I was convinced that there was a more efficient and transparent way to manage risks in the wholesale markets for electric power and natural gas. Therefore, in 1997, I purchased a small energy trading platform that was located in Atlanta, and I formed ICE. The ICE over-the-counter platform was designed to bridge a void that existed between a bilateral, voice-brokered over-the-counter market, which were opaque, and open up futures exchanges, which were inaccessible or they lacked products that were needed to hedge power markets. ICE has grown substantially over the past decade, and we now own three regulated futures exchanges and five regulated clearinghouses. Yet, we still continue to offer the over-the-counter processing along with futures markets. In discussing the need for the over-the-counter regulation, it is important to understand the size of the over-the-counter derivatives market and their importance to the health of the U.S. economy. In this current credit crisis, derivatives have been commonly described as complex, financially engineered products transacted between large banks. However, in reality, an over-the-counter derivative can encompass anything from a promise of delivery in the future between a farmer and his grain elevator, to a uniquely structured instrument, like an exotic option, and much of the Nation's risk management occurs in between these two extremes. Derivatives are not confined to large corporations. Small utilities, farmers, manufacturing companies and municipalities all use derivatives to hedge their risks. Providing clearing, electronic execution and trade processing are core to ICE's business model. As such, my company would clearly stand to benefit from legislation that required all derivatives to be traded and cleared on an exchange. However, forcing all OTC derivatives onto an exchange would likely have many negative and unintended consequences for our markets as a whole. In derivative markets, clearing and exchange trading are separate concepts. At its core, exchange trading is a service that offers order matching to market participants. Listing a contract on an exchange does not necessarily mean it will have better price discovery. Exchange trading works for highly liquid products, such as the Russell 2000 or standardized commodity contracts that appeal to a whole host of a broad set of market participants. However, for many other markets, exchange trading is not the best solution as the market may be illiquid, with very wide bid offer spreads, leading to poor or misleading price signals. Nonetheless, these illiquid products can still offer value to hedgers and thus they have a place in the over-the-counter deliberative market. Turning to clearing, this technique gracefully reduces counterparty and systemic risk in markets where you have standardized contracts. However, forcing unstandardized contracts into a clearinghouse could actually increase market risk. Where the market depth is poor or the cost of contracts are not accurate for price discovery, it is essential that the clearinghouse be operated so that it can see truly discovered value. So while ICE certainly supports clearing as much standardized product as is possible, there will always be products which are either non-standard nor sufficiently liquid for clearing to be practical, economic or even necessary. Firms dealing in these derivatives should nonetheless have to report them to regulators so that regulators have a clear and a total view of the market. ICE has been a proponent of appropriate regulatory oversights of markets and as an operator of global futures and over-the-counter markets, we know the importance of ensuring the utmost confidence, which regulatory oversight contributes to. To that end, we have continuously worked with regulatory bodies in the United States and abroad to ensure that they have access to relevant information that is available from ICE regarding trading activity in our markets. We have also worked closely with Congress and regulators to address the evolving oversight challenges that are presented by complex derivatives. We continue to work cooperatively to seek solutions that promote the best marketplace possible. Mr. Chairman, thank you for the opportunity to share our views with you, and I will be happy to answer any questions that you may have. [The prepared statement of Mr. Sprecher can be found on page 182 of the appendix.] " FOMC20060510meeting--141 139,MR. FISHER.," Well, I think Bill Poole has summarized a lot of what I would have said. I forecasted that in the memo that was sent around. I would advocate tightening 50 basis points. I would dispute only one comment of President Poole’s. Getting ahead of the markets is less important than getting ahead of the economy. I do take note of your FOMC surprise chart. The question really is, If we undertake an action, will it lead to a market reaction that might affect the economy negatively? It’s not so much that we have a market surprise. We’re going to have market surprises at any time, and I can walk you through, after thirty years of operating a hedge fund, a four-year cycle of market surprises. A market surprise is going to hit us at some point, but the question is, Is it a trip wire? There is a risk that the trip wire would be the housing market. We’ve discussed that to a great degree, although you, Mr. Chairman, I think gave us some good data on the offset. I think it’s important for us to get ahead of what I view—not just because of the anecdotal evidence we have but also because of the work done by our staff—as a significant expansion in capital expenditures with growth shifting to very strong business investment, excess liquidity that is going to fuel that investment, and as we all discussed, significant indications that inflation is stronger than we would like to see it. We see that analytically, as I said earlier, with the way we calculate inflation in Dallas, but also from the anecdotal evidence. Having said that, I think the wording that is now in alternative B is more attractive. I know there are some who would like to provide what I call a full frontal view of what we look like and what we discussed. But as I like to say, Mr. Chairman, in romancing the market sometimes a little modesty might be more effective in achieving the ultimate goal. I think we’ve achieved that to an extent. I do not like the language that we see growth as likely to moderate because I don’t have confidence in that statement and I’m not sure it’s necessary. I’d prefer the wording that President Poole sent around in terms of its brevity. However, in the interest of perhaps more exposure, or a more-revealing presentation, I would like to add one word, which is the word “global” before “resource utilization.” [Laughter] Thank you very much." FOMC20081029meeting--250 248,MR. WARSH.," Thank you, Mr. Chairman. The first sentence of the Greenbook said that ""recent economic and financial news has been dismal""; and the last sentence on page 1 of the Bluebook said that ""markets generally remain extremely illiquid and volatile."" I can't do better than that, but I can certainly do worse; so let me give that a try. [Laughter] Market prices and official and corporate data confirm an additional leg down in midSeptember, which has been much discussed. I think it is going to become increasingly clear that October, particularly the first 20 days of the month, was materially worse. So if we fell off the cliff in the middle of September, I think that once the data come out and find their way into the marketplace in October, the Greenbook forecast might look a bit more positive than the facts on the ground would suggest. As a result, my own forecast is less optimistic than the Greenbook, but there is plenty of uncertainty, as I think Dave Stockton talked about yesterday. Let me make a few comments about financial markets before turning to the broader economy. I expect a prolonged period of significantly strained credit markets, and that strain is likely to be exacerbated between now and year-end and I suspect even well into 2009. The credit intermediation process that we've talked about is fundamentally broken. I talked six months ago about the financial architecture that was fundamentally being changed. I think that has all happened faster than I could have anticipated. Confidence, not just in counterparties but in basic rules of doing business across financial markets, has been lost, and my own sense is that loss of confidence is not easily fixed, even by well-intended government programs. We should all be quite patient in terms of seeing the benefits of the rather dramatic actions taken by the official sector, both here in the United States and overseas. Corporate bond rates and other risk spreads may well fall from their recent peaks, as suggested in the Greenbook, but spreads across asset classes are likely to stay far wider than historical norms throughout the forecast period. I think these new spread relationships are uncertain. So what we thought would be sort of normal spreads of LIBOR and normal spreads of corporate bonds, all have to be reassessed not just by us but also by market participants. Even if credit is now made more available to businesses through some of these new Treasury and other programs, I suspect the all-in cost of capital is likely to materially impede business investment, particularly given expectations by businesses for a weaker economy in the upcoming period. As Vice Chairman Geithner suggested, monetary policy might be able to do a bit about this, but it is not going to be able to change it very much. Let me turn to three points on the economy before closing. First, in the near term, given my sense of how October is tracking, it's likely to be extraordinarily weak. I expect weaker fourthquarter consumption than the Greenbook, weaker labor markets going into 2009, and a materially weaker fourth-quarter GDP print. Some labor surveys--including some of my own preferred measures, like the JOLTS--seem to be holding up; but I'm not sure that that's going to hold for another couple of months. So I'd expect the labor markets to trend more materially in the direction that I've discussed. Well, what about beyond the near term? What about 2009 and beyond? It strikes me that the catalysts for marked improvement are lacking. When I think about fiscal policy, regulatory policy, tax policy, and trade policy, which I talked about previously, it's not obvious to me that any of those are going to provide some kind of catalyst for a marked change in the contour of the economy. On the fiscal front, I assume that the fiscal stimulus is likely to be larger, maybe even materially larger, than in the Greenbook alternative simulation, but my own conclusions are similar to the Greenbook's, which is that I'm not sure it's going to be terribly effective. I'm not sure it's going to be constructed in that way, and I'm not sure it will do nearly as much as it will inevitably be advertised to do. A more disturbing trend probably even than the efficacy of a fiscal package-- which in my own view is absolutely necessary, but again I query whether it's going to be structured in a way to do what it needs to do--is that potential output in the forecast period is likely to fall. Trend growth rates are coming down, and I expect productivity to fall perhaps even more than in the Greenbook projection. The vaunted resilience of the U.S. economy, which I've talked about for a long time, is certainly going to be tested during this period. Business investment, it strikes me, will be a useful gauge as we get into the first quarter of 2009 to see how tough an economic period we have in front of us, and I worry about the decisions that business people will be making. Now, of course, against all of this, markets could snap back, as we saw a little yesterday--2009 could look better. We have to remain open minded about the possibility that the economy will continue, as it has over the past ten or fifteen years, to outperform model-based expectations. Let me turn to foreign growth. These decouplers, which were so prominent for so long, are somehow hard to find these days. Foreign growth strikes me as likely to fall faster and stay lower than in the Greenbook projection. The road back is not likely to begin as early as the first quarter of 2009 for our major trading partners. The ""more financial fallout"" alternative simulation strikes me as significantly more likely for foreign growth. In light of a growth trajectory that is better here in the United States than outside the United States, at least relative to current market expectations, I'd expect the foreign exchange value of the dollar on balance to strengthen against a basket of foreign currencies. So let me turn finally to inflation. The trend on import prices, the broad measures of commodity prices, and the expected dollar strength all suggest that inflation problems are abating markedly. I think an open question, which isn't likely to be dispositive but is likely to be interesting, is how sticky prices are, particularly from the consumer product companies during this period--how long the various surcharges and increases in prices we've seen can stay high and the companies attempt to keep profit margins. My guess is that they can make profit margins look decent for another quarter or two; but beyond that, prices across a broad set of products and services are likely to retrace some of the gains in recent periods. I'll save the balance of my remarks for the next round. Thank you, Mr. Chairman. " fcic_final_report_full--572 Economics 64 (2008): 223. 31. Michael Calhoun and Julia Gordon, interview by FCIC, September 16, 2010. 32. Annamaria Lusardi, “Americans’ Financial Capability,” report prepared for the FCIC, February 26, 2010, p. 3. 33. FCIC staff estimates based on analysis of Blackbox, S&P, and IP Recovery, provided by Antje Berndt, Burton Hollifield, and Patrik Sandas, in their paper, “The Role of Mortgage Brokers in the Sub- prime Crisis,” April 2010. 34. William C. Apgar and Allen J. Fishbein, “The Changing Industrial Organization of Housing Fi- nance and the Changing Role of Community-Based Organizations,” working paper (Joint Center for Housing Studies, Harvard University, May 2004), p. 9. 35. Herb Sandler, interview by FCIC, September 22, 2010. 36. Wholesale Access, “Mortgage Brokers 2006” (August 2007), pp. 35, 37. 37. Jamie Dimon, testimony before the FCIC, First Public Hearing of the FCIC, panel 1: Financial In- stitution Representatives, January 13, 2010, transcript, p. 13. 38. October Research Corporation, executive summary of the 2007 National Appraisal Survey, p. 4. 39. Dennis J. Black, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis— Miami, session 2: Uncovering Mortgage Fraud in Miami, September 21, 2010, p. 8. 40. Karen J. Mann, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis— Sacramento, session 2: Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacramento Region, September 23, 2010, p. 2. 41. Gary Crabtree, testimony before the FCIC, Hearing on the Impact of the Financial Crisis— Greater Bakersfield, session 4: Local Housing Market, September 7, 2010, transcript, p. 172. 42. Complaint, People of the State of New York v. First American Corporation and First American eAppraiseIT (N.Y. Sup. Ct. November 1, 2007), pp. 3, 7, 8. 43. Martin Eakes, quoted in Richard A. Oppel Jr. and Patrick McGeehan, “Along with a Lender, Is Citigroup Buying Trouble?” New York Times , October 22, 2000. 44. Pam Flaherty, quoted in Erick Bergquist, “Judging Citi, a Year Later: Subprime Reform ‘on Track’; Critics Unsatisfied ,” American Banker, September 10, 2001. 45. “Citigroup Settles FTC Charges against the Associates Record-Setting $215 Million for Subprime Lending Victims,” Federal Trade Commission press release, September 19, 2002. 46. Mark Olson, interview by FCIC, October 4, 2010. 47. Timothy O’Brien, “Fed Assess Citigroup Unit $70 Million in Loan Abuse,” The New York Times , May 28, 2004. 48. Federal Reserve Board internal staff document, “The Problem of Predatory Lending,” December 5, 2000, pp. 10–13. 49. Federal Reserve Board, Morning Session of Public Hearing on Home Equity Lending, July 27, 2000, opening remarks by Governor Gramlich, p. 9. 50. Scott Alvarez, interview by FCIC, March 23, 2010. 51. Alan Greenspan, written testimony for the FCIC, Hearing on Subprime Lending and Securitiza- tion and Government-Sponsored Enterprises (GSEs), day one, session 1: The Federal Reserve, April 7, 2010, p. 13. 52. Alan Greenspan, quoted in David Faber, And Then the Roof Caved In: How Wall Street’s Greed and Stupidity Brought Capitalism to Its Knees (Hoboken, N.J.: Wiley, 2009), pp. 53–54. 53. “Truth in Lending,” Federal Register 66, no. 245 (December 20, 2001): 65612 (quotation), 65608. 569 54. Robert B. Avery, Glenn B. Canner, and Robert E. Cook, “New Information Reported under HMDA and Its Application in Fair Lending Enforcement,” Federal Reserve Bulletin 91 (Summer 2005): 372. 55. Alan Greenspan, interview by FCIC, March 31, 2010 56. Sheila Bair, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 2, ses- sion 2: Federal Deposit Insurance Corporation, September 2, 2010, transcript, p. 191. 57. Dolores Smith and Glenn Loney, memorandum to Governor Edward Gramlich, “Compliance In- spections of Nonbank Subsidiaries of Bank Holding Companies,” August 31, 2000. 58. GAO, “Consumer Protection: Federal and State Agencies Face Challenges in Combating Preda- tory Lending,” GAO 04–280 (Report to the Chairman and Ranking Minority Member, Special Commit- tee on Aging, U.S. Senate), January 2004, pp. 52–53. 59. Sandra Braunstein, interview by FCIC, April 1, 2010. Transcript pp. 32–33. 60. Greenspan, interview. 61. Ibid. 62. Edward M. Gramlich, “Booms and Busts: The Case of Subprime Mortgages,” Federal Reserve Bank of Kansas City Economic Review (2007): 109. 63. Edward Gramlich, quoted in Greg Ip, “Did Greenspan Add to Subprime Woes? Gramlich Says Ex- Colleague Blocked Crackdown On Predatory Lenders Despite Growing Concerns,” Wall Street Journal, June 9, 2007. See also Edmund L. Andrews, “Fed Shrugged as Subprime Crisis Spread,” New York Times, December 18, 2007. 64. Patricia McCoy and Margot Saunders, quoted in Binyamin Appelbaum, “Fed Held Back as Evi- dence Mounted on Subprime Loan Abuses,” Washington Post, September 27, 2009. 65. GAO, “Large Bank Mergers: Fair Lending Review Could be Enhanced with Better Coordination,” GAO/GDD-00-16 (Report to the Honorable Maxine Waters and Honorable  Bernard Sanders, House of Representatives), November 1999; GAO, “Consumer Protection:  Federal and State Agencies Face Chal- lenges in Combating Predatory Lending.” 66. “Federal and State Agencies Announce Pilot Project to Improve Supervision of Subprime Mort- gage Lenders,” Joint press release (Fed Reserve Board, OTC, FTC, Conference of State Bank Supervisors, American Association of Residential Mortgage Regulators), July 17, 2007. 67. “Truth in Lending,” pp. 44522–23. “Higher-priced mortgage loans” are defined in the 2008 regula- tions to include mortgage loans whose annual percentage rate exceeds the “average prime offer rates for a comparable transaction” (as published by the Fed) by at least 1.5% for first-lien loans or 3.5% for subordi- nate-lien loans. 68. Alvarez, interview. 69. Raphael W. Bostic, Kathleen C. Engel, Patricia A. McCoy, Anthony Pennington-Cross, and Susan M. Wachter, “State and Local Anti-Predatory Lending Laws: The Effect of Legal Enforcement Mecha- nisms,” Journal of Economics and Business 60 (2008): 47–66. 70. “Lending and Investment,” Federal Register 61, no. 190 (September 30, 1996): 50965. 71. Joseph A. Smith, “Mortgage Market Turmoil: Causes and Consequences,” testimony before the Senate Committee on Banking, Housing, and Urban Affairs, 110th Cong., 1st sess., March 22, 2007, p. 33 (Exhibit B), using data from the Mortgage Asset Research Institute. 72. Lisa Madigan, written testimony for the FCIC, First Public Hearing of the FCIC, day 2, panel 2: Current Investigations into the Financial Crisis—State and Local Officials, January 14, 2010, p.12. 73. Commitments compiled at National Community Reinvestment Coalition, “CRA Commitments” (2007). 74. Josh Silver, NCRC, interview by FCIC, June 16, 2010. 75. Data references based on Reginald Brown, counsel for Bank of America, letter to FCIC, June 16, 2010, p. 2; Jessica Carey, counsel for JPMorgan Chase, letter to FCIC, December 16, 2010; Brad Karp, counsel for Citigroup, letter to FCIC, March 18, 2010, in response to FCIC request; Wells Fargo public commitments 1990–2010, data provided by Wells Fargo to the FCIC. 76. Karp, letter to FCIC, March 18, 2010, in response to FCIC request. 77. Carey, letter to FCIC, December 16, 2010, p. 9; Brad Karp, counsel for JP Morgan, letter to FCIC, FOMC20081029meeting--164 162,MS. KOLE.," 4 I'm referring to the next exhibits that are attached to the material you are already looking at. Since the September FOMC meeting, financial market distress has intensified and has spread around the world, threatening many emerging market economies that previously had been less affected by the U.S. and European credit crisis. As shown in the top left panel, equity prices have fallen sharply in Europe, 4 The materials used by Ms. Kole are appended to this transcript (appendix 4). Japan, and the United Kingdom. Indeed, the Nikkei is at a 26-year low today. The carnage has been just as pronounced in emerging markets, shown on the right. Credit spreads between industrial countries' risky corporates and government bonds (plotted in the middle left panel) soared, especially in the euro area; and as shown in the right panel, credit default swap premiums on sovereign debt in many emerging market economies have skyrocketed. The widespread pullback from risk led to safe-haven flows into dollar assets; as shown in the bottom left panel, the dollar appreciated nearly 11 percent against the major currencies (the black line) despite a 9 percent depreciation against the yen (the red line) as carry trades were unwound. The dollar strengthened 9 percent against the currencies of our other important trading partners. As shown on the right, effective exchange values of the currencies of Brazil, Mexico, and Korea were particularly hard hit. In your next exhibit, the top left panel shows the extent to which investors fleeing risk have been liquidating emerging market equity funds. Several foreign governments, notably Russia's, have fought related currency pressures by drawing down their reserves (the top right panel). For instance, since the peso fell sharply against the dollar in early October, the Bank of Mexico has deployed 15 percent of its reserves to shore up its value. China and Russia have even intervened to stem the fall in their equity prices. Following the collapse of Lehman Brothers, credit markets seized up, and dollar funding needs intensified. Since then, governments around the world have taken several steps to support their banking systems (the middle panel). Some central banks have injected massive amounts of liquidity, and many have cut policy rates or reserve requirements or both. In addition to the countries joining the Fed in a coordinated 50 basis point rate cut on October 8, a wide range of other economies have eased policy lately. Note that there have been a few exceptions: Hungary, Iceland, and Denmark increased rates to counter currency pressures. Governments have also expanded bank deposit insurance and guaranteed new bank lending in order to improve confidence and liquidity. Following a similar initiative in the United Kingdom, euro-area governments announced plans to guarantee the issuance of new medium-term senior debt by banks and to directly assist their recapitalization if necessary. In recent weeks, authorities have announced capital injections into a number of banks whose financial soundness was in question. The swap lines extended by the Federal Reserve to foreign central banks have been expanded. The ECB approved a 5 billion swap line for Hungary and a 12 billion one for Denmark, and several Asian countries are currently negotiating swap lines with each other as well. Private firms in several emerging market economies have confronted pressures in rolling over foreign currency funding, and authorities there have also raised deposit guarantees, guaranteed bank lending, and injected capital into vulnerable banks. Finally, several countries have applied to the IMF for assistance. The bottom left panel shows median credit default swap premiums for banks in Europe, the United Kingdom, and the United States. The declines since the beginning of this month suggest that the announcement of these plans has improved confidence in banks' safety, even if they have not restored confidence in broader economic prospects. As shown by the implied OIS forward rates in the bottom middle panel, market participants expect considerably more monetary policy easing in Europe than they did at the time of the last FOMC meeting. We assume that further cuts in official rates (shown on the right) will be forthcoming as output falls short of potential and inflation recedes. As can be seen in exhibit 3, highly stressed global financial conditions and the weaker U.S. outlook have led us to take a whack out of our outlook for foreign growth. Comparing lines 1 and 2, we have marked down our estimate of total foreign growth for the third quarter more than 1 percentage point, and we have slashed our forecast even more for Q4 and 2009. We project outright recessions in the advanced foreign economies (lines 3 through 7) and in Mexico (line 12). In other emerging economies, we foresee growth rates well below potential. Chinese real GDP growth (line 10) is estimated to have slowed considerably in the third quarter. We expect some payback in Q4, but beyond that we have revised down our outlook. As can be seen in the middle left panel, exports fell in August in many of our largest trading partners, though they still chugged along in China through September. The black line in the middle panel shows that the volume of exports from Canada has been falling for some time, but exports had held up in Japan and Germany until the third quarter, when they fell. Industrial production in Japan (the red line in the middle right panel) has fallen nearly 5 percent below its year-ago level, and IP has also fallen over the past year in the United Kingdom and the euro area. As global demand has slumped, oil prices (the black line in the bottom left panel) have plummeted, and nonfuel commodity prices have fallen as well. The decline in commodity prices along with slackening economic activity is projected to help bring down inflation in all of the regions shown (on the right). Exhibit 4 focuses on the outlook for Europe. Banks remain leery of lending to each other, as evidenced by the growing amount of funds parked at the ECB's deposit facility. The latest BoE bank lending survey (the top right panel) pointed to further tightening of U.K. lending standards in the third quarter and suggested that banks expected to tighten them somewhat further in the fourth quarter (the striped bars). Notably, this survey was taken before Lehman failed. A confidential conversation with a contact at the BoE who had talked with a few bankers more recently suggested that the latest survey considerably underestimated the recent tightening of standards. The quarterly growth of U.K. loans to nonfinancial corporations (the red line in the middle left panel) fell from double-digit paces for the past two years to 5 percent in the third quarter. Credit expansion to households (the dashed line) declined as well. Loan growth in the euro area (the middle panel) also slowed. Europe has clearly moved into recession. The middle right panel shows that house prices have fallen over the past year in the United Kingdom and Ireland and have also slowed in other European locales. But it is not just the property sector that has slumped. Business confidence (the bottom left) has disintegrated. Total economy purchasing managers' indexes (the middle panel) are in the downturn range in both the United Kingdom and the euro area. Unemployment rates have increased, especially in France and Spain, where construction activity has slowed sharply. Your next exhibit takes a quick tour through the rest of the world. In Japan, business confidence (the red line) has plunged, partly because lending terms faced by firms, particularly small and medium-sized enterprises, have become more restrictive. Investment intentions (not shown) have deteriorated as shipments (the black line) and exports have declined. The labor market has deteriorated, with the ratio of job offers to applicants (in blue) falling to its lowest level in the past four years. The Bank of Japan recently downgraded its outlook and stepped up measures to deal with financial market stresses. In China, investment spending (the black dashed line in the top right panel) continued to be strong through September, and retail sales accelerated. However, industrial production (middle left panel) slowed this summer partly because of efforts to reduce pollution in Beijing during the August Olympics but also because of declining steel production, suggesting further slowing. Industrial production has also slowed in Korea and Taiwan, and export orders (shown on the right) are falling in China, Brazil, and Singapore. As shown in the bottom left panel, Mexico has suffered a steep fall in remittances, flattening industrial production, and declining auto exports. Oil revenues (not shown) are down as well. Finally, global PMI and new orders indexes, which aggregate data for 26 major countries, are both in contractionary territory but have not yet reached their depths at the trough of the 2001 recession. Exhibit 6 reviews the main elements of the U.S. external outlook. As shown in line 1 of the top panel, net exports contributed 1.8 percentage points to growth in the first half of this year, but we expect this contribution to drop off considerably in coming quarters as exports (line 3) slow with foreign growth and imports (line 5) remain flat. Total foreign growth (the black line in the middle left panel) is now projected to dip down about as much as U.S. growth, while the dollar (shown on the right) is well above the level we projected in the September Greenbook. As shown in line 3 of the table, we now expect export growth to move down sharply starting in the current quarter and to remain well below what we'd written down in our last forecast. Although lower U.S. demand caused us to lower import growth (line 5), the projected contribution of net exports to GDP growth has, on net, been revised down a bit over the forecast period. The bottom panel gives a longer perspective on U.S. external deficits. The non-oil trade deficit (the dashed orange line) and current account deficit (the red line) have continued to narrow over the past year and a half although oil imports have remained large. The current account deficit to GDP ratio is forecast to fall below 3 percent in 2010, a level last reached in 1998. Brian Madigan will continue with our presentation. " FOMC20050630meeting--377 375,MR. KOHN.," Thank you, Mr. Chairman. I made only small revisions to my forecast from last January. We’ve seen some notable fluctuations in data and sentiment over the last five months, but basically I think we’ve ended up pretty close to where we started, with prospects for growth that are close to the growth rate of potential, perhaps a bit above, and core PCE inflation stable at a little over its rate of last year. The data we received over the intermeeting period reinforced this favorable outlook, assuaging some of the concerns on both the demand and inflation fronts that I had at our meeting in early May. Growth in private final purchases has been good, with the second-quarter forecast to be around 4 percent. Slack in labor markets has continued to erode gradually. Core CPI inflation slowed, supporting the notion that some of the earlier pickup was a product of the pass-through of previous increases in energy and other import prices, and core PCE inflation has been stable. Commodity and intermediate goods price pressures have abated, consistent with the moderate pace of increase in production and a judgment that the global economy was not facing significant bottlenecks, except possibly in energy markets. And importantly, inflation expectations fell on balance despite the further increase in oil prices. The recent further rise in oil prices will indeed put some upward pressure on core inflation, but that should be limited in time, and increases in the prices of other imports should abate considerably, owing to the strength of the dollar. Moreover, the behavior of most measures of labor compensation suggests to me that labor markets are not in the process of overheating and may even have some degree of slack remaining. And declines in inflation expectations provide some assurance that past increases in energy and June 29-30, 2005 146 of 234 Over time, of course, it is appropriate monetary policy that will keep the balance between demand and potential supply and inflation in check, and I actually found that thinking about the appropriate path for policy was harder than thinking about the outlook. In a fundamental sense, the favorable outlook rests on a judgment that over the last year or so monetary policy has been well calibrated to the evolving situation. Market participants seem comfortable with policy to date and with their expectations for the future. The simultaneous decline in expected funds rates and inflation expectations over the intermeeting period indicates confidence that inflation will be contained. And the rise in equity prices and still fairly narrow risk premiums in credit markets must rest on expectations of continued solid growth. I think we can be fairly confident that appropriate policy is likely to require additional tightening even beyond this meeting. That’s what is built into the yield curve, and that structure of rates seems to be consistent with growth continuing around or perhaps a little above the rate of potential and with the output gap about disappearing. And with output probably close to its sustainable potential and inflation already having picked up a little, I agree with the rest of you that we’re at a point in the cycle at which we need to be especially careful about keeping inflation pressures contained. But how much further we need to tighten in order to accomplish that, and at what pace, are the interesting questions. The staff and markets have built in a leveling out of the funds rate at about 3¾ to 4 percent. That’s quite low by historical standards. The Greenbook has an implied short-run r* of only 1½ percent. Still, that’s not implausible, judging from the experience of the last few years when very accommodative policy has been associated with growth only moderately in excess of potential. And the recent downward revisions to market expectations for growth abroad—and expected policy June 29-30, 2005 147 of 234 demand. Nonetheless, the underlying truth is that we really don’t know how much we need to tighten, and, fortunately, we don’t need to figure that out today. I recognize that the 25-basis-points-per-meeting path is not an optimum policy. As we can see from the Bluebook simulations, an optimum policy would tend to flatten out the trajectory as we get close to what we think is a stopping point. The risk is that the 25-basis-points-per-meeting pace will tend to ratify your prediction, Mr. Chairman, that our last tightening will be one too many. Given the lags in the effects of policy, if we wait to see confirming signs that past increases have slowed growth on a sustainable basis—and we aren’t seeing just another soft patch—we probably will indeed have overshot the mark. The path could be especially problematic if it extends into the fall when our meetings get closer together. Surely, the pace of tightening shouldn’t be dictated by the meeting schedule rather than economic needs. But I do take some comfort in the expectation that policy doesn’t have to be that precise. The market will tend to compensate for any overshooting by building in a reversal, provided we let it know that we are open to that possibility when the time comes. For now, sticking to our path of gradual rate increases would seem to be the most prudent course, but such a path is conditional on the economy following its expected path. We should be willing to deviate either way, even as early as August, should the data indicate a very substantial deviation in the path of spending or prices. And our statement today should not be read as implying anything about our expectations beyond August. That will depend on data. The higher we go with rates, the more we need to keep an open mind about stopping places and possibly even the pace of tightening. Thank you, Mr. Chairman. June 29-30, 2005 148 of 234" FOMC20060808meeting--50 48,MS. YELLEN.," Thank you, Mr. Chairman. So far the economy has stuck pretty close to the script of the soft landing sketched out in the June Greenbook. Real GDP growth slowed markedly in the second quarter. Housing construction has declined sharply, and house prices have decelerated; this situation suggests that our policy actions have taken hold in this interest-sensitive sector. The recent sharp rise in oil prices should also put a damper on growth of real income and consumer spending. Most forecasters now expect below-trend growth in the current quarter. Nonfarm payroll employment has shifted down to a more-sustainable pace, and the unemployment rate has risen to 4.8 percent, just a bit below standard estimates of the NAIRU. Core inflation, although uncomfortably high, came in 0.2 percentage point below the June Greenbook’s forecast in the second quarter. In addition, despite further large increases in the price of oil, inflation expectations held firm. In light of these developments, a reasonable forecast is for growth to continue to run slightly below its potential rate, the unemployment rate to edge up, and core inflation to recede gradually. At our last meeting, I laid out some of my concerns about downside risks to the outlook for growth and upside risks to inflation. Quite honestly, I cannot say that the recent data have done much to assuage my angst on either account. The recent falloff in housing activity and the deceleration in house prices have been faster than expected. The current Greenbook has residential investment falling at an annual rate of 14 percent in the second half of this year, nearly twice as fast as projected in June. These surprises intensify the risk of a sharper slowdown as the lagged effects of our past policy actions come fully into effect. For example, the housing slowdown could become an unwelcome housing slump as envisioned in one of the Greenbook alternative scenarios. A large homebuilder in our District summarized the views of many of our contacts when he recently commented that “the housing market has not yet popped, but a hissing sound is now clearly audible.” [Laughter] He pointed to rapidly rising cancellations as a particularly ominous sign. I will be watching the incoming data closely for signs as to whether the housing slowdown remains orderly as hoped or takes a steeper downward slide, posing a greater risk to the economy. My concerns about inflation have also been somewhat heightened by the recent data or, more precisely, revisions to past data. Core measures of inflation continue to be well above my comfort zone. Of course, after the experience of last year, when core inflation was revised up by a considerable amount, I approached this year’s annual NIPA revision with some considerable trepidation. I was relieved to see that the core PCE price inflation data came out of the revision relatively unscathed, revised up just 0.1 percentage point for 2005; but other aspects of the report were somewhat less reassuring for the inflation outlook. First, the rate of labor productivity growth over the past three years has been a bit slower than we thought, primarily because of downward revisions to the rate of capital accumulation, so that the Greenbook now projects structural productivity growth of 2.7 percent, about ¼ percentage point slower than we thought back in June. This revision suggests somewhat less downward pressure on inflation emanating from cost reductions and, therefore, greater upside risks to inflation. But that wasn’t the only surprise tucked away in the annual revision. The upward revision to compensation growth over the past four quarters implies that growth in unit labor costs over the past year has been more rapid than we had believed. I had thought that there was a good chance that compensation per hour and unit labor costs would increase relatively moderately going forward, helping to contain inflationary pressures. The data revision was thus a bit of a wake-up call for me, and I have revised upward my views on the outlook for compensation and unit labor costs. My reading of the report is that the revised data provide a clearer and less sanguine picture of the trend in this measure of compensation. However, the employment cost index was in line with expectations in June and continues to show moderate growth. Moreover, even with revisions to productivity and compensation, the markup in the nonfarm business sector remains very high by historical standards, suggesting that firms do have room to absorb costs. Overall, I view the inflation outlook as highly uncertain, with a pronounced upside risk. As I mentioned at the last meeting, we just don’t have a good handle on why core inflation has risen of late or how persistent this rise will be. While it is comforting to attribute the increase to energy and commodity-price pass-through, empirical evidence suggests that pass-through effects have been quite modest since the mid-1980s. If so, the door is open for other explanations that may have a more lasting influence and require a more aggressive policy response. Something that makes me even more uncertain about the inflation outlook is that standard backward-looking Phillips curve models of inflation appear to be breaking down. It has been widely noted that the estimated effect of resource utilization on inflation in such models has become much smaller over time. But equally striking is the finding that the sum of coefficients on lagged inflation when freely estimated appears to have fallen as well, suggesting that inflation has become far less persistent. In fact, our staff finds that, in looking over the past ten years, it is better to assume that core inflation will return to its sample average over the next four quarters than that it will remain in its recent range or follow a standard Phillips curve model. Interestingly, this decline in the persistence of core inflation has occurred at roughly the same time that long-run inflation expectations, as measured by the Survey of Professional Forecasters, appear to have become well anchored, and this may not be a coincidence. Economic models with forward-looking inflation expectations tell us that, if the central bank has credibility and holds to a fixed long-run inflation target, then inflation will be less persistent than is implied by the standard backward-looking Phillips curve model. Indeed, the puzzle for macroeconomists has been why we see so much inflation persistence. Perhaps we no longer do. If that is true, inflation may decline faster than the Greenbook expects. Admittedly, the past ten years form a relatively small sample from which to draw definitive conclusions. But the inflation process may have changed in a fundamental way, and we should be open to that possibility. I would like to stress that this evidence and the analysis concern the simple correlations of the inflation data that are used for forecasting. The evidence does not relate to structural relationships, and therefore it does not necessarily inform us about how our policy decisions affect the economy or about the best course for policy. In summary, although my modal forecast is relatively benign, I remain very concerned about risks to both growth and inflation." FOMC20080805meeting--104 102,MR. EVANS.," Thank you, Mr. Chairman. Overall there has been little change in the sentiment of my business contacts since our last meeting. Most are still reporting sluggish domestic demand with little evidence of any improvement over the near term. On the price front, everyone continued to cite cost pressures. Manufacturers have long lists of materials cost increases, while retailers note large increases in wholesale prices of imported consumer goods. Everyone discusses how they are planning to continue passing these costs along to customers in second-round effects. Undoubtedly weak market conditions will limit their efforts, but I suspect that many will be successful in raising prices significantly. Turning to the financial situation, to start I should note that I did hear some good reports with regard to liquidity in Chicago financial markets. A contact at the Chicago Mercantile Exchange told us that they conducted extensive liquidity reviews for their largest clearing members, with special scrutiny of firms that had substantial volumes of hard-to-value assets on their books. The clearinghouse was very pleased with the results, finding that these firms had good access to liquidity. Overall, however, my financial conversations this round were relatively downbeat. I did hear some interesting details, though, about the dynamics of the restructuring of credit intermediation. With commercial-mortgage-backed securities markets effectively shut down, a highly rated owner-developer of high-end shopping malls described his increasingly difficult attempts to find funding for his regular flow of balloon payments on mortgage properties. He has gone from restrictive loans from life insurance companies to attempting to put together his own structured-debt securitization. They want to issue bonds backed by the revenues generated from a pool of their high-quality properties and sell them to major fixed-income investment funds. This is one example of what economists like Kashyap and Shin estimate will be a reduction of at least $1 trillion in lending to nonfinancial institutions due to mortgage-related losses at U.S. financial institutions. It is also an example of how firms are trying to find workarounds for the functions that intermediaries used to do for them. But such restructuring must be raising the cost of financing in ways that are not obviously amenable to mitigation through liquidity policies. Turning to the national outlook, the information we have received over the past several weeks has contained many crosscurrents, but overall our forecast for output growth is little changed from our June projections. With regard to prices, I am concerned that inflation risks continue to grow. The most recent news on core prices has not been good. Oil prices may be coming off the boil, but they are still scalding. Prices are still down only to where they were in May. My impression from my contact calls is that the ultimate pass-through to final product prices of earlier increases could take a disconcertingly long period of time. Furthermore, I continue to think that the current funds rate in conjunction with our enhanced lending facilities represents a quite accommodative monetary policy stance, even given the disruptions in financial markets. If the policy path remains as accommodative as futures markets expect, then improvement in inflation will most likely require fortuitous favorable developments in inflation expectations and more restraint from resource slack than we might have otherwise expected. This brings me to three considerations that I would like to highlight as we evaluate the riskmanagement positions underlying our views on appropriate policy and our economic projections. The first factor is that, according to many econometric estimates, the 5� to 6 percent unemployment rate envisioned in the projections would provide only very modest restraint on inflation. In addition, costly reallocation could lead to less resource slack, perhaps temporarily driving the NAIRU above 5 percent. You know, when I talk to my staff, they assure me that there are very good reasons, demographically based, to believe a NAIRU under 5 percent. But I tend to think I've read a few too many papers on policy and policy mistakes where that's exactly the issue--when you think the sustainable unemployment rate is lower than it actually is. So that's a risk, I think. The second factor is that many individuals and businesses see the large relative price changes in oil, food, and commodities as precursors to more-persistent inflation. Whether or not their assessments are analytically correct depends on their expectations of our policy response. A substantive response may be necessary to prevent self-fulfilling price increases and keep inflation under control. Words can take us only so far. The third consideration is the potential diminishing returns through our efforts to mitigate distressed financial market conditions. It is my interpretation that our current accommodative monetary policy and suite of lending facilities are set to mitigate severe downside risks and the systemic risks that you mentioned earlier, Mr. Chairman. This is helpful under the assumption that reducing liquidity strains will assist financial markets to return to normal operations and prevent a permanent impairment of our financial infrastructure. But financial conditions seem unlikely to return to our previous perceptions of normal, at least for some time. Thus, I see a risk that extra accommodation intended to grease the financial wheels could be left in place too long and prove counterproductive for price stability. Indeed, the old perception of ""normal"" likely is not the correct benchmark for us to use in looking for whether we are experiencing structural changes in the intermediation process in which new liquidity providers are playing enhanced roles in the lending process and in which risk standards are changing. So when thinking about market functioning, it would be useful to discuss this within a longer-term framework of what we can feasibly expect from market functioning and what central bank liquidity has the ability to usefully and appropriately influence. Thank you, Mr. Chairman. " CHRG-111hhrg55811--269 Mr. Hixson," Thank you. My name is Jon Hixson, and I am director of Federal Government relations at Cargill. I want to thank you for the opportunity to testify today. Cargill is an international provider of food, agricultural, and risk-management products and services. As a merchandiser and processor of commodities, Cargill is an extensive end-user of derivatives on both regulated exchanges and in the OTC markets. Cargill's activity in offering risk-management products and services to commercial customers and producers in the agriculture and energy markets can be highlighted with the following OTC examples: We offer customized hedges to help bakeries manage price volatility of their flour so that their retail prices for baked goods can be as stable as possible for consumers and grocery stores; we issue critical hedges to help regional New England heating oil distributors manage price spikes and volatility on their purchases so that they can offer families stable prices throughout the winter season; and we offer customized hedges to help a restaurant chain maintain stable prices on their chicken so the company can offer consistent prices and value for their retail customers when selling chicken sandwiches. Chairman Frank's discussion draft is a positive step in addressing comprehensive market reforms of the OTC market. While we have some areas of concern, there are many well-supported elements included in this proposal. The discussion draft would improve transparency with dealer registration and audit trails, the proposal would create a regulated trade data repository and has a stronger focus on reducing systemic risk and more rigorous requirements for inter-dealer transactions. The bill also provides flexibility for end-users and traditional hedgers utilizing OTC risk-management products and clearly establishes regulatory authority to ban any swap deemed abusive. Cargill supports these provisions and appreciates the work of the chairman and other members of the committee in developing this discussion draft. The draft bill represents a significant improvement over many other proposals that, in our view, would overly restrict the use of OTC markets for hedging purposes. Our main concerns with the discussion draft relate to two areas of the legislation: first, the application of capital and margin requirements. The discussion draft gives regulators discretion in whether to impose margining requirements in traditional hedging and risk-management transactions. We appreciate this flexibility. However, we are concerned that, given recent regulatory statements and testimony, the imposition of mandatory margining for hedging transactions would still likely occur. This will make it very difficult, if not unlikely, that firms would be able to affordably and efficiently hedge their flour, heating oil, and chicken risks as described earlier. To ensure congressional intent, the legislation could include a list of factors and in a similar style as the provisions within the discussion draft that provide greater guidance on the clearing requirement. In addition, capital requirements should clearly recognize and reflect the risk-management processes utilized by dealers. When Cargill offers tailored risk-management products to our customers like the bakery hedge, we offset a substantial amount of that risk by taking positions on a regulated, centrally cleared exchange, margined for daily mark-to-market exposure. We also use margin agreements with most of our customers. These steps greatly reduce overall risks in the hedging transaction. Regulators should consider such prudent risk-management actions as they analyze and develop appropriate capital requirements to ensure that the charges are based on actual risk of loss. Regulators are also given much discretion in setting margin and capital requirements for non-bank dealers. The provisions often call for requirements as strict or stricter than those a prudential regulator would establish for a systemically significant financial institution. While we are very sensitive to the role played by a non-banking firm in last year's financial crisis, there should be some recognition that the bakery hedge, for example, did not cause systemic risks for the financial system. Excessive requirements on our segment will likely only result in less competition among dealers within the OTC segment. Surrogation of assets is our second area of concern. We are sympathetic to those who lost initial margin money last year and would like to work with others, including members of this committee, to address this issue. However, restrictions around variation margining will have the unintended consequence of curtailing sound business practices that would otherwise minimize the risks of a hedging transaction. We appreciate the opportunity to testify before the committee to offer examples of our use of OTC products in risk management and to highlight our areas of support and concern within the discussion draft. We look forward to working together as this legislation continues to develop. [The prepared statement of Mr. Hixson can be found on page 135 of the appendix.] Ms. Bean. Thank you for your testimony. We are going to proceed to the next witness, Professor Rene Stulz, chair of banking and monetary economics at the Fisher College of Business at Ohio State University. STATEMENT OF RENE M. STULZ, EVERETT D. REESE CHAIR OF BANKING AND MONETARY ECONOMICS, FISHER COLLEGE OF BUSINESS, THE OHIO CHRG-111shrg50815--117 CLAYTON Q.1. Access to Credit: A potential outcome of the new rules could be that consumers with less than a 620 FICO score could be denied access to a credit card. Such an exclusion could affect 45.5 million individuals or over 20 percent of the U.S. population. Without access to traditional credit, where do you believe that individuals would turn to finance their consumer needs? A.1. It is likely that consumers perceived to have higher levels of risk--including those that are new to credit--will bear the brunt of credit reductions resulting from the rule. Thus, as noted in your question, the inability to price risk effectively may well mean less access to credit for very deserving individuals just because card issuers are unsure of the credit risk involved and will not be able to price for that risk as it becomes more apparent. As the credit needs of these individuals are unlikely to disappear--and, in fact, may actually increase due to exigent economic circumstances, e.g., unemployment--these consumers will likely be forced to turn to non-federally regulated lenders including payday lenders and loan sharks. Q.2. Risk-Based Pricing: Banks need to make judgments about the credit-worthiness of consumers and then price the risk accordingly. Credit cards differ from closed-end consumer transactions, such as mortgages or car loans, because the relationship is ongoing. I am concerned by the Federal Reserve's new rules on risk-based repricing for a couple of reasons. First, without the ability to price for risks, banks will be forced to treat everyone with equally stringent terms, even though many of these individuals perform quite differently over time. Second, without a mechanism to reprice according to risk as a consumer's risk profile changes, many lenders will simply refuse to extend credit to a large portion of the population. Do you believe that consumers will have access to less credit and fewer choices because of the Fed's new rule? If so, is this a desirable outcome? A.2. The new rule will affect every aspect of the credit card business, from how cards are funded, to how they are priced, to how they are marketed, and to how credit is allocated among customers of differing credit histories and risk. Because the rules are so strong, card lenders may have to increase interest rates in general, lower credit lines, assess more annual fees, and reduce credit options for some customers. The full impact of these changes will likely not be fully known for several years as business practices are changed and as the credit availability works its way through the economy. The new rule may also lead to higher interest rates or fees (such as annual fees) for all cardholders in order to compensate for the inability to price risk effectively. Thus, the least risky borrowers must now bear the cost for higher risk borrowers because the higher-risk borrowers will no longer bear the full cost of the exposure they pose to lenders. It may also be the case that payment allocation requirements will lead to the elimination of low-rate balance transfers that consumers and small businesses previously used to lower overall debt costs. Simply put, the sum total of all these rules will likely lead to reduced access to credit and higher prices to all consumers, in addition to many fewer choices on card products. We do not believe this is a desirable outcome for both consumers and the broader economy. Q.3. Safety and Soundness and Consumer Protection: I believe firmly that safety and soundness and consumer protection go hand-in-hand. One needs only to look at the disaster in our mortgage markets, for clear evidence of what happens when regulators and lenders divorce these two concepts. A prudent loan is one where the financial institution fully believes that the consumer has a reasonable ability to repay. Do you agree that prudential regulation and consumer protection should both be rigorously pursued together by regulators? A.3. A system linking bank regulation and consumer protection forces more balanced supervision without the turf battles and inefficiency inherent in bifurcated jurisdiction. The two are highly integrated, and that one aspect cannot and should not be divorced from the other. This ensures that, for example, safe and sound lending would not be compromised by fee and rate restrictions envisioned by a consumer regulator only concerned with driving consumer costs down unencumbered by a need to consider the impact such restrictions may have on adequate return. Q.4. Subsidization of High-Risk Customers: I have been receiving letters and calls from constituents of mine who have seen the interest rates on their credit cards rise sharply in recent weeks. Many of these people have not missed payments. Mr. Clayton, in your testimony you note that credit card lenders have increased interest rates across the board and lowered credit lines for many consumers, including low-risk customers who have never missed a payment. Why are banks raising interest rates and limiting credit apparently so arbitrarily? Does this result in low-risk customers subsidizing people who are high-risk due to a track record of high-risk behavior? A.4. The rising interest rates and limitations on credit are due primarily to three factors. First, in the present challenging economic time, lenders are being more careful. Delinquencies on credit card accounts have significantly increased as a result of rising unemployment and uncertainty in the economy. This substantial increase in repayment risk affects the ability of lenders to make new loans, and requires companies to carefully evaluate and minimize their risk across the board so that they may stay in business and continue to make new loans. Second, funding costs have increased dramatically in the secondary market, which funds nearly half (or approximately $450 billion) of all credit card loans made by commercial banks. Investors are extremely sensitive to changes in the terms and conditions of the underlying asset, as has been evident in the current market, where investors have shunned nearly all forms of asset-backed securities over fears in the underlying economy. This drives up the cost of funding new credit, and leads to higher costs to consumers. Third, all businesses are concerned for the future, as borrowers' ability to repay may become severely compromised. This is particularly true with respect to credit card loans, which are open-end lines of credit, unsecured and greatly subject to changing risk profiles of borrowers. Banks need to ensure they will be paid for the risks they have taken in credit card loans; otherwise they will not be able to continue to make loans. As a result, many institutions must raise rates and reduce risk exposure in order to continue to lend. This results in all borrowers having to bear the cost of higher risk generally, a trend that will be exacerbated by the new regulations that limit the ability of lenders to price particular individuals for the risk they pose. Q.5. Effects on Low-income Consumers: I want to put forward a scenario for the witnesses. Suppose a credit card customer has a low income and a low credit limit, but a strong credit history. They use their credit card for unexpected expenses and pay it off as soon as possible, never incurring late fees. With the new regulations approved by the Federal Reserve, banks will be restricted in their use of risk-based pricing. This means our cardholder could see his or her interest rates and fees increased to pay for the actions of other card holders, many of whom have higher incomes. Do any of the witnesses have concerns that moving away from risk-based pricing could result in the subsidization of credit to wealthy yet riskier borrowers, by poorer but lower-risk borrowers? A.5. Reducing the ability of lenders to manage risk forces them to apply more general models to all account holders. The consequence of applying general models is that all account holders pay somewhat equally. Lower-risk borrowers at all income levels bear the brunt of this burden. Q.6. Role of Securitization: It is my understanding that during the height of the credit boom nearly half of all credit card debt outstanding was held in securitization trusts. Over the last 18 months much of the securitization market has been severely constrained. The Federal Reserve wants to revive the securitization markets through the Term Asset Lending Facility (TALF), but it is not yet operational. How important is a rebound in the securitization market to the availability of consumer credit? In other words, how much greater will the contraction be in the credit card space without securitization? A.6. The rebound in the securitization market is a critical component to the availability of credit in our economy. Credit cards are funded from two primary sources: deposits and secondary market funding, each accounting for about half--approximately $0.5 trillion dollars--of the total funding of card loans to consumers. Funding in the secondary market relies on investors' willingness to hold securities that are backed by credit card receivables. Any change in the terms of issuance can greatly impact the receptivity of investors to holding these securities. If investors perceive that there is greater risk, they are less likely to hold these securities, or may require significantly higher interest rates or other enhancements to compensate them for the risk. This means that less funding will be available, and if available, more costly. This translates into less credit available at higher cost to customers. It is hard to speculate as to the extent of greater contraction caused by a non-functioning securitization market, as lenders will have to turn to a limited number of alternative--and higher priced--funding mechanisms. However, we do believe the additional contraction would be very significant, and is reflected in the Administration's concern over this important aspect of the marketplace. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM JAMES C. FOMC20080130meeting--75 73,MR. SHEETS.," Your first international exhibits focus on the recent strength of the U.S. external sector. As shown in the top panel of exhibit 11, U.S. exports are now seen to have expanded at a moderate 4� percent pace in the fourth quarter, following the 19 percent surge in the third quarter. With import growth in the fourth quarter stepping down to 2 percent, net exports are estimated--as shown on line 3-- to have made a positive arithmetic contribution to real GDP growth of 0.2 percentage point. Going forward, we see the external sector contributing 0.5 percentage point to GDP growth in 2008 and 0.3 percentage point in 2009. Exports are expected to expand at a crisp 7� percent pace in both years, supported by stimulus from the weaker dollar. The pace of import growth, after stepping down on average in the first half of this year, should pick up some through the forecast period, broadly mirroring the contour of U.S. growth. As shown in the bottom left panel, some additional impetus to import growth should come from a projected decline in core import price inflation, due to moderation in both exchange-rate-adjusted foreign prices (the red bars) and commodity price increases (the blue bars). Returning to line 4 of the upper panel, we estimate that the current account deficit increased to 5� percent of GDP during the fourth quarter, driven up by a surge in the oil import bill. We see the deficit declining to 4� percent of GDP in 2009, as the non-oil trade deficit narrows to just 1� percent of GDP. As shown on the bottom right, the oil import bill--which has increased from around 1 percent of GDP early this decade to about 3 percent of GDP at present--looms as an increasingly important factor influencing the evolution of the current account balance. Your next exhibit examines U.S. external performance from a longer-term perspective. As shown in the top panel, the arithmetic contribution from net exports was persistently negative from 1997 to 2005, subtracting � percentage point on average from the growth of U.S. real GDP. The contribution from net exports, however, has swung into positive territory over the past two years, adding about � percentage point to growth, and we expect net exports to continue to make a positive contribution over the next two years. As shown in the middle left panel, this upswing in the net export contribution has reflected--in roughly equal measure--an acceleration in exports and a slowing of import growth. Over the past two years, export growth has stepped up to 8� percent, more than twice its average 1997-2005 pace, and it is projected to moderate only slightly in 2008 and 2009. In contrast, import growth over the past couple of years has fallen off to less than half its 19972005 average and is expected to remain soft through the forecast period. The individual contributions of exports and imports to U.S. GDP growth have both risen about � percentage point in recent years. This swing in U.S. external performance has been driven in large measure by the cumulative effects of the decline in the dollar (shown on the middle right). Since its peak in early 2002, the dollar is down more than 20 percent in broad real terms, including a 30 percent fall against the major currencies. We project that going forward the broad real dollar will depreciate at a pace of a little less than 3 percent a year, with this decline coming disproportionately against many of the emerging market currencies (including the Chinese renminbi), which have moved less since the dollar's peak in early 2002. The bottom panel highlights another factor that has supported the shift in U.S. external performance. From 1997 to 2005, U.S. growth was on average just � percentage point below that of our trading partners. In recent years, U.S. growth has slowed relative to foreign growth, and this gap has widened substantially, reaching 1� percentage points on average in 2006 and 2007. This has, consequently, restrained imports relative to exports. Our forecast calls for this gap to narrow only slightly through the forecast period. But this projection depends crucially on the resilience of growth abroad--an issue that is examined in your next exhibit. Recent data have confirmed our expectation that foreign activity slowed markedly in the fourth quarter. As shown in the top left panel of exhibit 13, economic sentiment in the euro area fell in December for the seventh consecutive month, and the ECB's survey of bank lending pointed to further tightening of credit standards for both households and firms. In addition, euro-area retail sales volumes and industrial production (not shown) have moved down in recent months. In the United Kingdom, the preliminary reading on fourth-quarter GDP growth was surprisingly strong, but other indicators seem to point to some softness going forward. As shown on the right, the Bank of England's new survey of credit conditions indicates a further decline in the availability of credit to corporations during the fourth quarter, and the level of new mortgage lending has plunged. Other indicators, including consumer confidence, have also slid of late. The Japanese economy may be weakening as well. As shown in the middle left panel, the December Tankan survey showed a further retreat in business confidence, including a softening of sentiment among both large manufacturers and large nonmanufacturers. Housing starts have declined dramatically lately, as the construction sector adjusts to new, tighter building standards. We also see signs that labor market conditions may be weakening. As shown in the bottom panel, our assessment is that total foreign GDP growth slowed to about 2� percent during the fourth quarter, distinctly down from the 4 to 4� percent pace recorded through 2006 and the first three quarters of 2007. Notably, the fourthquarter slowdown was broadly based. We estimate that growth in Mexico (line 8) declined sharply, in line with a contraction in U.S. manufacturing output. Chinese GDP data, which were reported after the Greenbook went to press, indicate that growth in the fourth quarter remained below its double-digit pace in the first half of the year, with exports posting a contraction. The middle right panel summarizes what we see as the key sources of this nearterm slowing. First, a number of countries have experienced headwinds from the ongoing financial turmoil; this is particularly the case for the euro area, the United Kingdom, and Canada. In addition, sharp recent declines in equity markets have occurred in a much broader set of countries. The softening of U.S. growth is a second factor weighing on activity abroad, especially for countries like Canada and Mexico and many in emerging Asia that have sizable trade linkages with the United States. Third, through 2006 and 2007, many of the foreign economies enjoyed exceptionally rapid cyclical expansions, so some eventual moderation in the pace of growth seemed inevitable, and we have been projecting a deceleration for some time. Returning to the bottom panel, we see these factors as continuing to weigh on foreign activity through the first half of the year. Thereafter, growth should gradually strengthen, to 3 percent in the second half and to 3.4 percent in 2009, as financial turmoil subsides and as the U.S. economy rebounds. Nevertheless, we expect that growth will remain well below the heady pace recorded over the past two years. As shown in the top left panel of exhibit 14, our foreign outlook is also supported by projected easing of monetary policy abroad. Given mounting evidence of economic weakness and continued financial stress, we see the ECB and the Bank of Canada cutting policy rates 50 basis points by the middle of the year, and the Bank of England easing 75 basis points. Given the persisting inflation risks, this is admittedly an aggressive call. But we see the case for monetary action as compelling and believe that these central banks will be persuaded, notwithstanding their recent hawkish rhetoric. The futures markets also appear to be pricing in some easing, albeit at a more gradual pace than we envision. Finally, we now expect the BoJ to remain on hold until the end of 2009. To be sure, there are a number of risks surrounding our forecast, most of which are on the downside. First, the prevailing financial headwinds or the slowing of U.S. growth may be larger or more protracted than we currently project. Second, we do not yet have a good sense of the extent to which many foreign financial institutions have been affected by the recent turmoil, and the release of year-end financial statements over the next six weeks or so could bring some bad news. A third risk is that overly optimistic expectations of decoupling may lead to policy mistakes. Specifically, to the extent that foreign authorities are convinced that they have decoupled from the United States--or that they are immune from spillovers due to the financial turmoil--they may be too slow to ease policy to address weakening demand. Policy abroad may also be restrained by too narrow a focus on the recent rise in inflation, a topic to which I will return momentarily. Finally, housing markets in some countries may be vulnerable. As shown in the bottom left panel, many countries have experienced run-ups in house prices in recent years that are similar to or even exceed those recorded in the United States, and house prices are now decelerating sharply in a number of these countries. Further weakening of house prices poses the risk of adverse wealth effects. Notably, of the major economies shown in the right panel, only the United States has yet seen a marked downward swing in the contributions from residential investment to GDP growth. Your final international exhibit discusses our projections for foreign inflation. As shown in the top panel of exhibit 15, average foreign inflation jumped up to an annual rate of 4� percent in the fourth quarter, with marked increases in both the advanced foreign economies (line 2) and the emerging markets (line 7). The sources of this rise in inflation--including rapid increases in the prices of food and oil--have been well documented. Going forward, we see average foreign inflation moving back down to an annual rate of 2� percent in the second half of this year and continuing at that pace in 2009. Despite the run-up in realized inflation rates, readings on long-term inflation expectations have remained well anchored. As shown in the middle left panel, breakeven inflation rates for the advanced foreign economies have continued to hover around 2.3 percent on average, and long-term inflation forecasts have stayed near 2 percent. For the emerging markets, average long-term inflation forecasts (shown on the middle right) have remained between 3 and 3� percent in recent years. The bottom panels show four-quarter percent changes for the prices of oil, food, and metals. Given the marked slowing of global activity, the stage seems set for some deceleration in commodity prices; indeed, metals prices are already on a downward trajectory. Thus, in line with quotes from futures markets, we see the pace of increases in oil prices and food prices as declining significantly over the next few quarters. Nevertheless, we have been wrong on this score before and freely acknowledge that there are upside risks to this projection. Brian Madigan will now continue our presentation. " FOMC20070321meeting--113 111,MR. KOHN.," Thank you, Mr. Chairman. Like many others, I view the data over the intermeeting period as not fundamentally undermining the basic contours of our expected forecast. We’re still on track for moderate growth and gradually ebbing inflation. The economy has enough underlying strength, bolstered by financial conditions that remain quite supportive of growth, so that the housing correction should not be enough to knock the economy off the moderate growth track. Growth modestly below potential, along with the unwinding of some special factors like rent increases, should allow further declines in inflation. Real-side data reflect the fact that the downshift from above-trend growth for several years to expansion at or a little below trend hasn’t been entirely smooth, and maybe we never should have expected it to be so. Besides the overpricing and overbuilding of housing, businesses apparently built their stocks of inventories and fixed capital in anticipation of continued strong growth, and we’re seeing downshifts in demand for inventories and capital to align them with the slower pace of expected growth. Businesses typically also hoard labor under these circumstances, resulting in weaker productivity growth, and we may just be seeing this adjustment getting under way, judging from the gradual upcreep in initial and continuing claims. The inherently uneven nature of the stock adjustment process and the uncertainty around it help to explain both the overall contours of the recent data and the short-run swings in the data and perceptions of them. A number of factors, most of them mentioned by others, do support expectations of moderate growth ahead. Outside the subprime market, financial conditions remain supportive of growth. Intermediate and long-term rates are low in real as well as in nominal terms. The dollar has fallen. The fallout from the recent turbulence has been very limited. Aside from housing, a good portion of the inventory correction is behind us or is being put behind us. So over time production ought to line up better with sales. Both a rise in the national ISM index and increases in industrial commodity prices, especially in metals, support the notion of a coming recovery in manufacturing, though I admit the increase in metals prices may be a factor of the global economic expansion as well. Continued good growth of jobs to date will support increases in personal income, and as many have remarked, growth in the rest of the world has been pretty strong. I was struck by the upward revision in rest-of-world growth in the Greenbook despite weakness in the United States, the rise in oil prices, and the decline in equity values. So as Karen remarked, domestic demand abroad seems to be strengthening, and I think this bodes well for global external adjustment as well as for U.S. exports. But the information we have received over the intermeeting period not only shifted expected growth down a little but also highlighted some downside risk to activity. In housing, those downside risks center on the implications of the subprime debacle. Will it affect housing demand? Will lending terms tighten beyond the subprime market and the mortgage market? How much will tightening spill over to other lending markets, such as home equity lines of credit, and perhaps affect consumer demand? The possible answers to these questions seem to me to have downside tails that are fatter than the upside tails. Unexpected weakness in investment spending outside housing and auto-related industries is another risk factor. The question is whether this weakness represents just a short-term adjustment to moderate growth or whether businesses themselves see a downside shift in underlying demand that we don’t see. Financial conditions may not remain as supportive of growth, besides the possibility of the dropping of other shoes, such as private equity, as many have mentioned. I see a distinct downside risk to the staff’s assumption of continued increases in equity prices given the likelihood that, if the economy evolves the way the staff anticipates, long-term interest rates will rise and profits will be very disappointing to market analysts. Despite weaker spending, we still face upside risks to the gradual downdrift in inflation. Recent data haven’t been as favorable to deceleration as we would have hoped: Softer investments, slower growth of productivity, and continued strength in labor markets could suggest a slower path of trend productivity growth. If so, we would need to adjust down our expectations for growth, and labor costs would get a boost even at slower growth rates unless increases in nominal wages also downshifted pretty promptly. Good growth in labor demand could suggest a stronger path for demand and less slack than the staff is estimating. Finally, the NAIRU could well be lower than the 5 percent that the staff is estimating, especially in light of the relatively slow updrift in many measures of compensation. But, at 4½ percent, the unemployment rate is low by historical standards, and this suggests to me that the risks from resource utilization remain toward higher inflation. In sum, downside risks to our maximum employment objective have increased, but I do not think they outweigh the continuing upside risk to more-moderate inflation, at least not yet. Thank you, Mr. Chairman." FOMC20050322meeting--216 214,MR. OLSON.," Thank you, Mr. Chairman. I also agree with the ¼ point increase, and I know there’s a lot of anticipation looking forward to the May meeting. I look forward to it now with some trepidation. [Laughter] I am fearful that creativity may be epidemic by the time we get there. While I was not here in 1994, I was here in 2003, when we made significant changes in our statement in successive meetings, and that significantly confused the marketplace. I would think that our experience has taught us that there is value in taking incremental steps in terms of how we communicate, particularly as Bill Poole has suggested, when the economy is moving in a manner that is significantly predictable. So, I would encourage us to keep that history in mind when we think about the changes that we might make in May." CHRG-111shrg55278--112 PREPARED STATEMENT OF ALICE M. RIVLIN Senior Fellow, Economic Studies, Brookings Institution July 23, 2009 Mr. Chairman and Members of the Committee, I am happy to be back before this Committee to give my views on reducing systemic risk in financial services. I will focus on changes in our regulatory structure that might prevent another catastrophic financial meltdown and what role the Federal Reserve should play in a new financial regulatory system. It is hard to overstate the importance of the task facing this Committee. Market capitalism is a powerful system for enhancing human economic well-being and allocating savings to their most productive uses. But markets cannot be counted on to police themselves. Irrational herd behavior periodically produces rapid increases in asset values, lax lending and overborrowing, excessive risk taking, and outsized profits followed by crashing asset values, rapid deleveraging, risk aversion, and huge loses. Such a crash can dry up normal credit flows and undermine confidence, triggering deep recession and massive unemployment. When the financial system fails on the scale we have experienced recently the losers are not just the wealthy investors and executives of financial firms who took excessive risks. They are average people here and around the world whose jobs, livelihoods, and life savings are destroyed and whose futures are ruined by the effect of financial collapse on the world economy. We owe it to them to ferret out the flaws in the financial system and the failures of regulatory response that allowed this unnecessary crisis to happen and to mend the system so to reduce the chances that financial meltdowns imperil the world's economic well-being.Approaches To Reducing Systemic Risk The crisis was a financial ``perfect storm'' with multiple causes. Different explanations of why the system failed--each with some validity--point to at least three different approaches to reducing systemic risk in the future.The highly interconnected system failed because no one was in charge of spotting the risks that could bring it down. This explanation suggests creating a Macro System Stabilizer with broad responsibility for the whole financial system charged with spotting perverse incentives, regulatory gaps and market pressures that might destabilize the system and taking steps to fix them. The Obama Administration would create a Financial Services Oversight Council (an interagency group with its own staff) to perform this function. I think this responsibility should be lodged at the Fed and supported by a Council.The system failed because expansive monetary policy and excessive leverage fueled a housing price bubble and an explosion of risky investments in asset backed securities. While low interest rates contributed to the bubble, monetary policy has multiple objectives. It is often impossible to stabilize the economy and fight asset price bubbles with a single instrument. Hence, this explanation suggests stricter regulation of leverage throughout the financial system. Since monetary policy is an ineffective tool for controlling asset price bubbles, it should be supplemented by the power to change leverage ratios when there is evidence of an asset price bubble whose bursting that could destabilize the financial sector. Giving the Fed control of leverage would enhance the effectiveness of monetary policy. The tool should be exercised in consultation with a Financial Services Oversight Council.The system crashed because large interconnected financial firms failed as a result of taking excessive risks, and their failure affected other firms and markets. This explanation might lead to policies to restrain the growth of large interconnected financial firms--or even break them up--and to expedited resolution authority for large financial firms (including nonbanks) to lessen the impact of their failure on the rest of the system. Some have argued for the creation of a single consolidated regulator with responsibility for all systemically important financial institutions. The Obama Administration proposes making the Fed the consolidated regulator of all Tier 1 Financial Institutions. I believe it would be a mistake to identify specific institutions as too-big-to-fail and an even greater mistake to give this responsibility to the Fed. Making the Fed the consolidated prudential regulator of big interconnected institutions would weaken its focus on monetary policy and the overall stability of the financial system and could threaten its independence.The Case for a Macro System Stabilizer One reason that regulators failed to head off the recent crisis is that no one was explicitly charged with spotting the regulatory gaps and perverse incentives that had crept into our rapidly changing financial structure in recent decades. In recent years, antiregulatory ideology kept the United States from modernizing the rules of the capitalist game in a period of intense financial innovation and perverse incentives to creep in. Perverse Incentives. Lax lending standards created the bad mortgages that were securitized into the toxic assets now weighting down the books of financial institutions. Lax lending standards by mortgage originators should have been spotted as a threat to stability by a Macro System Stabilizer--the Fed should have played this role and failed to do so--and corrected by tightening the rules (minimum down payments, documentation, proof that the borrow understands the terms of the loan and other no-brainers). Even more important, a Macro System Stabilizer should have focused on why the lenders had such irresistible incentives to push mortgages on people unlikely to repay. Perverse incentives were inherent in the originate-to-distribute model which left the originator with no incentive to examine the credit worthiness of the borrower. The problem was magnified as mortgage-backed securities were resecuritized into more complex instruments and sold again and again. The Administration proposes fixing that system design flaw by requiring loan originators and securitizers to retain 5 percent of the risk of default. This seems to me too low, especially in a market boom, but it is the right idea. The Macro System Stabilizer should also seek other reasons why securitization of asset-backed loans--long thought to be a benign way to spread the risk of individual loans--became a monster that brought the world financial system to its knees. Was it partly because the immediate fees earned by creating and selling more and more complex collateralized debt instruments were so tempting that this market would have exploded even if the originators retained a significant portion of the risk? If so, we need to change the reward structure for this activity so that fees are paid over a long enough period to reflect actual experience with the securities being created. Other examples, of perverse incentives that contributed to the violence of the recent perfect financial storm include Structured Investment Vehicles (SIV's) that hid risks off balance sheets and had to be either jettisoned or brought back on balance sheet at great cost; incentives of rating agencies to produce excessively high ratings; and compensation structures of corporate executives that incented focus on short-term earnings at the expense the longer run profitability of the company. The case for creating a new role of Macro System Stabilizer is that gaps in regulation and perverse incentives cannot be permanently corrected. Whatever new rules are adopted will become obsolete as financial innovation progresses and market participants find ways around the rules in the pursuit of profit. The Macro System Stabilizer should be constantly searching for gaps, weak links and perverse incentives serious enough to threaten the system. It should make its views public and work with other regulators and Congress to mitigate the problem. The Treasury makes the case for a regulator with a broad mandate to collect information from all financial institutions and ``identify emerging risks.'' It proposes putting that responsibility in a Financial Services Oversight Council, chaired by the Treasury, with its own permanent expert staff. The Council seems to me likely to be cumbersome. Interagency councils are usually rife with turf battles and rarely get much done. I think the Fed should have the clear responsibility for spotting emerging risks and trying to head them off before it has to pump trillions into the system to avert disaster. The Fed should make a periodic report to the Congress on the stability of the financial system and possible threats to it. The Fed should consult regularly with the Treasury and other regulators (perhaps in a Financial Services Oversight Council), but should have the lead responsibility. Spotting emerging risks would fit naturally with the Fed's efforts to monitor the State of the economy and the health of the financial sector in order to set and implement monetary policy. Having explicit responsibility for monitoring systemic risk--and more information on which to base judgments would enhance its effectiveness as a central bank. Controlling Leverage. The biggest challenge to restructuring the incentives is: How to avoid excessive leverage that magnified the upswing and turned the downswing into a rout? The aspect of the recent financial extravaganza that made it truly lethal was the overleveraged superstructure of complex derivatives erected on the shaky foundation of America's housing prices. By itself, the housing boom and bust would have created distress in the residential construction, real estate, and mortgage lending sectors, as well as consumer durables and other housing related markets, but would not have tanked the economy. What did us in was the credit crunch that followed the collapse of the highly leveraged financial superstructure that pumped money into the housing sector and became a bloated monster. One approach to controlling serious asset-price bubbles fueled by leverage would be to give the Fed the responsibility for creating a bubble Threat Warning System that would trigger changes in permissible leverage ratios across financial institutions. The warnings would be public like hurricane or terrorist threat warnings. When the threat was high--as demonstrated by rapid price increases in an important class of assets, such as land, housing, equities, and other securities without an underlying economic justification--the Fed would raise the threat level from, say, Three to Four or Yellow to Orange. Investors and financial institutions would be required to put in more of their own money or sell assets to meet the requirements. As the threat moderated, the Fed would reduce the warning level. The Fed already has the power to set margin requirements--the percentage of his own money that an investor is required to put up to buy a stock if he is borrowing the rest from his broker. Policy makers in the 1930s, seeking to avoid repetition of the stock price bubble that preceded the 1929 crash, perceived that much of the stock market bubble of the late 1920s had been financed with money borrowed on margin from broker dealers and that the Fed needed a tool distinct from monetary policy to control such borrowing in the future. During the stock market bubble of the late 1990s, when I was Vice Chair of the Fed's Board of Governors, we talked briefly about raising the margin requirement, but realized that the whole financial system had changed dramatically since the 1920s. Stock market investors in the 1990s had many sources of funds other than borrowing on margin. While raising the margin requirements would have been primarily symbolic, I believe with hindsight that we should have done it anyway in hopes of showing that we were worried about the bubble. The 1930s legislators were correct: monetary policy is a poor instrument for counteracting asset price bubbles; controlling leverage is likely to be more effective. The Fed has been criticized for not raising interest rates in 1998 and the first half of 1999 to discourage the accelerating tech stock bubble. But it would have had to raise rates dramatically to slow the market's upward momentum--a move that conditions in the general economy did not justify. Productivity growth was increasing, inflation was benign and responding to the Asian financial crisis argued for lowering rates, not raising them. Similarly, the Fed might have raised rates from their extremely low levels in 2003 or raised them earlier and more steeply in 2004-5 to discourage the nascent housing price bubble. But such action would have been regarded as a bizarre attempt to abort the economy's still slow recovery. At the time there was little understanding of the extent to which the highly leveraged financial superstructure was building on the collective delusion that U.S. housing prices could not fall. Even with hindsight, controlling leverage (along with stricter regulation of mortgage lending standards) would have been a more effective response to the housing bubble than raising interest rates. But regulators lacked the tools to control excessive leverage across the financial system. In the wake of the current crisis, financial system reformers have approached the leverage control problem in pieces, which is appropriate since financial institutions play diverse roles. However the Federal Reserve--as Macro System Stabilizer--could be given the power to tie the system together so that various kinds of leverage ratios move in the same direction simultaneously as the threat changes. With respect to large commercial banks and other systemically important financial institutions, for example, there is emerging consensus that higher capital ratios would have helped them weather the recent crisis, that capital requirements should be higher for larger, more interconnected institutions than for smaller, less interconnected ones, and that these requirements should rise as the systemic threat level (often associated with asset price bubbles) goes up. With respect to hedge funds and other private investment funds, there is also emerging consensus that they should be more transparent and that financial derivatives should be traded on regulated exchanges or at least cleared on clearinghouses. But such funds might also be subject to leverage limitations that would move with the perceived threat level and could disappear if the threat were low. One could also tie asset securitization into this system. The percent of risk that the originator or securitizer was required to retain could vary with the perceived threat of an asset price bubble. This percentage could be low most of the time, but rise automatically if Macro System Stabilizer deemed the threat of a major asset price bubble was high. One might even apply the system to rating agencies. In addition to requiring rating agencies to be more transparent about their methods and assumptions, they might be subjected to extra scrutiny or requirements when the bubble threat level was high. Designing and coordinating such a leverage control system would not be an easy thing to do. It would require create thinking and care not to introduce new loopholes and perverse incentives. Nevertheless, it holds hope for avoiding the run away asset price exuberance that leads to financial disaster.Systemically Important Institutions The Obama administration has proposed that there should be a consolidated prudential regulator of large interconnected financial institutions (Tier 1 Financial Holding Companies) and that this responsibility be given to the Federal Reserve. I think this is the wrong way to go. It is certainly important to reduce the risk that large interconnected institutions fail as a result of engaging in highly risky behavior and that the contagion of their failure brings down others. However, there are at least three reasons for questioning the wisdom of identifying a specific list of such institutions and giving them their own consolidated regulator and set of regulations. First, as the current crisis has amply illustrated, it is very difficult to identify in advance institutions that pose systemic risk. The regulatory system that failed us was based on the premise that commercial banks and thrift institutions that take deposits and make loans should be subject to prudential regulation because their deposits are insured by the Federal Government and they can borrow from the Federal Reserve if they get into trouble. But in this crisis, not only did the regulators fail to prevent excessive risk taking by depository institutions, especially thrifts, but systemic threats came from other quarters. Bear Stearns and Lehman Brothers had no insured deposits and no claim on the resources of the Federal Reserve. Yet when they made stupid decisions and were on the edge of failure the authorities realized they were just as much a threat to the system as commercial banks and thrifts. So was the insurance giant, AIG, and, in an earlier decade, the large hedge fund, LTCM. It is hard to identify a systemically important institution until it is on the point of bringing the system down and then it may be too late. Second, if we visibly cordon off the systemically important institutions and set stricter rules for them than for other financial institutions, we will drive risky behavior outside the strictly regulated cordon. The next systemic crisis will then likely come from outside the ring, as it came this time from outside the cordon of commercial banks. Third, identifying systemically important institutions and giving them their own consolidated regulator tends to institutionalize ``too-big-to-fail'' and create a new set of GSE-like institutions. There is a risk that the consolidated regulator will see its job as not allowing any of its charges to go down the tubes and is prepared to put taxpayer money at risk to prevent such failures. Higher capital requirements and stricter regulations for large interconnected institutions make sense, but I would favor a continuum rather than a defined list of institutions with its own special regulator. Since there is no obvious place to put such a responsibility, I think we should seriously consider creating a new financial regulator. This new institution could be similar to the U.K.'s FSA, but structured to be more effective than the FSA proved in the current crisis. In the U.S. one might start by creating a new consolidated regulator of all financial holding companies. It should be an independent agency but might report to a board composed of other regulators, similar to the Treasury proposal for a Council for Financial Oversight. As the system evolves the consolidated regulator might also subsume the functional regulation of nationally chartered banks, the prudential regulation of broker-dealers and nationally chartered insurance companies. I don't pretend to have a definitive answer to how the regulatory boxes should best be arranged, but it seems to me a mistake to give the Federal Reserve responsibility for consolidated prudential regulation of Tier 1 Financial Holding Companies, as proposed by the Obama Administration. I believe the skills needed by an effective central bank are quite different from those needed to be an effective financial institution regulator. Moreover, the regulatory responsibility would likely grow with time, distract the Fed from its central banking functions, and invite political interference that would eventually threaten the independence of monetary policy. Especially in recent decades, the Federal Reserve has been a successful and widely respected central bank. It has been led by a series of strong macroeconomists--Paul Volcker, Alan Greenspan, Ben Bernanke--who have been skillful at reading the ups and downs of the economy and steering a monetary policy course that contained inflation and fostered sustainable economic growth. It has played its role as banker to the banks and lender of last resort--including aggressive action with little used tools in the crisis of 2008-9. It has kept the payments system functioning even in crises such as 9/11, and worked effectively with other central banks to coordinate responses to credit crunches, especially the current one. Populist resentment of the Fed's control of monetary policy has faded as understanding of the importance of having an independent institution to contain inflation has grown--and the Fed has been more transparent about its objectives. Although respect for the Fed's monetary policy has grown in recent years, its regulatory role has diminished. As regulator of Bank Holding Companies, it did not distinguish itself in the run up to the current crisis (nor did other regulators). It missed the threat posed by the deterioration of mortgage lending standards and the growth of complex derivatives. If the Fed were to take on the role of consolidated prudential regulator of Tier 1 Financial Holding Companies, it would need strong, committed leadership with regulatory skills--lawyers, not economists. This is not a job for which you would look to a Volcker, Greenspan, or Bernanke. Moreover, the regulatory responsibility would likely grow as it became clear that the number and type of systemically important institutions was increasing. My fear is that a bifurcated Fed would be less effective and less respected in monetary policy. Moreover, the concentration of that much power in an institution would rightly make the Congress nervous unless it exercised more oversight and accountability. The Congress would understandably seek to appropriate the Fed's budget and require more reporting and accounting. This is not necessarily bad, but it could result in more Congressional interference with monetary policy, which could threaten the Fed's effectiveness and credibility in containing inflation. In summary, Mr. Chairman: I believe that we need an agency with specific responsibility for spotting regulatory gaps, perverse incentives, and building market pressures that could pose serious threats to the stability of the financial system. I would give the Federal Reserve clear responsibility for Macro System Stability, reporting periodically to Congress and coordinating with a Financial System Oversight Council. I would also give the Fed new powers to control leverage across the system--again in coordination with the Council. I would not create a special regulator for Tier 1 Financial Holding Companies, and I would certainly not give that responsibility to the Fed, lest it become a less effective and less independent central bank. Thank you, Mr. Chairman and Members of the Committee. ______ FOMC20061212meeting--94 92,MR. KOHN.," Thank you, Mr. Chairman. As many of you have remarked, the incoming data on spending at least have been consistent with our basic outlook for economic activity. Weakness in housing and autos will hold activity to below the growth rate of potential for a few quarters but with limited spillover to other forms of household spending. As inventory overhangs in these two sectors are dealt with, growth will return to something like the growth rate of potential. From some perspectives, the recent data have actually suggested diminished downside risk to the story. Stabilizing house sales, recovering mortgage applications, and improving consumer attitudes toward home purchases may be the signs of a housing market beginning to find a bottom. The expected downward path of prices in the Case-Shiller index futures market has actually been revised higher over the intermeeting period; it is still sloping down but not as much. Auto producers have held production steady in the fourth quarter and announced a small increase in production for the first quarter. Moreover, consumption outside autos has remained on a healthy track. Now, the downside risks in these areas may be smaller, but they certainly haven’t been eliminated. The Greenbook projection has starts stabilizing at the current level, but we have yet to see hard evidence of that stability. The last data point was a substantial decline that was larger than we expected. Inventory overhangs in the housing sector are large and will be worked down fairly slowly in the staff forecast. Heads of households may be just coming to the realization that their kids’ tuition and their retirement will not be taken care of by further outsized increases in the value of their homes. A bit more troubling than the housing and consumption data—and perhaps indicative of other sources of downside risk—have been the rise in inventories and the softness in manufacturing production outside the auto and construction-related sectors. Much of the downward revision to private final demand from the last Greenbook to this one, taking into account both the third and the fourth quarters, was in business fixed investment, and it occurred when profits remained robust and sales—excluding autos and residential housing—strong. Evidence of broader weakness in the manufacturing sector seemed to account for at least a portion of the reaction of the financial markets over the intermeeting period. There are a number of reasons to think that this weakness is limited. The underlying economy remains in good shape. Commodity prices have continued to climb, probably partly reflecting the weaker dollar but also indicative of underlying strength in global demand. Firms are adding to payrolls in a way they wouldn’t if they were sensing the possibility of softness spreading outside manufacturing. Equity prices and risk spreads suggest expectations of continued good growth, even if in the eyes of investors it might take some easing of policy to produce that outcome. As President Stern noted, anecdotes—as reflected in the Beige Book and what we’ve heard from visitors, including the Reserve Bank chairs and vice chairs who were here very recently—suggest that businesses are experiencing and expect continued good business conditions. These anecdotes very markedly contrast to the fall of 2000, when by November the tone of the feedback from businesses had turned decidedly gloomier. The Committee has been focused on housing and consumption, but the recent data and the financial market’s response may suggest the possibility that something else could be going on. Perhaps the removal of policy accommodation has affected other forms of spending more than we had anticipated. I think that the basic story of growth strengthening to potential over the next year remains valid and that it will be strong enough to withstand a rise in longer-term interest rates that would accompany a flat fed funds rate as in the Greenbook. Moreover, the overall downside risks to that forecast probably haven’t increased very much, but they may have changed source or character. We will need to be alert to possible sources of weakness that we hadn’t anticipated. With regard to the inflation outlook, I, like the staff, have characterized the incoming data as leaving expectations for a very gradual decline in inflation intact, if the economy follows something like the Greenbook path. To be sure, core PCE inflation did not ease back, but the CPI did quite a bit. Labor cost pressures appear to be less than we had previously estimated, and various measures of long-term inflation expectations remain within their ranges of the past several years. My presumption, like that of the staff, is that at some point lagging spending growth will be reflected in labor markets and will help to remove inflation pressures. But for now, the risks around the expected downward trend in inflation remain skewed to the upside. Unit labor costs are still accelerating, although not as much as we thought they were, and businesses won’t readily absorb higher costs and reduced profit margins. The unemployment rate remains low. The index of capacity utilization in manufacturing continues to be above its long-term average, suggesting continued pressures in resource markets and, by extension, in markets for goods and services, which will contribute both to higher costs and to the ability of businesses to pass them on. The forecast path to inflation is sufficiently gradual that upward deviations from it could entail outsized costs in terms of embedding another notch up in underlying inflation and inflation expectations. Thank you, Mr. Chairman." FOMC20080130meeting--186 184,MR. EVANS.," Thank you, Mr. Chairman. My assessment of the national economy is that we are in the midst of a period of very weak growth and that there is a significant chance of a serious downturn. The three-month average of our Chicago Fed National Activity Index in December was minus 0.67. Historically, by my calculation, such a value has been associated with a recession about 70 percent of the time. Now, in the Board briefings yesterday and again today, I noticed that Thomas Laubach's estimate is 45 percent based on the same data, and that is certainly large enough for concern. Reports from my business contacts seem broadly consistent with this slow but positive growth scenario. The most positive news I received was from firms whose international businesses were strong. As one would expect, the most dire reports were from those in residential construction and related industries. While I was surprised to hear from the CEO of a national specialty retail chain that its business over the past 60 days was the worst he has seen in 45 years, much of his business is in housewares and furniture; but he indicated that many other segments of the retail sector were also struggling. I also spoke with the CEO of General Motors. His outlook was a lot like what President Fisher was just mentioning from other CEOs. They are looking for slow economic growth overall, and they are concerned about the risk of a serious downturn. That is not what they are planning on. The industry is clearly facing softer demand, but his expectation for 2008 as a whole is for only a moderate decline in light motor vehicle sales, down to a pace of about 15� million units. GM's current production plans are not premised on recession-level sales, but they are prepared to cut production quickly if they see the economy turning down. He also reported that, while the performance of GMAC's auto loans currently was okay, the credit quality of prospective buyers--people coming into showrooms-- has declined and that lenders have tightened underwriting standards for those loans. In addition, if auto loans became more difficult to securitize, it would be a big additional problem. Apparently, so far they are robust, though. Turning to the forecast details, my modal outlook for 2008 is close to that in the Greenbook. I expect that we will eke out positive growth in the first half of 2008. This expectation largely reflects the judgment that businesses have not begun to ratchet down spending plans in the nonlinear fashion that characterizes a recession. My assessment also has been influenced by some positive developments that we have seen. The most notable ones in my mind are that UI claims have moved down, that major banks are having some success raising capital from a variety of sources, and that the orders data today were better. For the second half of 2008, I see growth increasing toward potential by year-end. This assessment depends importantly on accommodative monetary policy and expansionary fiscal policy. Our cumulative actions following this meeting should provide noticeable stimulus to the economy by midyear. Tax rebates should also help somewhat this year. In addition, the financial system should continue to sort through its difficulties, making further headway in price discovery and repairing capital positions. So in the absence of further negative developments, growth should improve in the second half of this year. I then see real GDP rising at a pace a bit above potential in 2009. Although this seems like a plausible projection, it has the feel of threading the needle, which brings to mind nimbleness, and Governor Kohn is our expert at nimbleness, so I start thinking about how his nimble fingers will be critical for threading this needle. The downside risks are large, and the recession scenarios are quite possible. Any of the factors currently holding back growth could intensify. For example, a reduction in bank lending capacity could make financial conditions much more restrictive. This, along with increased business pessimism and caution, could cause a more pronounced cutback in investment and hiring. Even a moderately weaker job market would add to the factors already weighing on consumer spending. Now, unfortunately, even while we are dealing with concerns on the growth front, the inflation picture is difficult and quite uncertain. The inflation outlook will likely be affected by more crosscurrents than usual. Headline inflation has been quite high, driven largely by increasingly high energy, food, and commodity prices. Although our best assessment is that these pressures will come off later this year, these influences have lasted longer than typical and could well continue to do so. I had calculated the same type of statistics that President Plosser calculated, but only since 1999. Headline PCE inflation has been running about 0.4 percentage point higher than core PCE since that time. This is a source of some concern and cautions us against relying too heavily on core inflation measures. I don't think that is a big issue today, but we need to be thinking about that in our inflation strategy. In addition, core inflation has not improved as much as I expected. As the Greenbook discusses, the decline during the second quarter of last year may have reflected technical quirks in the indexes rather than true improvements in underlying inflation as I had hoped. The weakening U.S. economy is likely to diminish inflation pressures somewhat in 2008, but it is unclear how big a factor this will be or, given our projection that growth improves, how long it will last. So I think that inflation risk will be rising next year. Consequently, recalibration of short-term interest rates will be an important element of monetary policy in 2009. Looking at the write-up, it seemed to me as though 10 out of 17 participants had that viewpoint--different timing. Our inflation projection has core PCE running 2.1 percent in 2008 and edging off to 2 percent by 2010. In the context of what Brian was talking about in terms of slack, we have a higher inflation path and inflation coming down with a bit of slack. Much of the Committee's discussion today has suggested that 2 percent is slightly higher than most participants' benchmarks. For me, the trajectory of my outlook is satisfactory as long as I see inflation prospects continuing to improve as we move beyond the end of our current forecast period. Thank you, Mr. Chairman. " CHRG-111hhrg55811--277 Mr. Holmes," Madam Chairwoman, Ranking Member Bachus, and members of the committee, my name is Steven Holmes, and I am the director of treasury operations for Deere & Company, also known as John Deere. Thank you for inviting me today to testify at this hearing on reform of the over-the-counter derivatives market. I am here today in my capacity as an executive of Deere & Company. My testimony reflects the views of Deere and the views of the Business Roundtable, of which we are a member, and which represents leading companies with more than $5 trillion in revenues and more than 10 million employees. Deere is a major U.S. company with significant overseas sales. We raise capital, manufacture products, and sell in the United States and in foreign markets. These international activities subject us to economic risk. To manage these risks, we use derivatives. We do not use them as speculative investments, but instead to convert transactions that carry inherent risk into ones that produce predictable cash flows. This enables us to offer competitively priced products and financing to our customers. Let me give you an example of how we use foreign exchange derivatives to manage currency risk. Australian farmers are important producers of agricultural commodities. Deere has sales and credit operations in Australia, but no manufacturing. The products we sell there are manufactured mostly in the United States and Europe. Australian farmers place orders for equipment well in advance of the use season to ensure they will be ready for the spring planting or fall harvest. There is a significant lead time to manufacture a tractor to the farmer's specifications and ship it to Australia. Since our sales are in Australian dollars and our manufacturing costs are in U.S. dollars and euros, we are exposed to exchange rate risk. Without hedging this exposure with derivatives, we would not be able to offer a reasonable fixed price to the Australian farmer, and we would lose sales. Let me provide one more example, this time of how we use interest rate swaps. We provide financing for our customers on a significant percentage of our sales. We offer both fixed- and variable-rate financing to meet the various long- and short-term needs of our customers. Derivatives enable us to match the interest rate characteristics of the funding available in the capital markets with our customers' requirements. This was especially critical during the credit crisis as capital was scarce. John Deere's volume of new loans increased during the credit crisis as we stepped in to replace other financial institutions that curtailed lending. We were able to issue long-term, fixed-rate debt and use interest rate swaps to match the shorter-term fixed and floating loans our customers required. Many investment-grade companies like Deere have debt covenants that prohibit the posting of collateral for derivatives. If existing derivative contracts are not permitted a grandfather exemption from the clearing and collateral requirements of the regulations, we will have to terminate these transactions at significant cost. Your bill takes key steps that accommodate the needs of derivative end-users like Deere. For example, your bill recognizes that many companies use derivatives for prudent risk management purposes. Your bill does not rely on clearinghouses to determine which transactions are accepted from central clearing. And your bill does not prohibit the use of non-cash assets to satisfy margin requirements. At the same time, we have concerns about the derivatives legislation that the committee plans to consider next week. I would offer the following three observations. First, we are concerned that regulators will be ceded too much authority to determine which companies are subject to higher regulatory thresholds and higher margin requirements. Second, we are concerned about the capital requirements for noncentrally cleared transactions. We believe that capital charges should be levied solely based on risk of loss and not as a means of forcing companies to centrally clear transactions. And finally, while your bill does not rely on a hedge accounting definition to determine which end-users are major market participants, we are concerned by the bill's open-ended definition of ``substantial net position,'' which creates uncertainty and again gives the regulators too much authority to determine which end-users are covered. Deere & Company is committed to working with this committee, the Administration, and other congressional bodies to enact thoughtful derivatives regulation that facilitates, not hinders, well-functioning capital markets. At the same time, the regulation should not be a disincentive to companies to enter into prudent hedging transactions. Thank you, and I am happy to respond to any questions you might have. [The prepared statement of Mr. Holmes can be found on page 140 of the appendix.] Ms. Bean. Thank you for your testimony. And now, we will hear from Christopher Ferreri, managing director of ICAP, on behalf of the Wholesale Markets Brokers Association. STATEMENT OF CHRISTOPHER FERRERI, MANAGING DIRECTOR, ICAP, ON FOMC20060510meeting--132 130,CHAIRMAN BERNANKE.," At this point I would normally try to summarize the remarks around the table. But since you have all just heard them and since my own views are not terribly different from many who have spoken, I think in the interest of time I will just go ahead and talk briefly on my own behalf about what I see the economy doing, and then we will turn to the policy go-round. First of all, with respect to growth, I think we are following the path laid out by the Greenbook toward greater moderation in the second half. The main difference is that, since our last meeting, the uncertainty around that prospective path has increased. Obviously, the key to this moderation is the housing market, and fundamental analysis would suggest that the combination of high prices and rising interest rates would make affordability a problem and would bring housing starts and housing prices down. So far we are seeing, at worst, an orderly decline in the housing market; but there is still, I think, a lot to be seen as to whether the housing market will decline slowly or more quickly. As I noted last time, some correction in this market is a healthy thing, and our goal should not be to try to prevent that correction but rather to ensure that the correction does not overly influence growth in the rest of the economy. I would also note that there are going to be some offsets to the decline in residential investment. We’ve noted increases in nonresidential construction, which is about half the size, as a share of GDP, of residential construction and, in terms of contribution to GDP, could make up something like a half of the direct impact of a decline in residential spending. We also have gotten a sense that capital spending is relatively strong, and world growth is also strong, which may enhance our exports. So there are some countervailing factors to help cushion the presumed decline in the housing market. But as we talk about the housing market, which is 6 percent of GDP, or nonresidential construction, which is 2.7 percent of GDP, we have to pay very close attention to consumption, which is 70 percent of GDP and which really is the center of the forecast for the rest of the year. The soft landing scenario viewed in the Greenbook requires that consumption grow the rest of the year at something around 3.4 percent, which is roughly what it has been doing in the last year or so on average. I think that is broadly plausible. There are factors on both sides of it. Supporting consumption, obviously, are some increases in compensation likely coming forward both in terms of hourly wages and in terms of hours worked, job availability, and to some extent maybe increases in stock prices. On the negative side, many people have pointed out the effect of rising interest rates and softening in housing prices. Energy is actually a bit of a mixed bag. Energy prices are obviously a negative for consumption in level terms, but we have had a big drag on consumption for the past two years from increasing energy prices, and so if energy prices do stabilize, the drag will actually be less in 2006 than in previous years. So, again, I do think that the slowdown that has been forecast by the Greenbook is plausible, but like a number of people around the table, I would note that so far it is largely a prospective slowdown and that the data have only begun to support that development. On the inflation side, I have somewhat more concern, like a number of people. Core inflation has been remarkably stable, and I do not think it is going to rise very much; but to the extent that there are risks, they are very largely to the upside. And I also have some concerns about the possible emergence of some inflation psychology, which is a very negative thing for our policymaking. The factors that support higher inflation are well known. First, energy and commodity prices. I would point out that, rather than being transitory, they have now undergone a long, sustained increase, which evidently must at some point get into the cost structure of firms. Second, the weakening dollar over the past month or so may be sufficient to add some pressure. Third, the effect of compensation, I understand, is a little ambiguous. There are some factors working in the other direction, including markups and productivity, but clearly the sense around the table is that compensation is beginning to move up somewhat, and the risks there I think are also to the upside. Finally, it is worth noting that, at a technical level, some of the components of the inflation indexes are moving upward—in particular, owners’ equivalent rent. It economically makes sense that, if house prices have risen so much, rents will begin to rise. Since that is a very large share of both the CPI and the PCE core measures, that is going to be an upside risk for us. Now, again, I do not want to overstate the problem. I think that core inflation will remain contained, to use our language, but I am concerned about those risks. Clearly, the markets have seen a strengthening of the economy and increased inflation risk. Despite all of our communication and language, it is summarized by an increase of about 25 basis points in where they think the federal funds rate is going to end up later this year. We have seen and already discussed the increase in inflation compensation and in other measures of inflation expectations. Much of our confidence that the pass-through from energy, from the dollar, and from labor costs to final goods inflation will be low is predicated on the view that inflation expectations are low and well contained. When that premise begins to break down, then all the other elements of the analysis also begin to come under pressure. Finally, as a number of people have noted, although we do not have an official definition of price stability, we are at the upper level of what might plausibly be called the region of price stability, and further increases will be difficult and potentially costly to reverse. So looking forward to the policy discussion, I think we are going to have to take into account the emerging inflation risk. At the same time, there is an awful lot of uncertainty about what is going on in the economy. It is going to be a difficult balancing act to try to maintain as much flexibility as possible so that policy can respond to new data as they arrive. At this point I would like to turn over the floor to Vincent, who will talk about the policy options." CHRG-109shrg30354--3 STATEMENT OF SENATOR PAUL S. SARBANES Senator Sarbanes. Thank you very much, Chairman Shelby. I welcome Chairman Bernanke before the Committee. I think it is fair to say this hearing comes at a particularly pivotal time for monetary policy. The economy is slowing down and the run-up in oil prices is contributing to that slowdown. An oil price spike has preceded a number of recessions since 1973, but some spikes have occurred without a subsequent recession. We look to the Federal Reserve to help avoid a recession this time around. There are a number of signs of economic weakness. Job growth has been anemic for the last 3 months, averaging just over 100,000 jobs per month. The pace is less than 1 percent a year. Over the last half century we have tended to have such slow job growth when we are going into or coming out of a recession. It is less than half the pace of job growth for the 10 years of expansion from March 1991 to March 2001. Not only are jobs growing slowly, but also all the measures of wages and compensation show gains below inflation over the last year. Total compensation, including wages and benefit costs, have risen 2.8 percent in the last year. Such pay gains are not putting upward pressure on inflation because they are almost entirely offset by productivity gains, which are up 2.5 percent. Unit labor costs, which adjust hourly labor costs for productivity gains, are up by a negligible 0.3 percent in the last year. That is shown rather dramatically in this chart, which shows compensation, productivity, and unit labor costs. Unfortunately, the only people with pay gains that are keeping ahead of inflation are those at the top of the ladder. By this stage in previous business cycle expansions, people at the middle and bottom of the wage ladder have typically been enjoying healthy pay gains. This was certainly the case from 1995 to 2000. We need to keep the expansion going so that those at the middle and the bottom of the pay scale can finally share in the exceptional productivity gains that they have helped to create. With the higher cost of fuel and little room to cut back on fuel use, consumers have been forced to cut back on other types of spending and they go into debt. Consumer spending has risen at less than a 2 percent rate over the last 4 months. To manage even that modest increase, households have had to reduce savings and increase borrowing. The household savings rate has plunged to an unprecedented minus 1.7 percent. Where is the rise in inflation coming from? Although higher prices for oil and other commodities have contributed, much more important is the surge in profit margins. At this hearing 2 years ago, Chairman Greenspan drew attention to this, stating ``from an accounting perspective, between the first quarter of 2003 and the first quarter of 2004 all of the 1.1 percent increase in the prices of final goods and services produced in the nonfinancial corporate sector can be attributed to a rise in profit margins rather than cost pressures.'' He predicted at the time that competition to create new capacity and hire more workers would bring down the profit share to more normal levels, but that has not happened. In fact, the profit share of GDP hit 12.7 percent in the first quarter, the highest profit margin since 1950. With inflation racing ahead of wages and rising interest rates, we see a serious downturn in the housing industry. The housing affordability index has plunged to the lowest level since 1989 when declining housing led to a recession in 1990. New home sales so far this year are running 11 percent below the rate for the same period last year. With sales down, builders have cut back on new home construction. They are obtaining permits at a rate of more than 1.7 million a year for 5 months last year, but that rate fell below 1.5 million in the latest months. We are now down below 1.4 million. This is new single family home permits, and it shows a rather marked decline over the last year. Last week's report on the consensus of blue chip economic forecasters should also give Federal Reserve policymakers pause. The consensus expects growth below the trend line starting with the just-completed second quarter through the end of 2007. In addition, the blue chip economic forecasters expect inflation to slow down to about 2.5 percent next year. I am hopeful that this morning Chairman Bernanke can put to rest some troubling concerns about monetary policy. The Fed's statements that future changes in interest rates will depend on new data, not an all together unreasonable statement I might say, but it has been interpreted by some commentators to mean that the Federal Reserve will raise interest rates at every meeting until inflation comes down. The headlines of the last two weekly reports from Goldman Sachs are ``The Stance of Monetary Policy, Enough is Enough.'' And the other one ``Bernanke Preview, Monetary Policy Begins to Bite.'' Two recent headlines from Merrill Lynch state that its ``getting tougher for the Fed to justify what it is doing'' and ``nearly every indicator showing signs of a slowdown.'' Merrill Lynch Economist David Rosenberg, in a report last Friday entitled, ``To Pause Or Not To Pause: That Is The Conundrum,'' expressed this concern: ``The Fed has managed to elevate a pause to something that is a pretty major event. What was normal in prior cycles, up or down, is now something that grabs headlines. The Fed paused twice in the 1999-2000 cycle and three times in the 1994 cycle, and it elicited a yawn from the markets. This time around a `pause' is being treated as an `ease,' which has basically put the Fed in a pickle.'' The 17 Fed rate hikes over the last 2 years are having an effect. You can see that in the housing sector, job growth, the blue chip forecast. Both for subdued growth and for falling inflation over the next year. I look forward to the opportunity to pursue these concerns with the Chairman in the question period. I also, just to send a warning, hope to be able to ask you about the Basel II situation which I think is a matter that calls for very close attention, which I do not think it has been receiving. Thank you very much, Mr. Chairman. " CHRG-111hhrg53242--21 Mr. Snook," Thank you, Mr. Chairman, and members of the committee. We appreciate the opportunity to testify at this important hearing. We appreciate your continued leadership on regulatory reform. SIFMA supports efforts to make the regulatory reform changes necessary to restore confidence in the financial markets and meet the challenges of the 21st Century marketplace and to protect consumers and investors. The financial system is critical to the Nation's competitiveness, and reform must provide a durable platform for steady economic growth, employment, and investment. I would like to now highlight elements from our written testimony. Systemic risk has been at the heart of the financial crisis. We have testified before as to the need for a financial markets stability regulator as a first step in addressing the challenges facing financial regulatory reform. Generally, we support Treasury's recommendations for a single accountable systemic risk regulator, balanced with the newly created Financial Services Oversight Council, as it would improve upon the current system. We think this construct should effectively assess threats to financial stability and ensure appropriate action is taken promptly. A Federal resolution authority for certain systemically important financial institutions should be established. Being systemically important in our judgment does not mean too-big-to-fail, but does require an orderly resolution plan should it be needed. The FDIC has broad powers to act as conservator or receiver of a failed or severely troubled bank, but does not have the experience with the operations of other types of systemically important financial institutions. We welcome Treasury's proposal to establish this authority for other institutions, and urge that it draw upon the experience of regulators familiar with the entity being resolved. We support proposals for increased regulation, reporting, and transparency in the derivatives markets. Clearing is a useful tool in the comprehensive risk management framework, and we support clearing of standardized OTC derivative transactions by financial firms whenever possible, but strongly believe there is a role for the continued use of customized contracts, which are employed by thousands of manufacturing and other companies across America every day to manage various kinds of risks. We believe that the transparency needed can readily be achieved without mandating exchange trading of OTC derivative products. SIFMA supports Treasury's proposal to harmonize the regulation of securities and futures. The key concern in this area is that the law should expressly delegate the regulation of financial products such as broad market indices, currencies, and interest rate swaps to the SEC, and nonfinancial products such as commodities to the CFTC. We agree that targeted reforms are needed in order to restore confidence and functionality to the securitization market, one of the keys to a better functioning market broadly, and the industry is working aggressively to make improvements in this area. We support efforts to find appropriate ways to have skin in the game, for securitization market participants to have skin in the game. One mechanism that can promote this goal is the required retention of a meaningful economic interest in securitized exposures, helping to align the incentives of originators and transaction sponsors with those of investors. SIFMA supports strengthening consumer protection regulation, including the creation of national standards governing consumer credit products and lending practices. There are concerns that creating a new agency for these purposes might result in mixed messages and conflicting directives, and therefore may fail to deliver the hoped-for benefits that underlie the suggestion of a new agency. More critical is the balancing of functions of any new consumer protection entity with other regulators. The CFPA as proposed could inadvertently encroach on the jurisdiction of the SEC and the CFTC. And we understand it was not intended to supersede the broad investor protection mandate of these two agencies, but suggest the clarity of a full exclusion for investment products and services regulated by the SEC and CFTC. SIFMA has long advocated the modernization and harmonization of disparate regulatory regimes for brokers, dealers, investment advisers, and other financial intermediaries. Individual investors deserve, and SIFMA supports, the Administration's recent proposal to create a new Federal fiduciary standard of care that supersedes and improves upon existing fiduciary standards, which have been unevenly developed and applied over the years, and which are susceptible to multiple and differing definitions and interpretations under existing Federal and State law. The new Federal standards should function as a standard that is uniformly applied to both advisers and broker-dealers when they provide personalized investment advice to individual investors. When broker-dealers and advisers engage in identical service, they should be held to the same standard of care. Finally, the global nature of financial markets calls for a global approach to regulatory reform. Unless common regulatory standards are applied and enforced across global markets, opportunities for regulatory arbitrage will arise. And so importantly, close cooperation among policymakers on an international basis is essential if we are to effectively address the challenges facing the financial system. We thank you for your time and look forward to your questions. [The prepared statement of Mr. Snook can be found on page 90 of the appendix.] " CHRG-111shrg53176--158 PREPARED STATEMENT OF JAMES CHANOS Chairman, Coalition of Private Investment Companies March 26, 2009 Chairman Dodd, Ranking Member Shelby, and Members of the Committee. My name is James Chanos, and I am President of Kynikos Associates LP, a New York private investment management company that I founded in 1985. \1\ I am appearing today on behalf of the Coalition of Private Investment Companies (CPIC), a group of about twenty private investment companies with a wide range of clients that include pension funds, asset managers, foundations, other institutional investors, and qualified wealthy individuals.--------------------------------------------------------------------------- \1\ Prior to founding Kynikos Associates LP, I was a securities analyst at Deutsche Bank Capital and Gilford Securities. My first job on Wall Street was as an analyst at the investment banking firm of Blyth Eastman Paine Webber, a position I took in 1980 upon graduating from Yale University with a B.A. in Economics and Political Science.--------------------------------------------------------------------------- I want to thank the Senators of this Committee for your efforts to develop and implement an approach to modernize financial regulation which would address the failures and inadequacies that contributed to the financial crisis confronting our country and our global economy. I am honored to have this opportunity to testify on behalf of CPIC and look forward to working with you and your staff in the months ahead.I. Executive Summary This is a difficult time for our Nation. Overhauling our regulatory structure is necessary to regain investor confidence. Honesty and fair dealing are at the foundation of the investor confidence our markets enjoyed for so many years. A sustainable economic recovery will not occur until investors can again feel certain that their interests come first and foremost with the companies, asset managers, and others with whom they invest their money, and until they believe that regulators are effectively safeguarding them against fraud. In recent years, prior to the current economic downturn, many observers of the financial system believed that hedge funds and other private pools of capital would be the source of the next financial crisis. Of course, as we have all painfully learned, in fact, the greatest danger to world economies came not from those entities subject to indirect regulation, such as hedge funds, but from institutions such as banks, insurance companies, broker-dealers, and government-sponsored enterprises operating with charters and licenses granted by state and federal regulators and under direct regulatory supervision, examination, and enforcement. Indeed, Bernard Madoff used his firm, Bernard L. Madoff Investment Securities, LLC--which was registered with the SEC as a broker-dealer and investment adviser and subject to examination and regulation--to perpetrate his Ponzi scheme. Nonetheless, hedge funds and other private investment companies are important market players, and we recognize that a modernized financial regulatory system--one that addresses overall risk to the financial system and that regulates market participants performing the same functions in a consistent manner--will include regulation of hedge funds and other private pools of capital. We are ready to work with you as you seek to craft appropriate regulation for our industry. With respect to the new regime for monitoring systemic risk, CPIC would like to offer the following principles upon which to base legislative and regulatory action: First, regulation must be based upon activities, not actors, and it should be scaled to size and complexity. Second, all companies that perform systemically significant functions should be regulated. Third, regulators should have the authority to follow the activities of systemically important entities regardless of where in the entity that activity takes place. Fourth, as complexity of corporate structures and financial products intensifies, so, too should regulatory scrutiny. Fifth, there should be greater scrutiny based upon the ``Triple Play''--being an originator, underwriter/securitizer and investor in the same asset. Sixth, and above all, the systemic risk regulator must enforce transparency and practice it. With respect to increasing the functional regulation of hedge funds, CPIC offers the following for your consideration: Simply removing exemptions from the Investment Company Act and the Investment Advisers Act upon which private investment funds rely will prove unsatisfactory. Any new regulation should provide for targeted controls and safeguards to provide appropriate oversight of private investment companies, but should also preserve the flexibility of their operations. More detailed requirements for large private investment companies would address the greater potential for systemic risk posed by such funds, depending on their use of leverage and their trading strategies. Regulation should address basic common-sense protections for investors in private investment companies, particularly with respect to disclosure, custody of fund assets, and periodic audits. Areas such as counterparty risk, lender risk, and systemic risk should be addressed through disclosures to regulators and counterparties. With respect to hedge funds as significant investors in the capital markets, CPIC believes that maximum attention should be paid to maintaining and increasing the transparency and accuracy of financial reporting to shareholders, counterparties, and the market as a whole.II. The State of the Hedge Fund Sector Since I last testified before the Senate Banking Committee on May 16, 2006, \2\ the hedge fund industry has undergone profound change in the face of unprecedented challenges. In 2006, the industry was continuing its rapid growth and evolution into new strategies and products, to offer qualified investors greater flexibility and opportunities for managing risks and achieving returns that exceeded equity and bond markets' performance. In 2006, the industry had an estimated $1.47 trillion in assets under management and there were an estimated 9,462 funds. A year later, total assets under management for an estimated 10,096 funds rose to about $1.87 trillion, culminating 18 years of growth since 1990 at a cumulated average annual growth rate (CAGR) of 25 percent. In several markets, hedge funds became the main players, accounting for more than 50 percent of trading in U.S. convertible bonds, distressed debt, and credit derivatives. \3\ We experienced a host of new strategies to address investors' increasingly complex risk-management and asset growth demands, as the variety and complexity of financial instruments--and the global nature of those products--grew exponentially. The sheer variety of investment strategies that hedge funds employed strengthened capital markets, improved opportunities for price discovery, and facilitated the efficient allocation of capital. \4\--------------------------------------------------------------------------- \2\ Testimony of James Chanos, Chairman, Coalition of Private Investment Companies. U.S. Senate Committee on Banking, Housing, and Urban Affairs Subcommittee on Securities and Investment. Hearing on the Hedge Fund Industry. May 16, 2006. Available at: http://banking.senate.gov/public/_files/ACF82BA.pdf. \3\ Kambhu, John, Schuermann, Til and Stiroh, Kevin J., Hedge Funds, Financial Intermediation, and Systemic Risk. Economic Policy Review, Vol. 13, No. 3, December 2007 (available at SSRN: http://ssrn.com/abstract=1012348). \4\ Knowledge@Wharton, ``Hedge Funds Are Growing: Is This Good or Bad?'' June 29, 2005. Available at: http://knowledge.wharton.upenn.edu/article.cfm?articleid=1225&CFID=4349082&CFTOKEN=6202640. Jeremy Siegel, Professor of Finance at the Wharton School of the University of Pennsylvania, observes that short selling contributes to the market's process of finding correct prices, and it's valuable to have hedge funds doing this. Sebastian Mallaby, ``Hands Off Hedge Funds,'' Foreign Affairs, January/February 2007. Available at: http://www.foreignaffairs.org/20070101faessay86107/sebastian-mallaby/hands-off-hedge-funds.html. The importance of hedge funds has been acknowledged by the President's Working Group on Financial Markets, the Commodities Futures Trading Commission, the Securities and Exchange Commission, two chairs of the Federal Reserve Board, and members of Congress.--------------------------------------------------------------------------- The attraction of hedge funds was a function, too, of their performance. According to Hedge Fund Research, Inc., hedge funds have returned an average of 11.8 percent annually during the period 1990 through 2008, and an average 15.9 percent in the 12 months following the five largest historical declines. \5\--------------------------------------------------------------------------- \5\ Hedge Fund Research, Inc. ``Investors Withdraw Record Capital from Hedge Funds as Industry Concludes Worst Performance Year in History.'' Press Release. Available at: https://www.hedgefundresearch.com/pdf/pr_01212009.pdf.--------------------------------------------------------------------------- As Andrew W. Lo, a professor at the MIT Sloan School of Management, testified on November 13, 2008, ``[t]he increased risk-sharing capacity and liquidity provided by hedge funds over the last decade has contributed significantly to the growth and prosperity that the global economy has enjoyed.'' \6\ It is a point that Treasury Secretary Timothy F. Geithner made as Federal Reserve Bank President and CEO in speeches in 2004 and 2005. \7\--------------------------------------------------------------------------- \6\ Written Testimony of Andrew W. Lo, Hedge Funds, Systemic Risk, and the Financial Crisis of 2007-2008, Prepared for the U.S. House of Representatives Committee on Oversight and Government Reform November 13, 2008 Hearing on Hedge Funds. \7\ Mr. Geithner stated: ``Hedge funds play a valuable arbitrage role in reducing or eliminating mispricing in financial markets. They are an important source of liquidity, both in periods of calm and stress. They add depth and breadth to our capital markets. By taking risks that would otherwise have remained on the balance sheets of other financial institutions, they provide an importance source of risk transfer and diversification.'' Available at: http://www.ny.frb.org/newsevents/speeches/2004/gei041117.html. Mr. Geithner also stated ``Hedge funds, private equity funds and other kinds of investment vehicles help to disperse risk and add liquidity.'' See Keynote Address at the National Conference on the Securities Industry: Hedge Funds and Their Implications for the Financial System (November 17, 2004). Remarks at the Institute of International Bankers Luncheon in New York City (October 18,2005). Available at: http://www.ny.frb.org/newsevents/speeches/2005/gei051018.html.--------------------------------------------------------------------------- Despite the rapid growth and size of hedge funds ($1.41 trillion), their relative size with the financial sector is small, accounting for 0.7 percent of the $196 trillion invested in equities, tradable government and private debt, and bank deposits, according to McKinsey Global Institute. \8\--------------------------------------------------------------------------- \8\ McKinsey Global Institute, Mapping Global Capital Markets: Fifth Annual Report. October 2008. Available at: http://www.mckinsey.com/mgi/reports/pdfs/fifth_annual_report/fifth_annual_report.pdf.--------------------------------------------------------------------------- In the summer of 2007 and throughout 2008, financial markets began to unravel. Major regulated financial institutions collapsed or went bankrupt as the U.S. Treasury administered life support through both capital infusions and U.S.-backed guarantees to prevent the demise of banks, insurance companies, and others who were deemed ``too big to fail,'' and thereby stave off an imminent global economic collapse comparable to that of the Great Depression. A chain of interlinked securities--including derivatives and off-balance sheet vehicles--sensitive to housing prices triggered a death spiral in financial markets worldwide, demonstrating the scale and intensity of interdependence in the global economy and the vulnerability it causes. \9\ As the problems became more severe, the crisis mushroomed beyond subprime debt to threaten less risky assets. Credit markets dried up, and equity markets in 2008 posted one of their worst years since the 1930s. As a result, the value of financial assets held at banks, investment firms, and others collapsed, jeopardizing their survival as they sharply curtailed activities. Institutional investors rushed to the sidelines, seeking safe havens in cash investments. The downturn spread throughout our economy and worldwide, fueling job losses, prompting bankruptcies, and causing household wealth to erode. That is a greatly distilled and simplified recounting of the events in 2007-2009. And, as might be expected with those events, the hedge fund industry experienced a sharp reversal. \10\--------------------------------------------------------------------------- \9\ There are many research papers and studies that examine the source of the financial crisis. One example: Gary B. Gorton, ``The Panic of 2007.'' August 25, 2008. Yale ICF Working Paper No. 08-24. Available at: http://ssrn.com/abstract=1255362. \10\ I would encourage you to read the trenchant analysis by Lord Adair Turner, Chairman of the U.K. Financial Services Authority (``FSA''), in which he eloquently recounts how developments in the banking and the near-bank system caused serious harm to the real economy. Lord Adair Turner, Chairman, FSA. ``The financial crisis and the future of regulation.'' January 21, 2009. The Economist's Inaugural City Lecture (available at http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2009/0121_at.shtml. A more extensive discussion is provided in: The Turner Review: A Regulatory Response to the Global Banking Crisis. March 18, 2009 (available at http://www.fsa.gov.uk/pages/Library/Communication/PR/2009/037.shtml).--------------------------------------------------------------------------- As a consequence of the financial crisis, as was the case with other sectors of the financial services industry, the amount of money managed by hedge funds plummeted, reflecting an amalgam of sharp declines in asset values, the rise in client redemptions, and regulatory closures of margin accounts. Last year was easily among the worst in the industry's history, with total assets under management falling to $1.41 trillion--a decline of $525 billion from the all-time peak of $1.93 trillion reached mid-year 2008, with more than 1,471 funds--a record in 1 year--liquidating. Investors withdrew a record $155 billion. Hedge funds on average in 2008 posted their worst performance since 1990. The HFRI Fund Weighted Composite Index dropped 18.3 percent for all of last year, which was only the second calendar year decline since 1990. \11\ That said, though, hedge fund losses on average were less than those of the S&P500, with 24 different hedge fund strategies performing better than the S&P 500 benchmark.--------------------------------------------------------------------------- \11\ According to Hedge Fund Research, Inc. ``during 2008, the industry experienced a period of six consecutive months of declines between June and November, interrupted only by December's 0.41 percent gain, including a concentrated, volatile two-month period in September and October in which the cumulative decline approached 13 percent.'' See supra n. 5.---------------------------------------------------------------------------III. Mitigation of Systemic Risk The financial crisis of the past 2 years has raised many questions about the extent to which systemic risks are effectively contained and ameliorated within the U.S. and global economies. As globalization has led to better risk sharing and increased market liquidity, shocks originating in one market are more quickly transmitted to other markets. Regulators and central banks say they need more information to understand the sources of risks and potential impact on markets and economies. Consensus is emerging among U.S. policy makers and in other countries for the need to strengthen systemic risk regulation. Towards that end, allow me to outline some basic principles to guide the thinking about establishing a regulator with responsibility for addressing systemic risks and the attendant laws and regulations to accomplish that objective. First, regulation must be based upon activities, not actors, and it should be scaled to size and complexity. Regulatory scrutiny should be triggered based upon any of the following: the overall scale of market participants, relative importance in a given market or markets, complexity of corporate structure, and complexity of financial instruments used for investment or dealer purposes. All participants undertaking a similar activity should be treated equally; for example, proprietary trading by financial institutions should not be treated in a different manner than trading by any other kind of entity. While the regulator should have broad and flexible authority to determine the basis upon which it wants to include systemically significant entities, it should be clear and transparent in disclosing the criteria upon which it seeks to include a specific market participant. Second, all companies that perform systemically significant functions should be regulated. The regulator should have the authority to examine and discipline market players such as credit rating agencies and financial guarantors, based on the importance of the integrity of their functions to the entire financial system. Third, the regulator should have the authority to follow the activities of systemically important entities regardless of where in the entity that activity takes place. No matter where the activity takes place in a corporation, regulators should be allowed to look into those activities. This point speaks against assigning regulators specific discrete parts of entities to cover and for an evolution of functional regulation. Fourth, as complexity of corporate structures and financial products intensifies, so, too should regulatory scrutiny. Greater regulatory scrutiny should be borne by complex enterprises--not just in the sense of adding additional functional regulation for each new piece of a diversified company but also in the sense of materially increasing the federal regulatory oversight exercised by any new systemic regulator. Entities should come under the ambit of a systemic regulator based upon the complexity, opacity, and system-wide interdependent nature of the instruments that they underwrite, produce, deal in or invest. Fifth, there should be greater scrutiny based upon the ``Triple Play''--being an originator, underwriter/securitizer, investor in the same asset. Greater regulatory scrutiny should be borne by those entities that endeavor to achieve the trifecta: that is, to own the ``means of production'' of an asset, to act as a dealer in financial instruments created from those assets, and to be a direct investor in those instruments or assets. In other words, if a company were a mortgage originator, a dealer in mortgage-backed securities, and an investor for its own account in mortgage-backed securities, that ``triple play'' would trigger oversight by the systemic regulator not only of the individual activities but also the management of the inherent conflicts of interest between those vertically integrated pieces. Sixth, and above all, a systemic risk regulator must enforce transparency and practice it. The regulatory structure should include reviews of how accurately entities make required disclosures of their true financial condition to their shareholders and/or counterparties and investors. The regulator, too, must be transparent; it should annually disclose the entities under its regulatory umbrella and the reason for their inclusion. The regulator should be accountable to Congress and the public. Although the markets alone are not up to the task of identifying and containing systemic risk, it is also the case that the government alone is not up to the task. The combined efforts of government regulators and market discipline brought about by transparent disclosure of risks are needed in any plan for future operation of our financial markets. Further, consideration should be given to modeling disclosure of regulatory or enforcement activity on those of the SEC or CFTC, rather than some of the other, more opaque, federal regulatory agencies.IV. Hedge Funds and Functional Regulation Private investment companies of all types play significant, diverse roles in the financial markets and in the economy as a whole. Venture capital funds, for instance, are an important source of funding for start-up companies or turnaround ventures. Other private equity funds provide growth capital to established small-sized companies, while still others pursue ``buyout'' strategies by investing in underperforming companies and providing them with capital and/or making organizational changes to improve results. These types of funds may focus on providing capital in the energy, real estate, and infrastructure sectors. Hedge funds trade stocks, bonds, futures, commodities, currencies, and a myriad of other financial instruments on a global level. These flexibly structured pools of capital provide substantial benefits to their investors and to the markets more broadly in terms of liquidity, efficiency, and price discovery. In addition, they are a potential source of private investment to participate with the government in addressing the current financial crisis. \12\ It, therefore, is in all of our interests that private investment funds continue to participate in our financial markets.--------------------------------------------------------------------------- \12\ United States Department of the Treasury, Fact Sheet: Public-Private Investment Program (Mar. 23, 2009) (available at http://www.treas.gov/press/releases/reports/ppip_fact_sheet.pdf).--------------------------------------------------------------------------- While it often is said that private investment companies are ``unregulated,'' they are, in fact, subject to a range of securities antifraud, antimanipulation, \13\ margin, \14\ and other trading laws and regulations that apply to other securities market participants. \15\ They also are subject to SEC enforcement investigations and subpoenas, as well as civil enforcement action and criminal prosecution if they violate the federal securities laws. However, private investment companies and their advisers are not required to register with the SEC if they comply with the conditions of certain exemptions from registration under the Investment Company Act of 1940 (the ``Investment Company Act'') and the Investment Advisers Act of 1940 (``Advisers Act''). \16\ Congress created exemptions under these laws because it determined that highly restrictive requirements of laws designed to regulate publicly offered mutual funds and investment advisers to retail investors were not appropriate for funds designed primarily for institutions and wealthy investors.--------------------------------------------------------------------------- \13\ See Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) (15 U.S.C. 78j) and Rule 10b-5 thereunder (17 C.F.R. 240.10b-5). \14\ 12 C.F.R. 220, 221, 224. \15\ See, e.g., Exchange Act 13(d), 13(e), 14(d), 14(e) and 14(f) (15 U.S.C. 78m(d), 78m(e), 78n(d), 78n(e) and 78n(f)) and related rules (which regulate and require public reporting on the acquisition of blocks of securities and other activities in connection with takeovers and proxy contests). \16\ Section 3(c)(1) of the Investment Company Act excludes a company from the definition of an ``investment company'' if it has 100 or fewer beneficial owners of its securities and does not offer its securities to the public. Under the Securities Act of 1933 and SEC rules, an offering is not ``public'' if it is not made through any general solicitation or advertising to retail investors, but is made only to certain high-net-worth individuals and institutions known as ``accredited investors.'' ``Accredited investors'' include banks, broker-dealers, and insurance companies. The term also includes natural persons whose individual net worth or joint net worth with a spouse exceeds $1 million, and natural persons whose individual income in each of the past 2 years exceeds $200,0000, or whose joint income with a spouse in each of the past 3 years exceeds $300,000, and who reasonably expect to reach the same income level in the current year. Section 3(c)(7) of the Investment Company Act excludes a company from the definition of an ``investment company'' if all of its securities are owned by persons who are ``qualified purchasers'' at the time of acquisition and if the Company does not offer its securities to the public. Congress added this section to the Investment Company Act in 1996 after determining that there should be no limit on the number of investors in a private investment fund, provided that all of such investors are ``qualified purchasers.'' In brief, ``qualified purchasers'' must have even greater financial assets than accredited investors. Generally, individuals that own not less than $5 million in investments and entities that own not less than $25 million in investments are qualified purchasers. Section 203(b)(3) of the Advisers Act exempts from registration any investment adviser that, during the course of the preceding twelve months has had fewer than fifteen clients and that does not hold itself out as an investment adviser nor act as an investment adviser to any investment company. Advisers to hedge funds and other private investment companies are generally excepted from registration under the Advisers Act by relying upon Section 203(b)(3), because a fund counts as one client. In some cases, where these companies and their advisers engage in trading commodity futures, they also comply with exemptions from registration under the ``commodity pool operator'' and ``commodity trading advisor'' provisions of the Commodity Exchange Act (``CEA''). These exemptions generally parallel the exemptions from registration under the securities laws.--------------------------------------------------------------------------- To date, legislative proposals to regulate private investment companies have been directed at removing the exemptions from regulation of private investment companies under the Investment Company Act and Advisers Act and thus subjecting private investment companies to the requirements of those Acts. But, for policy makers who believe private investment companies and their managers should be subject to greater federal oversight, I would argue that simply eliminating the exemptions in either or both of these statutes will prove unsatisfactory. \17\--------------------------------------------------------------------------- \17\ In my testimony before the SEC's public roundtable on hedge funds in 2003, I recommended that, as a further condition to exemption under the Advisers Act, hedge funds should be subject to specific standards relating to investor qualifications, custody of fund assets (an issue on which there now is significant focus as a result of the Madoff scandal), annual audits and quarterly unaudited reports to investors, clear disclosure of financial arrangements with interested parties (such as the investment manager, custodian, prime broker, and others--in order to address conflicts issues), clear disclosure of investment allocation policies, and objective and transparent standards for valuation of fund assets that are clearly disclosed, not stale, and subject to audit. Statement of James Chanos, President, Kynikos Associates, SEC Roundtable on Hedge Funds (May 15, 2003) (available at http://sec.gov/spotlight/hedgefunds/hedge-chanos.htm). When I testified before this Committee in 2004, I expanded upon these points and recommended that the SEC require, as a condition to a hedge fund's exemption under the Advisers Act, that hedge funds file basic information with the SEC and certify that they met the standards outlined above. Testimony before the Senate Committee on Banking, Housing and Urban Affairs, Hearing on Regulation of the Hedge Fund Industry (Jul. 15, 2004) (available at http://banking.senate.gov/public/index.cfm?FuseAction=Hearings.Hearing&Hearing_ID=79b80b77-9855-47d4-a514-840725ad912c). See also Letter from James Chanos to Jonathan Katz, SEC (Sept. 15, 2004) (available at http://www.sec.gov/rules/proposed/s73004/s73004-52.pdf). This would have provided the SEC with hedge fund ``census'' data it has long said it needs; it also would have provided a basis for SEC enforcement action against any fund failing to meet the above standards. Had the SEC adopted this recommendation, the agency would have avoided the legal challenge to the rule it adopted later that year to change its interpretation of the term ``client'' under the Advisers Act in order to require hedge fund managers to register. See Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). As this Committee knows, the SEC's hedge fund adviser registration rule was struck down in 2006, (id.) and the SEC decided not to appeal. Some hedge fund managers that had registered with the SEC under the rule withdrew their registrations. I decided that my firm should remain registered as an investment adviser (which we are still today), but, as I testified in 2006 before this Committee, the Advisers Act is ``an awkward statute for providing the SEC with the information it seeks . . . and for dealing with the broader issues that are outside the Act's purposes.'' Testimony of James Chanos, CPIC, before the Senate Committee on Banking, Housing and Urban Affairs, Subcommittee on Securities and Investment; Hearing on the Hedge Fund Industry, at 7 (available at http://banking.senate.gov/public/--files/ACF82BA.pdf).--------------------------------------------------------------------------- The first lesson we all learned in shop class is you need to use the right tool for the job. Although you can use a pipe wrench to pound in a nail, or a claw hammer to loosen up a pipe, it is not a good idea to do so. Neither the Investment Company Act nor the Advisers Act is the right tool for the job of regulating hedge funds and other private investment companies. They do not contain the provisions needed to address the potential risks posed by the largest large private investment companies, the types of investments they hold, and the contracts into which they enter. At the same time, those laws each contain provisions designed for the types of businesses they are intended to regulate--laws that would either be irrelevant to oversight of private investment companies or would unduly restrict their operation. If Congress determines that legislation is needed, I believe a more tailored and targeted law should be drafted in order to address current public policy concerns about investor protection and systemic risks. Yet, Congress should avoid trying to shoehorn private investment companies into laws designed for retail investors. For example, the Investment Company Act and Advisers Act are designed purely for investor protection, and have no provisions designed to protect counterparties or to control systemic risk. Similarly, these acts are generally silent on methods for winding down an investment fund or client account, an area which the law should address in some detail for large private investment companies. Further, the Advisers Act custody provisions exclude certain types of instruments that are commonly owned by private investment funds, an exclusion that would deprive investors in those funds of the protection that a custody requirement provides. At the same time, many requirements of the Investment Company Act and the Advisers Act are irrelevant, or would be counterproductive, if applied to private investment companies. For example, current restrictions on mutual funds from engaging in certain types of transactions, such as trading on margin and short selling, would severely inhibit or foreclose a number of hedge fund trading strategies that are fundamental to their businesses and the markets. \18\ As another example, requirements for boards of directors imposed by the Investment Company Act and compensation restrictions imposed by the Advisers Act are not particularly well suited to the regulation of managers of investment pools with high net worth and institutional investors. Such investors are fully capable of understanding the implications of performance-based fees, and do not need regulatory attention to protect themselves. Likewise, client-trading restrictions under the Advisers Act that require client consent on a transaction-by-transaction basis are unduly burdensome for private fund management. In sum, the Investment Company Act and Advisers Act, which were adopted in largely their current forms in 1940, are not well suited to being adapted for a new use in regulating investment structures and strategies developed primarily over the last 20 years.--------------------------------------------------------------------------- \18\ For example, convertible bond arbitrage relies on selling short the underlying equity security while buying the bond. This strategy provides an essential support for the convertible bond market, upon which many corporations rely for capital.--------------------------------------------------------------------------- Congress should think carefully as it considers the right tool for the task of regulating private investment companies. In my view, whatever legislation is developed should contain targeted controls and safeguards needed to provide appropriate oversight for the regulation of such entities, yet retain the flexibility of their operations. Congress may wish to consider more detailed requirements on large private investment companies (or families of private investment companies) in order to address the greater potential for systemic risk posed by such funds, depending upon their use of leverage and their trading strategies. Congress also may wish to consider giving legal effect to certain measures that were identified as ``best practices'' for fund managers in a report issued earlier this year by the Asset Managers' Committee (``AMC Best Practices'')--a group on which I served at the request of the President's Working Group on Financial Markets. \19\ For example, one of the most important of these recommendations is that managers should disclose more details--going beyond Generally Accepted Accounting Standards--regarding the portion of income and losses that the fund derives from Financial Accounting Standard (FAS) 157 Level 1, 2, and 3 assets. \20\ Another recommendation is that a fund's annual financial statements should be audited by an independent public accounting firm that is subject to PCAOB oversight. Still another recommendation would assure that potential investors are provided with specified disclosures relating to the fund and its management before any investment is accepted. This type of information should include any disciplinary history and pending or concluded litigation or enforcement actions, fees and expense structure, the use of commissions to pay broker-dealers for research (``soft dollars''), the fund's methodology for valuation of assets and liabilities, any side-letters and side-arrangements, conflicts of interest and material financial arrangements with interested parties (including investment managers, custodians, portfolio brokers, and placement agents), and policies as to investment and trade allocations.--------------------------------------------------------------------------- \19\ Report of the Asset Managers' Committee: Best Practices for the Hedge Fund Industry (January 15, 2009) (available at http://www.amaicmte.org/Asset.aspx). \20\ In brief, under FAS 157, Level 1 assets are those that have independently derived and observable market prices. Level 2 assets have prices that are derived from those of Level 1 assets. Level 3 assets are the most difficult to price--theirs are derived in part by reference to other sources and rely on management estimates. Disclosure of profits and losses from these categories will allow investors to better assess the diversification and risk profile of a given investment, and to determine the extent to which fund valuations are based on the ``best guess'' of fund management.--------------------------------------------------------------------------- Congress also should require safeguards that I have advocated for many years--simple, common-sense protections relating to custody of fund assets and periodic audits. As I mentioned earlier, there are areas of importance to the financial system that the Investment Company Act and Advisers Act do not address, including counterparty risk, lender risk, and systemic risk. These types of issues can be addressed through required disclosures to regulators and to counterparties. Of course, Congress also will need to choose a regulator, and since the SEC already has regulatory responsibility over publicly-offered funds, the SEC is the logical choice. If Congress decides to establish an overall systemic risk regulator, that regulator also may have a role in overseeing the largest, systemically important funds.V. Hedge Funds as Financial Investors One of the most important roles that hedge funds play in our economy is that of investor. Perhaps no other role played by hedge funds and other private investment vehicles, like venture capital funds, is more important to a return to economic growth than this one. From the point of view of an investor that provides capital to corporations by buying equity or debt, or of a potential purchaser of asset-backed securities in the secondary market, certain principles will be essential to encouraging investment in products that do not carry an explicit government and taxpayer guarantee against loss. One key principle is a generally accepted and respected valuation of assets. Mark-to-market (``MTM'') accounting is not perfect, but it does provide a compass for investors to figure out what an asset would be worth in today's market if it were sold in an orderly fashion to a willing buyer. Before mark-to-market accounting took effect, the Financial Accounting Standards Board (FASB) produced much evidence to show that valuing financial instruments and other difficult-to-price assets by ``historical'' costs, or ``mark to management,'' was folly. The rules now under attack are neither as significant nor as inflexible as critics charge. Mark-to-market accounting is generally limited to investments held for trading purposes, and to certain derivatives. For many financial institutions, these investments represent a minority of their total investment portfolio. For example, Bloomberg columnist David Reilly reports that of the 12 largest banks in the KBW Bank Index, only 29 percent of the $8.46 trillion in assets are at MTM prices. \21\--------------------------------------------------------------------------- \21\ David Reilly, Elvis Lives and Mark to Market Rules Fuel Crisis (Mar. 11, 2009), Bloomberg (available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aD11FOjLK1y4). ``Of the $8.46 trillion in assets held by the 12 largest banks in the KBW Bank Index, only 29 percent is marked to market prices, according to my analysis of company data. General Electric Co., meanwhile, said last week that just 2 percent of assets were marked to market at its General Electric Capital Corp. subsidiary, which is similar in size to the sixth-biggest U.S. bank. What are all those other assets that aren't marked to market prices? Mostly loans--to homeowners, businesses and consumers. Loans are held at their original cost, minus a reserve that banks create for potential future losses. Their value doesn't fall in lockstep with drops in market prices. Yet these loans still produce losses, thanks to the housing meltdown and recession. In fact, bank losses on unmarked loans are typically bigger than mark-to-market losses on securities like bonds backed by mortgages.''--------------------------------------------------------------------------- Why is that so? Most bank assets are in loans, which are held at their original cost using amortization rules, minus a reserve that banks must set aside as a safety cushion for potential future losses. MTM rules also give banks a choice. MTM accounting is not required for securities held to maturity, but you need to demonstrate a ``positive intent and ability'' that you will do so. Further, an SEC 2008 report found that ``over 90 percent of investments mark-to-market are valued based on observable inputs.'' \22\--------------------------------------------------------------------------- \22\ SEC, Office of the Chief Accountant, Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting (available at: http://www.sec.gov/news/studies/2008/marktomarket123008.pdf). The report concludes: ``The Staff observes that fair value accounting did not appear to play a meaningful role in bank failures occurring during 2008. Rather, bank failures in the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence. For the failed banks that did recognize sizable fair value losses, it does not appear that the reporting of these losses was the reason the bank failed.'' At 4.--------------------------------------------------------------------------- Obfuscating sound accounting rules by gutting MTM rules will only further reduce investors' trust in the financial statements of all companies, causing private capital--desperately needed in securities markets--to become even scarcer. Worse, decreased clarity will further erode confidence in the American economy, with dire consequences for many of the financial institutions who are calling for MTM changes. Greater transparency is also necessary in the over-the-counter derivatives markets. These markets play a critical role in the establishment of prices in almost every public or regulated market, from determining interest rates to share prices. Reducing the need for reliance on a few opaque counterparties, increasing regulatory access to price and volume and other transactional information, and fostering integrity in the price discovery function for OTC products that affect the borrowing costs of individual companies, are all objectives that should be aggressively pursued as part of this Committee's modernization of our financial regulatory structure.VI. Conclusion Honesty and fair dealing are at the foundation of the investor confidence our markets enjoyed for so many years. A sustainable economic recovery will not occur until investors can again feel certain that their interests come first and foremost with the companies, asset managers, and others with whom they invest their money, and until they believe that regulators are effectively safeguarding them against fraud. CPIC is committed to working diligently with this Committee and other policy makers to achieve that difficult but necessary goal. ______ FOMC20080130meeting--294 292,MR. FISHER.," Well, Mr. Chairman, I've seen the discount rate tally. I've listened carefully to all my fellow Presidents and to Governor Kohn. I suspect I know what your fellow Governors are going to recommend. I'm in a distinct minority at this table. This weekend, by the way, I searched the newspapers for something to read that didn't have anything to do with either a rogue French trader or market volatility or what the great second guessers were blabbing forth at the chat show in Davos; and in doing so I happened upon a delightful article. I hope you saw it in the Saturday New York Times on the search for a motto that captures the essence of Britain. My favorite was nemo ne inclune lacet, which very loosely translated, I think, means ""never sit on a thistle."" [Laughter] Well, that's where I am. I'm going to risk sitting on the thistle of opprobrium for my respective colleagues by making the recommendation that we not change the funds rate and that we stay right where we are. Now, for the record, I would have supported last week's 75 basis point cut for the reasons that it would put us ahead of the curve and bought adequate insurance against a recession. I told you that directly, Mr. Chairman, and I mentioned it to Governor Kohn as well. Judging by the policy rules on page 21 of the Bluebook, as well as by the adjusted rule that our economist Evan Koenig has developed in Dallas, we are, indeed, ahead of the curve from the Taylor rule standpoint as we meet today with the rate of 3.50. As was mentioned earlier, we have not been docile. We have cut rates 175 basis points in a matter of months, and we've taken some new initiatives that I think are constructive and useful. I'd like to see more along the lines of the TAF. To be sure, in the discussion that we had in that emergency meeting, I had the same concerns that President Hoenig expressed in the call, but with the wording change that was put forward by Governor Kroszner I ended up where President Hoenig did. I regret not voicing my discomfort with the penultimate sentence in the statement--the one dealing with appreciable downside risk after the move we took--as I felt that it undercut the potential effect of our decision. During that call, you may recall that I pointed out the pros and cons. I began my intervention on that call by saying that there's a very fine line between getting ahead of the curve and creating a sense of panic. I also expressed concern of the need to be mindful of inflation, as many have at this table today. There are some critics who say we panicked in response to the market sell-off of that Monday. I do not believe that's the case, and I don't believe it's the case because I find it impossible to believe. As I've said repeatedly in this room, other than in theory, markets are not efficient, and on the banks of the Hudson or the Thames or the Yangtze River, you cannot in practice satisfy the stock market or most other markets, including the fed funds futures market, in the middle of a mood swing. When the market is in the depressive phase of what President Lockhart referred to as a bipolar disorder, crafting policy to satisfy it is like feeding Jabba the Hutt--doing so is fruitless, if not dangerous, because it simply will insist upon more. But attempting to address the pathology of the underlying economy is necessary and righteous, and that's what we do for a living, and I think we are best sticking with it. We're talking about the fed funds rate. I liken the fed funds rate to a good single malt whiskey--it takes time to have its ameliorative or stimulative effect. [Laughter] But I'm also mindful of psychology, and that's what I want to devote the remainder of my comment to, and then I'll shut up. My CEO contacts tell me that we're very close to the ""creating panic"" line. They wonder if we know something that they do not know, and the result is, in the words of the CEO of AT&T, Randall Stephenson, ""You guys are talking us into a recession."" To hedge against that risk is something to them unforeseen, even after they avail themselves of the most sophisticated analysis that money can buy. CEOs are, indeed, doing what one might expect. They are tightening the ship. They're cutting head counts to lower levels. They're paring back capex where they can beyond the levels they would otherwise consider appropriate after imputing dire assumptions of the effects of housing. I'm going to quote Tim Eller, whom I consider the most experienced and erudite of the big homebuilders, which is Centex, who told me, ""We had just begun to feel that we were getting somewhat close to at least a sandy bottom. Then you cut 75 basis points and add `appreciable downside risks to economic growth remain' in your statement, and it scares the `beep' out of us."" He didn't use the word ""beep."" These are his words, not mine. Imagine scaring a homebuilder already living in hell. The CEOs and CFOs I speak to from Disney to Wal-Mart, to UPS, to Texas Instruments, Cisco, Burlington Northern, Southwest Airlines, Comerica, Frost Bank, even the CEO of the felicitously named Happy State Bank in Texas, repeated this refrain, ""You must see something that we simply do not see through our own business eyes."" They do see a slowdown. They are worried about the pratfall, as I like to call it, of housing. They're well aware of California's and Florida's economic implosion and broader hits to consumer welfare across the national map. I recited some data points from those calls yesterday. But they do not see us falling off the table. They worry aloud that by our words and deeds we are inciting the very economic outcome we seek to cut off at the pass by inducing them to further cut costs, defer cap-ex, and take other actions to hedge against risk. They can't fathom it but assume that we can. Our Beige Book contacts and the respondents to the business outlook survey in Dallas say pretty much the same thing. One of those actions is to fatten margins by passing on input costs. Now, I mentioned the rail adjustment factor yesterday, and I'm troubled by the comment that I quoted yesterday from the CEO of Tyson Foods. ""We have no choice but to raise prices substantially."" I mentioned that Frito-Lay has upped its price increase target for '08 to 7 percent from 3 percent. Kimberly-Clark notes that it is finding no resistance at all to increasing prices in both its retail and institutional markets, and I mentioned that Wal-Mart's leaders confirm that, after years of using their price leadership power to deflate or disinflate the price of basic necessities-- think about this--from food to shoes to diapers, they plan in 2008 to apply that price leadership to accommodate price increases for 127 million weekly customers. This can't help but influence inflation expectations among consumers. I experienced a different kind of price shock two weekends ago, when I went to buy a television so I could watch President Rosengren's football team demolish President Yellen's. [Laughter] I was told that they had doubled their delivery and installation fees because of a ""fuel surcharge."" Well, I reminded the store clerk that I had been there about the time of the Army-Navy game, around Thanksgiving, and that gas prices had not doubled since the Army-Navy game, and he said, ""Mr. Fisher, we're selling less, and we will take what we can get away with however we can get away with it."" With one-year-forward consumer expectations, according to the Michigan survey, already above 3 percent, everyone from Exxon to Valero to Hunt Oil and our own economists in the Greenbook telling me that oil is likely to stay above $80, and the national average price therefore above $3, this mindset really worries me. I'm going to add one more very troubling little personal anecdote. Driving home from work last week I heard a commercial for Steinway pianos. The essence of the advertisement was that manufacturing costs had increased and that you could buy a piano out of their current inventory at the ""old price"" that was in place in 2007; but come February 1, there would be sizable price increases, so you'd better purchase your piano quickly. It has been thirty years since I have seen advertisements to go out and buy now before the big expected price increases go into effect. Now, this is an isolated, little bitty incident, but I fear this may be just the beginning of the more pervasive use of this tactic. Everyone in this room knows how agnostic I am about the predictive value of TIPS and the futures instruments comparing TIPS with nominals, like the five-year, five-year-forward. I've sent around an eye popping chart that shows the predictive deficiencies of the professional forecasters that were tracked by the Philadelphia Fed. I know that dealers are telling us that inflation is contained, but I have spent many years in the canyons of Wall Street, and I would caution against their disinterest in the predictions that they offer. When I see that every measure of inflation has turned up, learn from studying the entrails of the last PCE that 83 percent of the items therein experienced a price upswing, consider the shortcomings of the few tools we have for evaluating expectations of future inflation, and then hear from microeconomic operators of the economy that, by golly, we're going to take what we can while the getting is good, I can't help but feel that we cannot afford to let our guard down by becoming more accommodative than we have already become with our latest move. Mr. Chairman, you know because we've talked about this that I've anguished over this. In fact, to be politically incorrect in a government institution, I have prayed over it. It is not easy to go against the will of the people you have enormous respect for, but I have an honest difference of opinion. I truly believe we have it right at 3� percent right now. I think that, even with some important language changes, we risk too much by cutting 50 basis points at this juncture and driving the real rate further into what I perceive, even on an expectations-adjusted basis, is getting very close to negative territory. Mr. Chairman, I think we've gone as far as is prudent for now, and that 3� percent, together with the other initiatives we've taken to restore liquidity, is sufficient. So I ask for your forbearance in letting me sit on the thistle of recommending no change. I do want to say as far as the language is concerned, since obviously we're going to go with alternative B despite my vote against it, that I strongly recommend you consider the changes that were given by Presidents Plosser, Yellen, and Poole, and I would strongly advocate particularly at the end adding that we will act as needed to foster price stability and sustainable economic growth. I thank you for paring back alternative B, paragraph 3, in terms of getting away from discussing only energy, commodity, and other import prices. Thank you, Mr. Chairman. " FOMC20061212meeting--30 28,MR. KAMIN.," A few months ago, when Karen Johnson asked me to fill in for her at the December FOMC meeting, I immediately wrote to Santa Claus and asked, as my present, for some major international event to take place, be it an emerging- market crisis, skyrocketing commodity prices, or a spectacular collapse of the dollar. Such developments are not always welcomed by financial market participants or by ordinary working people, but they certainly make for interesting conversation. [Laughter] Well, if you believe what you read in the financial press, Santa granted me my third wish: As Dino has discussed, since you last met, the dollar is down about 5 percent against the euro and 4½ percent against sterling. Two weeks ago, The Economist saw fit to put on its cover a picture of a dollar bill with George Washington’s jaw dropping. To put these recent developments in perspective, however, the dollar declined considerably less against the currencies of most of our other major trading partners, and the broad dollar has fallen only about 2 percent over the intermeeting period. This is still a significant decline for so short a period, but is only half the size of the drop posted between the March and May FOMC meetings earlier this year. Also, we have seen nothing to indicate that a major rebalancing of investor portfolios away from the greenback is imminent. Accordingly, as is our practice, in our forecast we have adjusted down the starting point for the projected path of the dollar but continue to project only a modest decline in its real value going forward. Even before the dollar’s recent decline, we were seeing some limited evidence of improvement in the U.S. external balance. A few weeks after your October meeting, we received data indicating that the monthly nominal trade deficit had shrunk from a record $69 billion in August to $64 billion in September. Although this downshift principally reflected declines in the price of imported oil, the trade deficit had been boosted by rising oil prices earlier this year, and their subsequent fall and stabilization at least should diminish one factor widening the deficit going forward. This morning, October trade data were released; they indicate that the trade deficit shrank a bit further, to about $59 billion. This deficit was even smaller than we’d anticipated, with exports a bit stronger and imports a bit weaker. The recent performance of real net exports also appears a little more positive. The September trade data and other recent information point to somewhat weaker- than-expected real import growth in the third quarter and nearly flat real imports in the current quarter; this flattening is due in part to a sharp decline in the volume of oil imports as domestic users work off an unusually high level of inventories. With real exports estimated to have continued expanding solidly, the December Greenbook shows real net exports in the third and fourth quarters combined adding slightly to U.S. GDP growth in comparison with the slight drag we wrote down in October. This morning’s October trade release suggests that we’ll probably revise that contribution up a little further. Over the next two years, real import growth should pick up as U.S. activity accelerates and oil imports stabilize. With export growth holding steady, supported by the ongoing expansion abroad and the declining dollar, real net exports start deteriorating again and subtract about 0.1 percentage point from GDP growth in 2007 and 0.25 percentage point in 2008. This drag is quite small, however, compared with the nearly 0.5 percentage point drag exerted by net exports on average from 2000 through 2006. It is also about 0.1 percentage point smaller than in the October Greenbook, and we would attribute this principally to the weaker dollar. Consistent with the improved performance of net exports, the weaker dollar has also led us to project slightly stronger trade and current account balances. The current account deficit now expands just a touch, from about 6¾ percent of GDP at present to 7 percent by the end of 2008, whereas the trade deficit remains about flat as a share of GDP—at around 5½ percent—over the forecast period. Does this flattening out suggest that sustainability of the U.S. external balance is just around the corner? Absolutely not! [Laughter] The trade deficit is still projected to widen a bit in nominal, dollar-value terms. As long as the trade balance remains substantially in deficit, borrowing to finance that deficit ultimately will lead to growing external debt, rising payments on that debt, and ever-larger current account deficits. Our projection has the net international investment position, which was negative 21 percent of GDP in 2005, sliding to negative 36 percent of GDP by 2008. The slower deterioration of U.S. external balances that we anticipate depends on continued solid economic growth among our trading partners. Our trade-weighted aggregate of foreign real GDP growth clocked in at about 4½ percent in the first half of this year, which likely was a little faster than its trend rate. The data we’ve received since the October Greenbook reinforce our view that a stepdown is in train, with growth in China, Mexico, Japan, and the euro area all slowing in the third quarter from previous unusually elevated rates. We estimate that, all told, the foreign economy decelerated to a pace of 3¼ percent in the second half of this year, and we see it staying at this more sustainable rate going forward. Can foreign growth remain this strong, even as U.S. GDP growth is projected to average less than 2½ percent over the forecast period? U.S. growth and foreign growth are highly correlated, reflecting both direct trade links and indirect links through financial markets and confidence effects. However, growth rates here and abroad do not move in lockstep. Over the past thirty years, gaps in excess of 2 to 3 percentage points have periodically opened up between U.S. and foreign growth; at about 1 percentage point, the growth differential we are projecting is not unusual. Of course, were the United States to fall into recession, this would likely be bad news for our trading partners. Since 1970, five recessions have been dated for the U.S. economy, and on all those occasions foreign growth slumped as well. As we put together our outlook, we also had to consider whether it would take a sharper slowdown than we are projecting to prevent widespread inflationary pressures. We are heartened to see that, as in the United States, the decline in oil prices since August has led to sharp declines in headline CPI inflation in many of our trading partners. For example, euro-area twelve-month inflation has fallen through the ECB’s 2 percent target ceiling to only 1.8 percent, while Canadian inflation has fallen to 1 percent. However, inflation abroad should pick up again with projected increases in oil prices. Moreover, resource utilization abroad has been rising, and it is difficult to identify much slack in the major foreign economies. To date, measures of core inflation and wage growth are not signaling significant upward pressures, but unemployment rates are generally near lows last reached at the end of the 1990s. The emergence of more-pronounced inflationary pressures, should that occur, would likely trigger a more substantial further tightening of monetary policy and financial conditions than we are currently anticipating, leading to a falloff from the steady foreign growth called for in the Greenbook forecast. This, in turn, could put the U.S. trade and current account balances on a more negative trajectory than we now expect. That concludes my remarks." CHRG-111shrg51290--60 STATEMENT OF STEVE BARTLETT President and Chief Executive Officer, Financial Services Roundtable March 3, 2009 Chairman Dodd, Ranking Member Shelby and Members of the Senate Banking Committee. I am Steve Bartlett, President and Chief Executive Officer of the Financial Services Roundtable. The Roundtable is a national trade association composed of the nation's largest banking, securities, and insurance companies. Our members provide a full range of financial products and services to consumers and businesses. Roundtable member companies provide fuel for America's economic engine, accounting directly for $85.5 trillion in managed assets, $965 billion in revenue, and 2.3 million jobs. On behalf of the members of the Roundtable, I wish to thank you for the opportunity to participate in this hearing on the role of consumer protection regulation in the on-going financial crisis. Many consumers have been harmed by this crisis, especially mortgage borrowers and investors. Yet, the scope and depth of this crisis is not simply a failure of consumer protection regulation. As I will explain in a moment, the root causes of this crisis are found in basic failures in many, but not all financial services firms, and the failure of our fragmented financial regulatory system. I also believe that this crisis illustrates the nexus between consumer protection regulation and safety and soundness regulation. Consumer protection and safety and soundness are intertwined. Prudential regulation and supervision of financial institutions is the first line of defense for protecting the interests of all consumers of financial products and services. For example, mortgage underwriting standards not only help to ensure that loans are made to qualified borrowers, but they also help to ensure that the lender gets repaid and can remain solvent. Given the nexus between the goals of consumer protection and safety and soundness, we do not support proposals to separate consumer protection regulation and safety and soundness regulation. Instead, we believe that the appropriate response to this crisis is the establishment of a better balance between these two goals within a reformed and more modern financial regulatory structure. Moreover, I would like to take this opportunity to express the Roundtable's concerns with the provision in the Omnibus Appropriations bill that would give State attorneys generals the authority to enforce compliance with the Truth-in-Lending Act (TILA) and would direct the Federal Trade Commission to write regulations related to mortgage lending. As I will explain further, we believe that one of the fundamental problems with our existing financial regulatory system is its fragmented structure. This provision goes in the opposite direction. It creates overlap and the potential for conflict between the Federal banking agencies, which already enforce compliance with TILA, and State AGs. It also creates overlap and the potential conflict between the Federal banking agencies, which are responsible for mortgage lending activities, and the Federal Trade Commission. While it may be argued that more ``cops on the beat'' can enhance compliance, more ``cops'' that are not required to act in any coordinated fashion will simply exacerbate the regulatory structural problems that contributed to the current crisis. My testimony is divided into three parts. First, I address ``What Went Wrong.'' Second, I address ``How to Fix the Problem.'' Finally, I take this opportunity to comment on the lending activities of TARP-assisted firms, and the Roundtable's continuing concerns over the impact of fair value accounting.What Went Wrong The proximate cause of the current financial crisis was the nation-wide collapse of housing values, and the impact of that collapse on individual homeowners and the holders of mortgage-backed securities. The crisis has since been exacerbated by a serious recession. The root causes of the crisis are twofold. The first was a clear breakdown in policies, practices, and processes at many, but not all, financial services firms. Poor loan underwriting standards and credit practices, excessive leverage, misaligned incentives, less than robust risk management and corporate governance are now well known and fully documented. Corrective actions are well underway in the private sector as underwriting standards are upgraded, credit practices reviewed and recalibrated, leverage is reduced as firms rebuild capital, incentives are being realigned, and some management teams have been replaced, while whole institutions have been intervened by supervisors or merged into other institutions. So needed corrective actions are being taken by the firms themselves. More immediately, we need to correct the failures that the crisis exposed in our complex and fragmented financial regulatory structure. Crises have a way of revealing structural flaws in regulation, supervision, and our regulatory architecture that have long-existed, but were little noticed until the crisis exposed the underlying weaknesses and fatal gaps in regulation and supervision. This one is no different. It has revealed significant gaps in the financial regulatory system. It also revealed that the system does not provide for sufficient coordination and cooperation among regulators, and that it does not adequately monitor the potential for market failures, high-risk activities, or vulnerable interconnections between firms and markets that can create systemic risk and result in panics like we saw last year and the crisis that lingers today. The regulation of mortgage finance illustrates these structural flaws in both regulation and supervision. Many of the firms and individuals involved in the origination of mortgage were not subject to supervision or regulation by any prudential regulator. No single regulator was held accountable for identifying and recommending corrective actions across the activity known as mortgage lending to consumers. Many mortgage brokers are organized under State law, and operated outside of the regulated banking industry. They had no contractual or fiduciary obligations to brokers who referred loans to them. Likewise, many brokers were not subject to any licensing qualifications and had no continuing obligations to individual borrowers. Most were not supervised in a prudential manner like depository institutions engaged in the same business line. The Federal banking regulators recognized many of these problems and took actions--belatedly--to address the institutions within their jurisdiction, but they lacked to power to reach all lenders. Eventually, the Federal Reserve Board's HOEPA regulations did extend some consumer protections to a broader range of lenders, but the Board does not have the authority to ensure that those lenders are engaged in safe and sound underwriting practices or risk management. The process of securitization suffered from a similar lack of systemic oversight and prudential regulation. No one was responsible for addressing the over-reliance investors placed upon the credit rating agencies to rate mortgage-backed securities, or the risks posed to the entire financial system by the development of instruments to transfer that risk worldwide.How to Fix the Problem How do we fix this problem? Like others in the financial services industry, the members of the Financial Services Roundtable have been engaged in a lively debate over how to better protect consumers by addressing the structural flaws in our current financial regulatory system. While our internal deliberations continue, we have developed a set of guiding principles and a ``Draft Financial Regulatory Architecture'' that is intended to close the gaps in our existing financial regulatory system. We are pleased that the set of regulatory reform principles that President Obama announced last week are broadly consistent and compatible with the Roundtable's principles for much needed reforms. Our first principle in our 2007 Blueprint for U.S. Financial Modernization was to ``treat consumers fairly.'' Our current principles for regulatory reform this year build on that guiding principle and call for: 1) a new regulatory architecture; 2) common prudential and consumer and investor protection standards; 3) balanced and effective regulation; 4) international cooperation and national treatment; 5) failure resolution; and 6) accounting standards. Our plan also seeks to encourage greater coordination and cooperation among financial regulators, and to identify systemic risks before they materialize. We also seek to rationalize and simplify the existing regulatory architecture in ways that make more sense in our modern, global economy. The key features of our proposed regulatory architecture are as follows. Financial Markets Coordinating Council To enhance coordination and cooperation among the many and various financial regulatory agencies, we propose to expand membership of the President's Working Group on Financial Markets (PWG) and rename it as the Financial Markets Coordinating Council (FMCC). We believe that this Council should be established by law, in contrast to the existing PWG, which has operated under a Presidential Executive Order since 1988. This would permit Congress to oversee the Council's activities on a regular and ongoing basis. We also believe that the Council should include representatives from all major Federal financial agencies, as well as individuals who can represent State banking, insurance, and securities regulation. This Council could serve as a forum for national and State financial regulators to meet and discuss regulatory and supervisory policies, share information, and develop early warning detections. In other words, it could help to better coordinate policies within our still fragmented regulatory system. We do not believe that the Council should have independent regulatory or supervisory powers. However, it might be appropriate for the Council to have some ability to review the goals and objectives of the regulations and policies of Federal and State financial agencies, and thereby ensure that they are consistent.Federal Reserve Board To address systemic risk, we believe the Federal Reserve Board (Board) should be authorized to act as a market stability regulator. As a market stability regulator, the Board should be responsible for looking across the entire financial services sector to identify interconnections that could pose a risk to our financial system. To perform this function, the Board should be empowered to collect information on financial markets and financial services firms, to participate in joint examinations with other regulators, and to recommend actions to other regulators that address practices that pose a significant risk to the stability and integrity of the U.S. financial services system. The Board's authority to collection information should apply not only to depository institutions, but also to all types of financial services firms, including broker/dealers, insurance companies, hedge funds, private equity firms, industrial loan companies, credit unions, and any other financial services firms that facilitate financial flows (e.g., transactions, savings, investments, credit, and financial protection) in our economy. Also, this authority should not be based upon the size of an institution. It is possible that a number of smaller institutions could be engaged in activities that collectively pose a systemic risk.National Financial Institutions Regulator To reduce gaps in regulation, we propose the consolidation of several existing Federal agencies into a single, National Financial Institutions Regulator (NFIR). This new agency would be a consolidated prudential and consumer protection agency for banking, securities and insurance. More specifically, it would charter, regulate and supervise (i) banks, thrifts, and credit unions, currently supervised by the Office of the Thrift Supervision, the Office of the Comptroller of the Currency, and the National Credit Union Administration; (ii) licensed broker/dealers, investment advisors, investment companies, futures commission merchants, commodity pool operators, and other similar intermediaries currently supervised by the Securities and Exchange Commission or the Commodities Futures Trading Commission; and (iii) insurance companies and insurance producers that select a Federal charter. The AIG case illustrates the need for the Federal Government to have the capacity to supervise insurance companies. Also, with the exception of holding companies for banks, the NFIR would be the regulator for all companies that control broker/dealers or national chartered insurance companies. The NFIR would reduce regulatory gaps by establishing comparable prudential standards for all of these of nationally chartered or licensed entities. For example, national banks, Federal thrifts and federally licensed brokers/dealers that are engaged in comparable activities should be subject to comparable capital and liquidity standards. Similarly, all federally chartered insurers would be subject to the same prudential and market conduct standards. In the area of mortgage origination, we believe that the NFIR's prudential and consumer protection standards should apply to both national and State lenders. Mortgage lenders, regardless of how they are organized, should be required to retain some of the risk for the loans they originate (keep some ``skin-in-the-game''). Likewise, mortgage borrowers, regardless of where they live or who their lender is, should be protected by the same safety and soundness and consumer standards. As noted above, we believe that is it important for this agency to combine both safety and soundness (prudential) regulation and consumer protection regulation. Both functions can be informed, and enhanced, by the other. Prudential regulation can identify practices that could harm consumers, and can ensure that a firm can continue to provide products and services to consumers. The key is not to separate the two, but to find an appropriate balance between the two.National Capital Markets Agency To focus greater attention on the stability and integrity of financial markets, we propose the creation of a National Capital Markets Agency through the merger of the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC), preserving the best features of each agency. The NCMA would regulate and supervise capital markets and exchanges. As noted above, the existing regulatory and supervisory authority of the SEC and CFTC over firms and individuals that serve as intermediaries between markets and customers, such as broker/dealers, investment companies, investment advisors, and futures commission merchants, and other intermediaries would be transferred to the NFIR. The NCMA also should be responsible for establishing standards for accounting, corporate finance, and corporate governance for all public companies.National Insurance Resolution Authority To protect depositors, policyholders, and investors, we propose that the Federal Deposit Insurance Corporation (FDIC) would be renamed the National Insurance and Resolution Authority (NIRA), and that this agency act not only as an insurer of bank deposits, but also as the guarantor of retail insurance policies written by nationally chartered insurance companies, and a financial backstop for investors who have claims against broker/dealers. These three insurance systems would be legally and functionally separated. Additionally, this agency should be authorized to act as the receiver for large non-bank financial services firms. The failure of Lehman Brothers illustrated the need for such a better system to address the failure of large non-banking firms.Federal Housing Finance Agency Finally, to supervise the Federal Home Loan Banks and to oversee the emergence and future restructuring of Fannie Mae and Freddie Mac from conservatorship we propose that the Federal Housing Finance Agency remain in place, pending a thorough review of the role and structure of the housing GSEs in our economy.TARP Lending and Fair Value Accounting Before I close I would like to address two other issues of importance to policymakers and our financial services industry: lending by institutions that have received TARP funds, and the impact of fair value accounting in illiquid markets. Lending by institutions that have received TARP funds has become a concern, especially given the recessionary pressures facing the economy. I have attached to this statement a series of tables that the Roundtable has compiled on this issue. Those tables show the continued commitment of the nation's largest financial services firms to lending. Fair value accounting also is a major concern for the members of the Roundtable. We continue to believe that the pro-cyclical effects of existing policies are unnecessarily exacerbating this crisis. We urge this Committee to direct financial regulators to adjust current accounting standards to reduce the pro-cyclical effects of fair value accounting in illiquid markets. We also urge the U.S. and international financial regulators coordinate and harmonize regulatory policies to development accounting standards that achieve the goals of transparency, understandability, and comparability.Conclusion Thank you again for the opportunity to appear today to address the connection between consumer protection regulation and this on-going financial crisis. The Roundtable believes that the reforms to our financial regulatory system we have developed would substantially improve the protection of consumers by reducing existing gaps in regulation, enhancing coordination and cooperation among regulators, and identifying systemic risks. We also call on Congress to address the continuing pro-cyclical effects of fair value accounting. Broader regulatory reform is important not only to ensure that financial institutions continue to meet the needs of all consumers but to restart economic growth and much needed job creation. Financial reform and ending the recession soon are inextricably linked--we need both. We need a financial system that provides market stability and integrity, yet encourages innovation and competition to serve consumers and meet the needs of a vibrant and growing economy. We need better, more effective regulation and a modern financial regulatory system that is unrivaled anywhere in the world. We deserve no less. At the Roundtable, we are poised and ready to work with you on these initiatives. As John F. Kennedy once cited French Marshall Lyautey, who asked his gardener to plant a tree. The gardener objected that the tree was slow growing and would not reach maturity for 100 years. The Marshall replied, ``In that case, there is no time to lose; plant it this afternoon!'' The same is true with regard to the future of the United States in global financial services--there is no time to lose; let's all start this afternoon. ______ CHRG-111hhrg51698--390 Mr. Marshall," Thank you, Mr. Chairman. Gentleman, I am going to have to ask that some of you answer for purposes of the record; in other words, do a little bit more work after this hearing responding to questions, because I just have too many questions for you to respond to verbally now. I apologize for the extra work. I would like for you to respond not only for the record, but if you could send your responses to my office as well, I appreciate it. Mr. Morelle, God bless you and I appreciate your interests, but I just can't imagine the regulatory arbitrage problems that we would have if we broadened this to 50 jurisdictions within the United States. We already have regulatory arbitrage problems, and it is just hard for me to fathom. Particularly when our principal concern is how this affects our money supply globally, and how this affects the large institutions that are too big to fail, at least we are identifying them as too big to fail. We are here largely because of that right now. And to suggest that individual states will be having a large say in decisions that could affect global money supplies, national money supplies, just seems far-fetched to me. You might want to comment on that if you could in writing. You also define ``naked'' too broadly. It seems to me that if one institution needs hedging and they go to A and A says sure, I will hedge with you, then A has this risk. A then might go to B and say--A, by the way, in deciding whether or not it can actually cover the risk, is taking into account the fact that it could conceivably to go to B, C and D. But it goes to others and tries to lay off that risk. So A, I would assume in a reasonable definition of what is ``naked,'' that person wouldn't be naked. And then going to the next person or the next entity, yes, that entity to start out with has no interest, but once that entity has gone ahead and covered some of the risk or offset the risk somehow, then B has got an interest. Then you see where I am going. So it is the characters that are totally on the sideline that just want to place bets among themselves that you really have in mind as being naked. Mr. Masters, you are arguing for position limits on and off-exchange and I have a lot of sympathy for that, but I suspect that maybe a lot of what you want to accomplish can be accomplished by simply having CDSs cleared. I should say that those that aren't cleared would be only permitted if some regulatory body, I would think the CFTC, says grace over them, probably in advance. There would have to be some sort of general scheme, the kinds that will be permitted, the kinds that won't. Then the clearinghouses are making public not the details of the private transactions, but generally making public information to enhance public transparency. And if the CFTC were required to do the exact same thing with regard to these things that aren't being cleared but are transparent to regulators, it seems to me, it is going to be an absolute minimum. I think that might accomplish a lot of your objectives. What worries me that everybody is going to have these position limits, on-exchange off-exchanges, that means that market makers, traditional market makers that are important to the liquidity of the market, they could be caught up in this and somehow limited in offering their liquidity. And they haven't been part of the problem. You don't think they are part of the problem, I don't think they are part of the problem. Then there are traditional speculators, who are not, as was described by Mr. Gooch yesterday as ``invesculators,'' who are not invesculators. They aren't just using these markets as a means to invest in commodities or something like that, they have helped us with price discovery and liquidity as well, historically. So if you could give some thought as to whether or not some lesser approach than simply across-the-board position limits would work, that would be great. Mr. Pickel, I am saving the best for last. I have the impression that the industry, you are the industry spokesperson and I credit you with being very effective in your job, but you are just stonewalling here. It is fine to say that there is no credible scholarship out there that demonstrates that CDS is a substantial part of the problem. A lot of obvious logical arguments for why they would be exist. But, at this point it would be very helpful if the industry produced credible scholarship showing that they aren't part of the problem as opposed to simply saying there isn't anything proving it. I think the burden has shifted at this point, and that is certainly the attitude in Congress and the attitude publicly. So I would encourage you to step forward with some real credible information that this is not a problem. And I would ask that the industry start considering compromises instead of just blowing through all of this, and saying that any compromise just doesn't make any sense that it would lessen liquidity substantially and cause people to run off overseas, et cetera. One of the compromises that has been suggested is this clearing compromise. Obviously all things can't be cleared, so some process that would take that into account, maybe CFTC approval to noncleared under these circumstances, or specifically looking at noncleared. And certainly there has to be at a minimum record-keeping, reporting to the regulator, with some sort of public reporting. I mean, you all need to start thinking about this and proposing something that works for your industry and will meet some of the real concerns that we have and solutions we are working on. And simply to stonewall repeatedly, I don't think cuts it here. So if you want a quick--my time is up. I guess you ought to have time to at least respond to that, and then if you could respond in writing in general, that would be great. Mr. Boswell [presiding.] We will be going back to the next round shortly, so we will just come right back to it. Mr. Goodlatte, are you ready? " FOMC20080318meeting--65 63,MR. SAPENARO.," Thank you, Mr. Chairman. Eighth District economic conditions have softened, but with considerable variability across industries and local areas. The outlook for District agriculture is very strong in the context of high commodity prices. This prospect is reflected in prices of agricultural land, which in areas within the District have risen at a rate of 20 to 25 percent over the past year in active markets. Production of agricultural equipment for the 2008 crop season is fully booked, and prices of used equipment are at or very close to prices of new equipment. There was major activity in the District energy industry, with significant construction projects of coal-fired generation facilities and rapidly developing exploration and production in the Fayetteville Shale play in Arkansas. Total natural gas production from this source roughly quadrupled during 2007. In a recently published study, it is estimated that the direct impact on Arkansas output from exploration and production will average about $2.5 billion per year for the next five years. For perspective, this is about 2.8 percent of the 2006 Arkansas gross state product. Overall activity in the Evansville, Indiana, metropolitan area is particularly strong. The unemployment rate there has declined year over year from 4.6 to 4.2 percent, and nonfarm employment has grown 1.4 percent from January '07 to January '08. A major investment in the auto parts industry is in the works for this area. Activity in housing markets in the District is soft, with building permits in the four largest metro areas down on average 16.8 percent during 2007. Nevertheless, house prices in the District have held up much better than the national experience. In 21 District metropolitan areas, house prices increased an average of 2.5 percent in 2007, with decreases in house prices reported in only 3 metro areas. However, in contrast to other parts of the nation, these areas did not experience major house-price inflation before 2007. From 2000:Q4 through 2006:Q4, the average annual price inflation in these areas was only 5.3 percent. Foreclosures have increased in 2007 in three of the four largest District metro areas but at much lower rates than nationally, and 2007 foreclosure rates are at or below national averages in three of these four areas. I solicited information on the national economy from a number of sources. Contacts in the air and ground cargo industry report significant cost pressures from higher energy prices. These affect everything from fuel costs to the cost of snow removal. Respondents indicate that these cost increases are significantly but not completely passed through to their prices. International cargo traffic is reported to show strong growth, but with some customers substituting sea for air shipment and choosing less rapid delivery service to reduce cost. Year-over-year traffic out of Asia to both Europe and North America has grown at double-digit rates. One contact indicated that volume appears to have bottomed out in the first half of 2007 and has slowly but steadily improved since. In contrast, a contact in the over-the-road trucking industry reported that there was not much change in the past two months. In his view, the industry has been in recession since December 2006. He sees improvement for his firm going forward not because of increased demand but because of small competitors exiting the industry through bankruptcy. Excluding fuel surcharges, freight prices are flat to down. A contact at a major credit card bank reported that their credit card activity indicates that retail sales, excluding autos, were flat in February and are likely to be flat to down in March. These February data were confirmed by the advance retail sales report last week. He also reported that a smaller percentage of customers are making full payment on their credit cards and that a larger percentage are making only the minimum required payment. He sees delinquencies spreading to credit cards. A contact at a major software producer indicates that revenue growth was robust prior to the first quarter of 2008 and, while remaining strong, has slackened since the beginning of the year. He reports strong retail sales, but that was possibly influenced by reductions in prices. He sees business IT spending in the United States remaining strong and no deterioration in the collection of receivables. Nevertheless, he is less optimistic about the industry outlook now than in January. Finally, a contact in the quick service restaurant industry, or fast food, sees business as stable at the moment, not getting worse but not getting better. He notes that while historically this industry is affected least when the economy slows down, this particular time he sees gasoline prices as a significant factor, with many consumers making fewer trips to purchase low-ticket items. He also views financial markets as closed to all but the largest and most highly rated nonfinancial corporations. In his words, there is no market for deals. The national economy certainly appears headed for a weaker first half of 2008 than seemed likely at the January meeting. A model estimated by our staff economists for forecasting recessions suggests a probability in the neighborhood of 60 percent that the NBER dating committee will label the current experience an official recession. Unlike some, I am not an optimist on the effect of the fiscal stimulus program on consumer demand. Economic theory and past experience with such oneoff stimulus programs do not provide a basis for assuming a strong response. In the current situation, with many consumers heavily leveraged, it is likely that the stimulus to consumption will be less than historical averages. Notwithstanding the February CPI report, the inflation situation is deteriorating and appears likely to continue deteriorating. Beyond the immediate issue of containing systemic risk, the most important issue is the subsequent economic recovery. We have eased aggressively already. We must not lose focus on the lagged effect of current policy actions on that recovery. We must preserve the credibility of our commitment to low and stable inflation. The greatest danger is a relapse into a period of higher inflation, which then promotes a policy response that could generate a future recession and start a vicious cycle of increasing inflation and increasing unemployment. Thank you, Mr. Chairman. " FOMC20050630meeting--374 372,VICE CHAIRMAN GEITHNER.," Thank you. We’re somewhat more confident in the strength and sustainability of the expansion than we were in May. Our view is very similar to the staff forecast. We expect real GDP growth to average roughly 3½ percent over the forecast period. We expect core PCE to follow a somewhat higher path and to end the forecast period slightly higher than we expected in May, at just under 2 percent. This forecast assumes that we’ll continue to tighten monetary policy, perhaps by a bit more than foreseen in the staff forecast and than is currently priced into the market. To us, the risks to this forecast seem roughly balanced. We see no new sources of potential risk. This is not to say June 29-30, 2005 138 of 234 daunting. It’s worth noting, though, that these risks—from a cliff in housing prices to a sharp increase in household saving, to a larger and more sustained oil shock, to less favorable future productivity outcomes, to a sharp increase in risk premia or to declines in asset prices—in general are risks that we can’t really mitigate substantially ex ante through monetary policy. However, by making sure we get the real fed funds rate up to a more comfortable level we can help. The alternative strategy, to oversimplify it, would be to follow a softer path for monetary policy to provide a preemptive cushion against the negative effects on employment of a fall in housing prices, a rise in risk premia, some rise in saving and a fall in consumption, and so forth. This would, I believe, be a less prudent strategy. Although there have been persistent concerns about the vulnerability of this expansion and about some of its less robust characteristics, the two most remarkable aspects of this recovery are encouraging. The first is its resilience. So far, each episode of incipient softness has proved to be shallow in depth and short in duration. Despite very prolonged and substantial headwinds in the context of an oil shock, a large ongoing drag from net exports, a significant tightening of financial conditions, a modest withdrawal of fiscal stimulus, etc., quarterly GDP growth—as Janet said— has shown impressive stability around a 3½ percent annual rate over the last year and a half. And this is a dramatic reduction in realized macroeconomic volatility. It makes the much-heralded “great moderation” look turbulent. The second positive feature of this period has been the behavior of underlying inflation and inflation expectations. Of course, underlying inflation seems to have moved up a bit, but large changes in oil and commodity prices and import prices have produced periods of substantial acceleration in headline inflation without, at least to this point, causing more than short-lived June 29-30, 2005 139 of 234 The behavior of productivity growth and expectations about future productivity growth explain some of this. Also important, of course, is the credibility engendered by the record of the FOMC. Changes in the structure of the financial system must matter, too. There are almost surely other factors—luck for one—that are at work. Among the choices in Vincent Reinhart’s note on interest rates, I’m inclined to support the more benign assessment of the recent behavior of forward interest rates and term premia, even though these factors can’t fully explain those moves, and even though the future may prove to be more volatile and adverse than the markets now seem to expect and than those explanations would imply. So what about monetary policy going forward? There are two salient dimensions of the forecast. One, of course, is growth slightly above trend from a starting point where the remaining amount of resource slack, if any, is substantially diminished. The other is an underlying inflation rate—just to focus on the core PCE—that now seems to be running at a modest margin above 1.5 percent and that we expect will end the forecast period above 1.5 percent. And inflation expectations, at the horizon over which monetary policy operates and with reasonable adjustments to translate them into a view on the PCE deflator, are still some margin above 1.5 percent. We don’t consider this inflation forecast a cause for serious concern. We anticipate upward pressures on inflation from some firming of compensation growth and from higher unit labor costs. We expect those pressures will face the countervailing forces of relatively moderate inflation expectations, strong competitive pressures, still substantial profit margins, the potential for some increase in the labor force participation rate, and pretty strong expected future productivity growth. And yet it should matter to us that, even in a world where the nominal fed funds rate peaks June 29-30, 2005 140 of 234 meaningfully above 1.5 percent. The range of estimates in the forecasts and model simulations before us, and the expectations we can derive from the market, place the terminal rate of the nominal fed funds rate now between 3½ and 4½ or between 3¾ and perhaps 4¼ percent. These estimates have moved down a bit over the last few months, but the shape of the path has steepened a bit. I don’t think we really know how much confidence we can have in these estimates, even if the forecast unfolds as we expect today. But my view remains that we are better off following a path that would put us at the higher end of these estimates than in taking the risk of doing too little and stopping prematurely or trying to manage the communication challenges of a temporary pause when we still believe we have further to go. Thank you." FOMC20070918meeting--168 166,CHAIRMAN BERNANKE.,"Chairman Bernanke Yes Vice Chairman Geithner Yes President Evans Yes President Hoenig Yes Governor Kohn Yes Governor Kroszner Yes Governor Mishkin Yes President Poole Yes President Rosengren Yes Governor Warsh Yes Thank you very much. We can recess now for half an hour for lunch. The Board of Governors will vote, but the rest can recess for lunch. [Laughter] During lunch, our Congressional Liaison person, Laricke Blanchard, will give us an informal update on congressional matters. We will try to reconvene around 2:00. [Meeting recessed for lunch]" FOMC20080625meeting--102 100,MR. MADIGAN.," 4 Thank you, Mr. Chairman. I will begin by referring to the draft announcement language in table 1, included in the package labeled ""Material for FOMC Briefing on Monetary Policy Alternatives."" As Chairman Bernanke noted yesterday, this version is only slightly revised from the version discussed in the Bluebook. Rather than keep you in suspense, I will note now that the revision is simply to strike the phrase ""near-term"" from alternative B, paragraph 4. Turning first to alternative A, the Committee would ease policy 25 basis points at this meeting and would issue a statement similar to the one published after the April FOMC meeting. The second paragraph would indicate that economic activity has remained weak in recent months. It would recognize that consumer spending appears to have firmed but would go on to mention other aspects of economic performance that remain weak. The paragraph on inflation would cite the recent further increase in energy prices but would also note the stability of core inflation. It would again express the Committee's expectation for inflation to moderate, partly reflecting a leveling-off of energy prices, but would acknowledge that uncertainty about the inflation outlook remains high. As in April, the final paragraph would be silent on the balance of risks and on the likely path of policy. For most of you, your baseline outlook would seem to provide little support for selection of alternative A at this meeting. As was noted yesterday, most of you conditioned your projections on a path for policy that begins to tilt up either immediately or sometime in the next few quarters. With such a policy path, the central tendency of your projections points to a gradual pickup in economic growth and a fairly prompt drop in total inflation as energy and other commodity prices level out but only a gradual decline in core inflation, which reflects the moderate amount of economic slack that you foresee over the next few years. As was illustrated in one of 4 The materials used by Mr. Madigan are appended to this transcript (appendix 4). the optimal control simulations presented in the Bluebook, a case can be made for alternative A if you agree with the staff baseline outlook and favor aiming for 2 percent inflation over the longer term. One of the estimated policy rules presented in the Bluebook also suggests modest further easing, but again that prescription relies on the staff's forecast rather than on your generally stronger near-term outlook. But given the modal outlooks of most members of the Committee, any case for easing at this meeting would seem to be best motivated by persisting concern about the downside risks to growth that many of you again cited in your forecast submissions. The ""recession"" simulation in the Greenbook provided one plausible scenario for the realization of such risks and suggested that the funds rate might need to be lowered to 1� percent. Under alternative B, the Committee would leave the stance of policy unchanged at this meeting. The statement would note that economic activity continues to expand and, as in alternative A, would mention the firming of consumer spending. It would cite the same factors that could restrain economic growth that were referenced in April and would add the rise in energy prices to the list. The inflation paragraph would again convey the Committee's anticipation that inflation will moderate but would elide the explanation for that expectation and would reference high uncertainty about inflation prospects. The final paragraph would indicate that the downside risks to growth appear to have diminished somewhat and that the upside risks to inflation and inflation expectations have increased. As I noted previously, we have suggested that the phrase ""near-term"" be struck as the Committee's focus presumably is on longer-term inflation. The references to risks to both growth and inflation would be consistent with the concerns that you expressed in your forecast submissions. The statement proposed for alternative B seems generally in line with market expectations, and an announcement along these lines is unlikely to provoke much market reaction. By pointing to reduced risks to growth and increased risks to inflation while not explicitly stating that the inflation risks predominate, the Committee would likely be seen as suggesting that its next policy move could be toward firming but also that such a move probably was not imminent. A policy approach along the lines of alternative B seems generally consistent with the projections that many of you provided for this round. Although most participants conditioned their projections on a steeper policy path than the one in the Greenbook, many also appeared to assume that the firming process would not commence until later this year or in 2009. A decision to stand pat at this meeting might be motivated importantly by your sense that the risks in both directions around your baseline projections are substantial. While staying your hand today might risk a further upcreep in inflation expectations, you might also be concerned that a policy firming now, given that financial markets are still fragile, would risk having outsized market effects with adverse implications for an economy that remains weak. As a result, you may see benefits to allowing more time for financial markets to recuperate and more time for information on the outlook to accumulate before taking policy action. Holding the funds rate at 2 percent at this meeting would be consistent with the Committee's past behavior as captured by the estimated outcome-based rule presented in the Bluebook. Under alternative C, the final column, the Committee would firm policy 25 basis points at this meeting. In the statement, the paragraph on real activity would be identical to that for alternative B. However, the third paragraph would provide the motivation for the action by emphasizing that overall inflation has been elevated, that energy prices have risen further, and that inflation expectations have risen further. No assessment of the balance of risks would be provided in the final paragraph, thus avoiding a suggestion that the firming signaled a sequence of further rate increases. Nonetheless, with market participants currently seeing only a small chance of a rate increase at this meeting, an announcement along the lines of alternative C would likely prompt a considerable jump in short- and intermediate-term market interest rates. Although most of your forecasts appeared to assume that policy firming would begin later this year or early next year, some of you explicitly assumed an earlier start to policy tightening. Members might believe that firming at this meeting is warranted partly by evidence of some reduction in downside risks to growth. Recent spending data suggest that economic activity has a bit more forward momentum than previously perceived, reducing the odds on recession; the modest improvement in financial market conditions points to some reduction in downside risks; and the Federal Reserve's special liquidity facilities appear to have been successful in reducing the odds of negative tail events and severe adverse feedback loops. Thus members might see it as appropriate now to begin to reverse some of the Committee's past policy actions to the extent that those actions were seen as motivated by downside risks that have now diminished. Also, near-term firming might be motivated by the further increases in inflation pressures and risks resulting from the continued upward march of energy and some other commodity prices. Finally, with inflation expectations continuing to show some signs of moving up, a firming of policy at this time might be viewed as a timely shot across the bow that could be helpful in restraining such expectations. I thought that it might be helpful to conclude by reviewing two exhibits from the medium-term strategies section of the Bluebook, starting with the optimal policy simulations that are reproduced in exhibit 2. The simulations underlying these exhibits are based on the FRB/US model after adjusting it to line up with the Greenbook forecast and extension. As usual, these simulations assume that you aim to minimize the sum of squared deviations of inflation from target, squared deviations of the unemployment rate from the NAIRU, and squared changes in the nominal funds rate. Two key points can be drawn from these simulations. First, whether policy firming should begin sooner or later may depend partly on your longer-run inflation objective. As shown by the black line in the top right-hand panel, if your objective for the longer run is to get back to a 2 percent inflation rate, these simulations suggest that you can hold the funds rate steady or even ease slightly further before beginning to firm in 2010. This policy path produces a somewhat faster decline in the output gap and thus somewhat slower disinflation than in the Greenbook and extension. In contrast, the simulations shown in the left-hand column suggest that pursuit of a 1� percent inflation objective would involve policy firming beginning quite soon. In general, the policy paths described by many of you in your forecast submissions seem to fall between these two scenarios, apparently reflecting your sense that aggregate demand growth could be a bit stronger and inflation pressures a bit more intense than projected by the staff as well as your dissatisfaction with a path for inflation that is as shallow as that for the scenario with a 2 percent inflation objective. The second point underscored by these simulations is that, even though the nearterm path for the unemployment rate is a bit lower than in April, reflecting the recent indications of somewhat greater strength in aggregate demand, the medium-term outlook involves larger and more persistent slack than foreseen in April under either inflation goal. Despite that greater slack, as shown in the bottom two panels, core inflation under both inflation objectives runs 0.1 to 0.3 percentage point higher over the next four years than in the April simulations. That, of course, is the fundamental nature of a negative supply shock: Policymakers are forced to accept some combination of greater economic slack and higher inflation during a period of transition to a lower output path and, presumably, to an unchanged long-run inflation rate. That same point was made in a Bluebook box and in a staff paper on this subject. Turning to your final exhibit, I would like to note that, in response to the comments of some members at recent FOMC meetings, the r* exhibit in the Bluebook has been augmented to include two additional measures of the real federal funds rate. Line 11 in the table at the bottom shows a measure of the real federal funds rate that uses lagged headline inflation as a proxy for expected inflation. By contrast, our standard measure, shown on line 10, employs lagged core inflation as the proxy. Line 12 shows a measure based on the staff's projection of headline inflation. Both of these new measures, at minus 1.3 percent, are considerably lower than the current value of the standard measure, minus 0.2 percent. I want to emphasize, first, that these additional measures should not be compared directly with the r* measures shown in lines 1 through 9 of the table because the values of those measures are in part a function of the proxy used for expected inflation. For example, the r* value that would be consistent with the Greenbook projection and the actual real funds rate based on the lagged four-quarter average of headline inflation is minus 0.7 percent. Moreover, even if we redefined the Greenbook-consistent measure of r* to use lagged headline inflation, the implied 0.6 percentage point gap between the actual and the estimated equilibrium real rates would not necessarily imply that you should quickly raise the nominal funds rate by more than � percentage point. If, like the staff, you think it likely that headline inflation will moderate substantially later this year, then it follows that a gradual firming of policy in nominal terms would be consistent with a substantial rise in the real funds rate on this measure over time. Indeed, in the staff's view, the average value of the real federal funds rate over the next few years on any measure is a bit above the corresponding value of r*, and consequently the trajectory of the real funds rate on any measure would be consistent with protracted slack and declining inflation over the next several years. Of course, you may not agree with the staff about underlying trends for prices and real activity and, hence, about the value of r*. Even if you do agree, you may be dissatisfied with the projected trajectories for key variables such as output, employment, and inflation. Such considerations illustrate why no estimate of r* can be a complete guide to policy. That completes my prepared remarks. " FOMC20070509meeting--75 73,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Our outlook has changed very little. As in March, we see the expansion continuing, with growth moving back up to potential—we see potential around 3 percent—later this year. This view rests on the familiar expectations: Housing stabilizes relatively soon without a major drop in prices; investment spending strengthens somewhat as the temporary factors holding it down recede and positive fundamentals reassert themselves; consumption moderates a bit but continues to be supported by strong income growth; the saving rate moves up but only modestly and slowly; and external demand remains strong. We still expect inflation to moderate gradually to a rate just below 2 percent for the core PCE by the end of ’08. We view the recent numbers as somewhat reassuring. Recent data in general have provided a bit more comfort for this scenario. On balance, the downside risks to growth have diminished a bit. The risk that inflation will fail to moderate sufficiently, however, remains significant and material. But in general, the overall outlook, in our view, hasn’t changed that much. Now, our forecast assumes that we hold the fed funds rate where it is for a while. Our expected path is above the market’s but below the Greenbook’s. We’re below the Greenbook because, although our expected forecast is really similar, we attach somewhat greater weight to alternative scenarios that suggest slower growth. The recent growth numbers have been, on balance, encouraging, and the markets are a bit more confident about the outlook than they were. But I still think the downside risks to growth are significant. Housing could still surprise on the downside, and we could see a deeper, more protracted contraction in activity and, of course, broadly based more-substantial declines in prices. Consumption could be weaker for this reason or because the saving rate rises for other reasons, such as pessimism about long-run income growth. The household sector is substantially more leveraged than it was, and it has less of a cushion to absorb shocks and, therefore, presents some risk of amplifying rather than mitigating broader weakness in the economy. Although a bit better than it was in March, the investment outlook is still a bit tenuous, and it seems unlikely to be a substantial source of strength if broader weakness in demand in the rest of the economy materializes. The most rapidly growing parts of the world are growing well above potential and face rising inflation and substantial asset-price inflation, and I think the authorities there are generally starting tentatively to tighten policy more significantly. On the inflation front, we still face substantial uncertainty about what is happening to underlying trends and how they will evolve. The broader inflation environment is, if anything, less benign than it has been over the past three quarters, with inflation accelerating a little outside the United States, energy and commodity prices continuing to show signs of rapid demand growth, the dollar potentially weakening further, compensation here firming a bit, and productivity growth probably staying a bit below what we thought was trend. In this context, with inflation still running about 2 percent, inflation expectations could drift up. Continuing on the risks for a bit, I still think we live with a significant risk of a sharp deterioration in financial markets. Credit spreads, other risk premiums, low levels of implied volatility, and the strength of asset prices in many parts of the world—all imply a level of confidence in ongoing, stable growth and low inflation that seems a bit implausible. In addition, the low level of long forward rates seems hard to reconcile with the strength of demand growth outside the United States, suggesting that much of the world is likely to need to move further toward tighter monetary policy. As financial conditions exert more restraint on demand growth globally, we could see a rapid unwinding of this long period of very benign assessment of fundamental risks. We, of course, face some risk of policy actions here in the form of trade or investment protection. This risk, against the backdrop of some uncertainty about the strength of productivity growth going forward, might make the rest of the world less comfortable financing our still-large external balance on the favorable terms that have prevailed thus far. On the longer-term outlook for potential in the United States, we are sticking with our forecast of 3 percent, but we have altered the mix a bit, just as the Greenbook has in some sense; however, we feel a little less comfortable with our basic view about potential. We lowered our productivity growth assumption a bit, to 2.25 for the nonfarm business sector, and raised our estimate of trend hours a bit. If potential is lower than we’re assuming, then we are less likely to see the moderation of inflation that we currently expect, but we would expect a lower path for output growth as well. At this stage, however, in view of the strength in income growth that we’ve seen, earning expectations, and other measures, we’re reluctant to embrace a more negative view about growth in potential. On balance, in view of these risks, I favor staying where we are for a while. I don’t think there is a very strong case for tightening policy or for inducing a significant rise in market expectations about the path of the fed funds rate going forward, nor do I think now that we’re at risk of being too tight. So, in general, I think the best choice for us is to continue to lean against the expectation that we will move to reduce rates soon. Thank you." FOMC20060808meeting--62 60,MR. PLOSSER.," Good morning. Thank you, Mr. Chairman. It’s a pleasure to be here today at my first meeting. Many people around the table I’ve known for many, many years. Others I don’t know so well, but I’m looking forward to getting to know you better. I realize that as the new kid on the block, so to speak, I have a lot to learn. I’ve been on the job one week today, and that realization has been driven home to me in the past week quite amply by the fact that I’ve struggled to prepare for this meeting. I have to confess that it did occur to me at a couple of points that maybe my start date should have been moved to August 15. [Laughter] Maybe that was a failure of rational expectations or maybe just a simple forecast error—I’m not sure yet. Nonetheless, I really am honored to be here and to be a part of this group, and I’m looking forward to working with all of you. Economic activity in the Third District continues to expand at a moderate pace, albeit somewhat more slowly than earlier in the year. Of course, this was in line with expectations in previous reports by Bill Stone to you. Regional manufacturing activity expanded in July. Our business outlook survey’s index of general activity fell to 6 in July, down from 13 in June, and the indexes of new orders and shipments also softened. But the levels of these indicators continue to point to expansion in terms of manufacturing in the region and manufacturers’ expectations of future activity. Conditions in our construction sector are similar to what other people have been reporting. Nonresidential construction continues to strengthen in our District. Bankers are reporting increased strength in commercial real estate lending. Office vacancy rates have been edging down, and rents have been moving up. Our business contacts expect those trends to continue. In contrast, as in much of the nation, residential construction and home sales are down. Residential mortgage lending has slowed considerably, although home equity lending has been quite strong. Realtors report that the inventory of homes for sale is at the highest level they’ve seen in a number of years; they also report that prices are higher than they were last year, but the rate of appreciation tends to be softening. Thus far the slowing in the region’s residential housing sector seems to have been an orderly one. Retailers report a firming of sales in general merchandise in June and July, with sales at stores specializing in high-end merchandise being stronger than those at the lower end. Manufacturers’ incentives have helped boost auto sales in July in the region, but dealers tell us that inventories remain above their desired levels. Payroll employment in our three states has been expanding at a somewhat slower pace than in the nation as a whole, but that’s not atypical of the region. The unemployment rate has edged down. In June, it was 4.7 percent. In most of the District’s labor markets, unemployment is lower now than it was a year ago. Our business contacts continue to report difficulty in filling positions. There has been some relief this summer with the influx of college students, but that cushion is about to end. It has been particularly hard in the District for firms to fill professional and managerial positions. Firms have received a good number of applications, but many of the applicants are unqualified. Consequently, salaries for these positions have risen more than others. Our manufacturers report that recent wage increases in the region are higher than they were last year. This is consistent with the employment cost index, which shows stronger compensation growth in the Northeast than in other parts of the nation. On balance, the regional conditions and outlook continue to be positive. The rate of expansion in the second half of the year is likely to be somewhat slower than in the first half; but, again, that was expected. I’m more concerned about signs of continued and growing price pressures in the District. Consumer prices appear to be rising at a faster pace in the Philadelphia region than in the nation as a whole. One factor contributing to the faster pace has been the increase in housing costs in metropolitan Philadelphia, but that may prove to be temporary as housing prices stabilize. Nonetheless, broad-based cost pressures persist in most sectors of the region. The indexes of both prices paid and prices received in our manufacturing survey have increased in July, and both are at very high levels. Business contacts say that price pressures continue to be one of their major concerns. I would characterize the national economy in a somewhat similar way. That is, right now I tend to be more concerned about inflation than I am about growth. I don’t view the second-quarter slowdown as necessarily a precursor to a significant weakening of the economy going forward. The below-trend growth in the second quarter was widely anticipated, and averaging over the first two quarters, as several people have done, output still grew at over 4 percent in the first two quarters. The slowdown in residential investment was expected, and much of the slowdown in consumer spending was due to auto sales, which are volatile and which had grown very strongly in the first quarter and considerably less in the second. One surprise, however, did occur in the second-quarter numbers. We expected business investment in equipment and software to slow last quarter from its very robust pace in the first quarter, but we didn’t expect an outright decline. About half that swing, it turns out, reflects the timing of business purchases, particularly of transportation and autos, so the weakness in investment may be more about timing than it is about trend. Indeed, as has been pointed out, corporate profits remain high, and capacity utilization rates remain high, and these data continue to point to the underlying strength in business investment. The July employment numbers released on Friday did little to change my view of the economy. Employment continues to grow at a reasonable pace, although somewhat slower than earlier in the year. In July, employment in the private sector expanded at its fastest pace since March. Although the number was not large, the trend was at least mildly encouraging. Employment based on the household survey fell. The unemployment rate increased 0.2 percent, but household employment has been volatile. The decline of 34,000 jobs in July followed a gain of 387,000 jobs in the household survey in June. If we abstract from the month-to-month volatility in these numbers, the unemployment rate remains low for the first half of the year at about 4.7 percent. At this point, I believe the economic indicators are consistent with sustained real growth near trend, as many people have suggested. The benchmark GDP revisions suggest that trend might be a tad lower than we thought, but nonetheless I think the risks to growth seem at least roughly balanced. The inflation picture, however, has not improved. Despite a slowing economy, price increases have been accelerating. The increases have been broadly based, as has been pointed out by Bill Poole and others. They are no longer confined to energy and other commodities. Indeed, in June the CPI rose less than did the CPI excluding energy. Core inflation is above the range I consider to be consistent with price stability, and to my mind, inflation risks remain tilted to the upside. The Greenbook’s baseline forecast has core inflation decelerating over the next year, but the staff has been marking up its forecasted path of inflation over time as the acceleration in inflation has persisted. Even with the projected deceleration, the baseline forecast has core PCE inflation remaining above 2 percent through 2007. Given this persistence in inflation, unacceptably high inflation seems likely to be around for a while. A year ago I wouldn’t have said that. In fact, I was in the camp that thought it was mostly a relative price phenomenon, but that position has become less compelling to me over the past year. The benchmark revisions to the GDP report show that both compensation per hour and unit labor costs have been trending up, not down as earlier data suggested. Energy-price increases have not abated, suggesting that we are likely to see continued pass-through to core inflation, perhaps for some time. Although the Committee has brought the fed funds rate up appreciably from historically low levels, real interest rates to my mind are not high. I don’t view monetary policy as particularly restrictive at this point. Thus, I have to put some weight on the Greenbook’s alternative scenario of persistently high inflation, and that leads to particularly poor outcomes. Even if I accept the baseline forecast as my point forecast, the fact that inflation remains at a level above the range consistent with price stability for a considerable period is troubling. I am comforted by the fact that medium- and longer-term inflation expectations have remained relatively stable despite the acceleration in inflation. That’s a testament to the credibility of the Fed in the marketplace—that it will keep inflation low. But how reasonable is it to think that inflation expectations will remain unchanged? By allowing inflation to remain at a high level for a time—we are, after all, as several people have pointed out, in the third year of core inflation running above 2 percent—do we risk sending the message that we are willing to tolerate higher inflation? If so, will expectations adjust accordingly? As the model simulations of optimal policy paths and outcomes in chart 7 of the Bluebook indicate, it’s very costly to get inflation back down once it has been above our objective, particularly if expectations are allowed to increase. I believe that monetary policy has an important role to play in ensuring that the recent high inflation readings do not raise longer-term inflation expectations. Thank you." FOMC20081029meeting--207 205,MS. YELLEN.," Thank you, Mr. Chairman. In the run-up to Halloween, we have had a witch's brew of news. Sorry. [Laughter] The downward trajectory of economic data has been hair-raising--with employment, consumer sentiment, spending and orders for capital goods, and homebuilding all contracting--and conditions in financial and credit markets have taken a ghastly turn for the worse. It is becoming abundantly clear that we are in the midst of a serious global meltdown. Like the Board staff, I have slashed my forecast for economic activity and now foresee a recession with four straight quarters of negative growth starting last quarter. I wish that I could claim that I place a lot of confidence in the sobering forecast, but I am sorry to say I can't. In fact, I think we will be lucky if the adverse feedback loop that is under way doesn't wrench us into a much more pronounced and more protracted downturn. The outlook for inflation has shifted markedly, too, with the days of heightened upside inflation risks behind us. In fact, I am concerned that beyond next year we run the risk of inflation falling below the level consistent with price stability. Even before the extraordinary deterioration in financial market conditions over the past few weeks, there were numerous signs that the economy had weakened dramatically. I won't recite the litany of disappointing data but instead try to touch upon some high, or I guess I should say low, notes based on what my contacts tell me. They are consistent with President Fisher's observations. Consumer purchases of durable goods, especially motor vehicles, have been particularly hard hit by the one�two punch of tight credit and reeling consumer confidence. The mood on showroom floors is downright grim. One auto dealer in my District reports that he is now experiencing the worst period in his thirty-plus years in the business. A home appliance retailer adds that he has never seen more uncertainty and gloom from both the retailers and the vendors. This sentiment is echoed by a large retailer who says simply, ""The holiday shopping season is going to stink."" Businesses are under siege from weak demand, high costs of borrowing, curtailed credit availability, and pervasive uncertainty about how long such conditions will last. Our contacts report that bank lines of credit are more difficult to negotiate. Many have become more cautious in managing liquidity and in committing to capital spending projects that can be deferred. They are even cutting back trade credit to customers. Even firms that are currently in good shape report that they are hunkering down, cutting back on all but essential spending, and preparing for the worst. Our venture capital and private equity contacts tell us that they are instructing their portfolio companies to cut costs, put expansion plans on hold, and draw down existing credit lines. The market for commercial mortgage-backed securities has all but dried up, and lenders have also become less willing to extend funding. With financing unavailable, I am hearing talk about substantial cutbacks on new projects and planned improvements on existing buildings, as well as the potential for distress sales of properties whose owners will be unable to roll over debt as it matures. The deterioration in overall financial conditions since the September FOMC meeting is truly shocking. Even with today's 900-point increase in the Dow, broad indexes are still down about 20 percent, and the latest data suggest house prices in a freefall. Baa corporate bonds are up about 200 basis points since our last meeting, low-grade corporate bonds are up a staggering 700 basis points, and to top it all, the dollar has appreciated nearly 10 percent against the currencies of our trading partners. The sharp deterioration in financial and credit conditions will weigh heavily on economic activity for some time. In addition, prospects for the one remaining cylinder in the engine of growth--namely, net exports--are bleak owing to the slowdown in global demand and the appreciation of the dollar. We now expect real GDP to decline at an annual rate of 1� percent in the second half of this year and to register two more negative quarters in the first half of next year. That forecast is predicated on cutting the funds rate to � percent by January, as assumed in the Greenbook, and also is premised on another fiscal package. An absolutely critical pre-condition for the economy to recover next year is for the financial system to get back on its feet. In that regard, I have been greatly heartened by the important actions that the Treasury, the FDIC, the Fed, foreign governments, and other central banks have taken in recent weeks to improve liquidity and inject capital into the financial systems. But we are fighting an uphill battle against falling home prices, an economy in recession, and collapsing confidence. It is not clear whether these steps will reopen credit flows to households and businesses, especially those with less than sterling credit. Under the Greenbook forecast we will see further large declines in housing prices over the next two years. Banks and other financial institutions will likely suffer larger losses than many had anticipated, and that will mute the impact of recent capital injections. The interaction of higher unemployment and rising delinquencies raises the potential for even greater losses by banks and other financial institutions and for an intensification of the adverse feedback loop we have worried about and are now experiencing. Such a sequence of events plausibly could lead to outcomes described in the ""more financial fallout"" alternative scenario in the Greenbook. There are considerable downside risks to the near-term outlook as well. As I mentioned, the most recent economic data have consistently surprised on the downside, and I see a real risk that the data may continue to come in weaker in the near term than the Greenbook has assumed. For example, a dynamic factor model that my staff regularly uses is much more pessimistic in the near term than is the Greenbook. This model aggregates the information contained in more than 140 data series. Based on the most recent economic and financial data available, this model predicts that real GDP will fall 2� percent in the fourth quarter. The model's pessimism reflects the combination of the recent weak data releases for the month of September, followed by the abysmal data that we have available so far for October, including financial market prices, regional business surveys, and consumer sentiment. Turning to inflation, the most recent data have been encouraging. Looking forward, the sharp decline in commodity prices, especially oil prices, will bring headline inflation down relatively quickly. More fundamentally, the considerable slack in labor and product markets will put downward pressure on the underlying rate of inflation over the next few years. A number of my contacts already report that their businesses are working on lower margins in the more challenging economic environment. I expect headline PCE price inflation to decline to about 1� percent in 2009 and core PCE price inflation to be 1� percent next year. I expect both inflation rates to edge down to 1� percent in 2010. Given the sizable downside risk to the forecast for growth, the risks to the inflation forecast are likewise weighted to the downside. In conclusion, I think the present situation obviously calls for an easing of policy, as I assumed in my forecast. Given the seriousness of the situation, I believe that we should put as much stimulus into the system as we can as soon as we can. " FOMC20080916meeting--106 104,MR. MADIGAN.," 2 I will be referring to the package labeled ""Material for FOMC Briefing on Monetary Policy Alternatives and Trial Run Survey Results."" The results of the survey are shown in exhibit 2. In the interest of time, I will not cover them this morning. The Subcommittee on Communications plans to be in touch with the Committee on this issue over the upcoming intermeeting period. The first page of the package reproduces the version of table 1 that you received yesterday afternoon. This version includes three policy alternatives. As in the Bluebook, alternative B would leave the stance of policy unchanged at this meeting, and alternative C would involve a 25 basis point firming today. However, alternative A now entails a 25 basis point policy easing rather than the unchanged funds rate that was specified in the Bluebook version of this alternative. I will begin by discussing alternative C. The discussion at your last meeting suggested that you generally saw the next move in policy as likely to be a firming, a point that was explicit in the minutes of the meeting. Even though market volatility and financial strains have increased notably in recent weeks, you might view those developments as having only limited implications for the economic outlook and hence see economic fundamentals as continuing to suggest that policy should soon be firmed. Inflation has been well above the rates that Committee members judge as appropriate for the longer run, and despite lower oil prices and greater slack in labor markets, there remains considerable uncertainty about how soon and how much core inflation will slow. In these circumstances, you may believe that a firming of policy is appropriate. Under the version of alternative B distributed yesterday evening, the Committee would hold the target funds rate constant at this meeting, and the statement would suggest that the Committee sees the risks to growth and inflation as roughly balanced. You may believe that this combination is appropriate for this meeting if your modal outlook for the economy has not changed much since the last meeting and if you judge that the upside risks to inflation have diminished, given the sharp drop in energy prices, the decline in indicators of inflation expectations, and the greater economic slack implied by the recent unexpectedly sharp jump in the unemployment rate. You might also believe that the downside risks to growth have increased as a result of the recent increase in financial strains. But at the same time, you may want 2 The materials used by Mr. Madigan are appended to this transcript (appendix 2). to let the dust settle a bit before concluding that these developments warrant an adjustment in your policy stance. In particular, you may think there is a good chance that the latest enhancements to the Federal Reserve's special liquidity facilities will help keep markets functioning and mitigate the risks to growth. Relative to the Bluebook version, the language of alternative B has been revised in three material ways. First, B2 now notes that ""strains in financial markets have intensified."" Second, the clause ""some indicators of inflation expectations have been elevated"" has been dropped from B3 in view of the recent declines in inflation compensation and survey measures of inflation expectations. Finally, the first sentence of B4 has been revised to suggest that the Committee now sees the significant risks to growth and inflation as roughly balanced. Given market participants' expectation that the funds rate could trade soft to the target for a time in light of recent developments, gauging exactly what is built into markets for the outcome of today's meeting is difficult. But earlier this morning, market prices appeared to incorporate high odds of at least a 25 basis point easing today or possibly more. Thus markets might well see a decision to keep the funds rate constant and to make no appreciable change to the language of the statement as signaling less concern about financial developments than they anticipated. If you saw recent developments as significantly boosting the downside risks to growth or noticeably lowering the modal outlook, you might consider easing the federal funds rate 25 basis points at this meeting, as in alternative A. The rationale language for this action would begin by noting that strains in financial markets have increased significantly and would go on to indicate that the policy action should help to promote moderate growth over time. The Committee would cite the recent decline in energy and other commodity prices and the increased slack in resource utilization as factors that are expected to foster a moderation of inflation. The risk assessment would indicate that ""the downside risks to growth have intensified, but the upside risks to inflation remain a concern to the Committee."" With a policy easing largely built into markets, shorter-term interest rates would likely decline modestly in response to such an action, depending on how much is built in, or they might be little changed. As the Chairman indicated earlier in the meeting, adjustments to the statement could be considered in light of the further volatility in markets over the past day. Thank you, Mr. Chairman. " FOMC20060808meeting--17 15,MR. MOSKOW.," President Poole asked a significant part of my question, or he presented a significant part of my question. [Laughter] But let me ask you about the markup part of this. You know, we have always thought that there was a cushion for compensation to go higher, for input costs to go higher, and for profit margins to shrink, and therefore we wouldn’t get any pass-through into price increases. Those markups have remained incredibly high—I mean, profit margins are very high. I was just wondering whether you think we should put less weight on this factor going forward when we’re looking at our forecasts, given what we’ve seen in unit labor costs, which you mentioned, and other changes in the forecast." FOMC20060510meeting--116 114,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. The basic contours of our forecast are essentially unchanged since March and are very similar to the Greenbook’s. However, the balance of risks has changed a little in our view, somewhat to the upside on inflation. But as in March, we expect core PCE inflation to run a little over 2 percent in ’06 and to moderate slightly below that in ’07 as tighter policy works to slow overall demand growth. We expect real growth to rise in the vicinity of its potential rate— 3¼, 3½ percent—throughout ’07. So we are a little higher than the Greenbook in that sense. As before, this forecast rests on some important assumptions: that little or no slack is left in resource utilization, that inflation expectations are held in check, and that term premiums remain relatively low by historical standards. The recent moves in medium-term inflation expectations and the rise in the other components of forward interest rates cast some doubts on these last two assumptions. For these and other reasons, we see a little more uncertainty around our central forecast than we did in our last meeting. However, on the growth outlook, on balance the recent data seem to confirm the picture of real GDP moderating toward potential. We face the familiar sources of risk to the downside, but not all the risks are to the downside. We may be underestimating the momentum in final demand growth. I think it is important to note that it is hard to find evidence in credit spreads or in equity prices of a substantial growth slowdown in prospect. On inflation, recent developments are not all that dark, but neither have they been entirely reassuring. Let me just go through the factors that we think are critical to the outlook on the inflation side. Almost every measure of underlying inflation that we look at is now above the level we generally associate with price stability. Headline inflation has been running and is still running substantially above core, and even with interest rates close to long-run measures of equilibrium, the staff forecast does not anticipate much moderation in core inflation over the two-year or even three-year or four-year period. Compensation growth does not yet appear to have accelerated significantly, and the growth of unit labor costs has remained reassuringly moderate. However, compensation to us seems likely to strengthen, and it is unlikely that productivity growth is going to accelerate significantly from current levels. Demand growth is still probably running a bit above potential here and in large parts of the world economy; with real short-term rates still quite low around the world and monetary policy only just beginning to tighten in many of those economies, global pressure on resource utilization may intensify or at least continue at its current intensity rather than moderate. And the rise in energy prices and commodity prices, of course, suggests a fair amount of strength in global demand. Our assumption that energy prices follow the futures curve means that our forecast is, of course, still vulnerable as it has been over the past three years to further upside surprises. It would be easier to discount this risk if we could determine with confidence the extent to which temporary supply factors rather than unrecognized or unanticipated strength in global demand have accounted for the trajectory of energy prices over the past few years. We face a lot of uncertainty about the likely path of the dollar, and the prospect of a significantly weaker dollar adds another source of upside risk to inflation and expected future inflation. We obviously have some uncertainty about the extent to which margins will prove flexible in the face of higher cost pressures. Finally, we have seen a material rise in long-term inflation expectations in the United States over the past several months, and this should make us somewhat less confident that we can assume that the gap between headline and core will be closed with headline moving down to core. Inflation expectations seem to have risen more here than in other countries, and the recent changes in the relationship between changes in short-term expectations about U.S. monetary policy and changes in breakeven inflation rates is somewhat disconcerting, with expectations deteriorating when statements by Committee members were interpreted as lowering the probability of moves beyond our meeting today. This pattern is more troubling than the size of the rise in medium-term inflation expectations. And I just want to make one comment in response to something Janet said. Even if we could tell with confidence how much of this rise in breakeven inflation was about uncertainty or inflation risk premiums and how much was actually about future expectations about inflation and even if we thought a substantial amount of that was uncertainty, it is not clear that that would be particularly reassuring in terms of credibility or in terms of its implications for monetary policy. So underlying inflation is less contained than we would like it to be, and it is expected to moderate less than we might hope. Both short-term and long-term measures of expectations have moved up uncomfortably, and we see somewhat greater upside risk to our inflation forecast than we did in March. Now, what might we learn over the next six weeks that would change our view about the outlook and its implications for monetary policy? We actually think it is unlikely that data are going to provide us with very strong signals that policy is markedly off track, but there are two important things to watch. One is the behavior of long-term inflation expectations. If those expectations were to continue to rise, that would obviously be a source of concern; and if inflation expectations were not responsive to changes in expectations about the path of the funds rate, that would also be troubling. On the data front, we at least will want to watch to see if the expected moderation in manufacturing activity in the United States materializes. If, in contrast, manufacturing activity here sustains its recent pace, it might suggest that growth abroad has picked up more than we thought or that the dollar is having a bigger effect in stimulating exports than we anticipated. These conditions would increase concern about upside risks to our central forecast because, of course, that forecast relies on a slowdown in overall domestic demand growth mitigating upward pressure on inflation over the forecast period. Just a few points to end on the topic of uncertainty: Even though the fundamental news is pretty positive and reassuring, we are now at the point where the limits of our knowledge about the underlying forces that affect the outlook for aggregate demand, supply, and inflation matter more than they have in the recent past. Relatively small differences, differences well within the limits of our knowledge about trend growth and productivity or employment or other factors, have more impact on our choices about monetary policy in the near term than they would have had over the past two years. What should we conclude from the substantial rise in real forward rates that we have seen over the past few months? This move, which has occurred across the major economies, brings expected real rates more in line with long-term averages, reducing, if not eliminating, the anomalistic line we had such trouble understanding. Now, does this mean we have less to do in terms of future tightening than we thought? Maybe. Or it might mean that monetary policy has been more stimulative than we thought and that we will have to do more to make up for that going forward. The fact that we cannot fully explain why these measures of expected real rates have moved around as much as they have just adds to the uncertainty we face today about how tight policy actually is. It is also a bit of a puzzle that measures of uncertainty about future interest rates have not increased very much, and I do think it is important that we try to continue encouraging—it is uncomfortable to say this—or to at least avoid discouraging an increase in uncertainty that is more commensurate with what we are experiencing ourselves. [Laughter] Monetary policy works through expectations, but our job is harder when we are not truly sure what we want to do to those expectations. Trying to make sure that we are not pushing down uncertainty as we continue to make sure that the markets understand that we’re going to work to keep inflation low and stable remains our principal challenge. Thank you." CHRG-111shrg54533--91 PREPARED STATEMENT OF TIMOTHY GEITHNER Secretary, Department of the Treasury June 18, 2009 Financial Regulatory Reform: A New FoundationIntroduction Over the past 2 years we have faced the most severe financial crisis since the Great Depression. Americans across the Nation are struggling with unemployment, failing businesses, falling home prices, and declining savings. These challenges have forced the government to take extraordinary measures to revive our financial system so that people can access loans to buy a car or home, pay for a child's education, or finance a business. The roots of this crisis go back decades. Years without a serious economic recession bred complacency among financial intermediaries and investors. Financial challenges such as the near-failure of Long-Term Capital Management and the Asian Financial Crisis had minimal impact on economic growth in the U.S., which bred exaggerated expectations about the resilience of our financial markets and firms. Rising asset prices, particularly in housing, hid weak credit underwriting standards and masked the growing leverage throughout the system. At some of our most sophisticated financial firms, risk management systems did not keep pace with the complexity of new financial products. The lack of transparency and standards in markets for securitized loans helped to weaken underwriting standards. Market discipline broke down as investors relied excessively on credit rating agencies. Compensation practices throughout the financial services industry rewarded short-term profits at the expense of long-term value. Households saw significant increases in access to credit, but those gains were overshadowed by pervasive failures in consumer protection, leaving many Americans with obligations that they did not understand and could not afford. While this crisis had many causes, it is clear now that the government could have done more to prevent many of these problems from growing out of control and threatening the stability of our financial system. Gaps and weaknesses in the supervision and regulation of financial firms presented challenges to our government's ability to monitor, prevent, or address risks as they built up in the system. No regulator saw its job as protecting the economy and financial system as a whole. Existing approaches to bank holding company regulation focused on protecting the subsidiary bank, not on comprehensive regulation of the whole firm. Investment banks were permitted to opt for a different regime under a different regulator, and in doing so, escaped adequate constraints on leverage. Other firms, such as AIG, owned insured depositories, but escaped the strictures of serious holding company regulation because the depositories that they owned were technically not ``banks'' under relevant law. We must act now to restore confidence in the integrity of our financial system. The lasting economic damage to ordinary families and businesses is a constant reminder of the urgent need to act to reform our financial regulatory system and put our economy on track to a sustainable recovery. We must build a new foundation for financial regulation and supervision that is simpler and more effectively enforced, that protects consumers and investors, that rewards innovation, and that is able to adapt and evolve with changes in the financial market. In the following pages, we propose reforms to meet five key objectives: 1. Promote robust supervision and regulation of financial firms. Financial institutions that are critical to market functioning should be subject to strong oversight. No financial firm that poses a significant risk to the financial system should be unregulated or weakly regulated. We need clear accountability in financial oversight and supervision. We propose: A new Financial Services Oversight Council of financial regulators to identify emerging systemic risks and improve interagency cooperation. New authority for the Federal Reserve to supervise all firms that could pose a threat to financial stability, even those that do not own banks. Stronger capital and other prudential standards for all financial firms, and even higher standards for large, interconnected firms. A new National Bank Supervisor to supervise all federally chartered banks. Elimination of the Federal thrift charter and other loopholes that allowed some depository institutions to avoid bank holding company regulation by the Federal Reserve. The registration of advisers of hedge funds and other private pools of capital with the SEC. 2. Establish comprehensive supervision of financial markets. Our major financial markets must be strong enough to withstand both systemwide stress and the failure of one or more large institutions. We propose: Enhanced regulation of securitization markets, including new requirements for market transparency, stronger regulation of credit rating agencies, and a requirement that issuers and originators retain a financial interest in securitized loans. Comprehensive regulation of all over-the-counter derivatives. New authority for the Federal Reserve to oversee payment, clearing, and settlement systems. 3. Protect consumers and investors from financial abuse. To rebuild trust in our markets, we need strong and consistent regulation and supervision of consumer financial services and investment markets. We should base this oversight not on speculation or abstract models, but on actual data about how people make financial decisions. We must promote transparency, simplicity, fairness, accountability, and access. We propose: A new Consumer Financial Protection Agency to protect consumers across the financial sector from unfair, deceptive, and abusive practices. Stronger regulations to improve the transparency, fairness, and appropriateness of consumer and investor products and services. A level playing field and higher standards for providers of consumer financial products and services, whether or not they are part of a bank. 4. Provide the government with the tools it needs to manage financial crises. We need to be sure that the government has the tools it needs to manage crises, if and when they arise, so that we are not left with untenable choices between bailouts and financial collapse. We propose: A new regime to resolve nonbank financial institutions whose failure could have serious systemic effects. Revisions to the Federal Reserve's emergency lending authority to improve accountability. 5. Raise international regulatory standards and improve international cooperation. The challenges we face are not just American challenges, they are global challenges. So, as we work to set high regulatory standards here in the United States, we must ask the world to do the same. We propose: International reforms to support our efforts at home, including strengthening the capital framework; improving oversight of global financial markets; coordinating supervision of internationally active firms; and enhancing crisis management tools. In addition to substantive reforms of the authorities and practices of regulation and supervision, the proposals contained in this report entail a significant restructuring of our regulatory system. We propose the creation of a Financial Services Oversight Council, chaired by Treasury and including the heads of the principal Federal financial regulators as members. We also propose the creation of two new agencies. We propose the creation of the Consumer Financial Protection Agency, which will be an independent entity dedicated to consumer protection in credit, savings, and payments markets. We also propose the creation of the National Bank Supervisor, which will be a single agency with separate status in Treasury with responsibility for federally chartered depository institutions. To promote national coordination in the insurance sector, we propose the creation of an Office of National Insurance within Treasury. Under our proposal, the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) would maintain their respective roles in the supervision and regulation of State-chartered banks, and the National Credit Union Administration (NCUA) would maintain its authorities with regard to credit unions. The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) would maintain their current responsibilities and authorities as market regulators, though we propose to harmonize the statutory and regulatory frameworks for futures and securities. The proposals contained in this report do not represent the complete set of potentially desirable reforms in financial regulation. More can and should be done in the future. We focus here on what is essential: to address the causes of the current crisis, to create a more stable financial system that is fair for consumers, and to help prevent and contain potential crises in the future. (For a detailed list of recommendations, please see Summary of Recommendations following the Introduction.) These proposals are the product of broad-ranging individual consultations with members of the President's Working Group on Financial Markets, Members of Congress, academics, consumer and investor advocates, community-based organizations, the business community, and industry and market participants.I. Promote Robust Supervision and Regulation of Financial Firms In the years leading up to the current financial crisis, risks built up dangerously in our financial system. Rising asset prices, particularly in housing, concealed a sharp deterioration of underwriting standards for loans. The Nation's largest financial firms, already highly leveraged, became increasingly dependent on unstable sources of short-term funding. In many cases, weaknesses in firms' risk-management systems left them unaware of the aggregate risk exposures on and off their balance sheets. A credit boom accompanied a housing bubble. Taking access to short-term credit for granted, firms did not plan for the potential demands on their liquidity during a crisis. When asset prices started to fall and market liquidity froze, firms were forced to pull back from lending, limiting credit for households and businesses. Our supervisory framework was not equipped to handle a crisis of this magnitude. To be sure, most of the largest, most interconnected, and most highly leveraged financial firms in the country were subject to some form of supervision and regulation by a Federal Government agency. But those forms of supervision and regulation proved inadequate and inconsistent. First, capital and liquidity requirements were simply too low. Regulators did not require firms to hold sufficient capital to cover trading assets, high-risk loans, and off-balance sheet commitments, or to hold increased capital during good times to prepare for bad times. Regulators did not require firms to plan for a scenario in which the availability of liquidity was sharply curtailed. Second, on a systemic basis, regulators did not take into account the harm that large, interconnected, and highly leveraged institutions could inflict on the financial system and on the economy if they failed. Third, the responsibility for supervising the consolidated operations of large financial firms was split among various Federal agencies. Fragmentation of supervisory responsibility and loopholes in the legal definition of a ``bank'' allowed owners of banks and other insured depository institutions to shop for the regulator of their choice. Fourth, investment banks operated with insufficient government oversight. Money market mutual funds were vulnerable to runs. Hedge funds and other private pools of capital operated completely outside of the supervisory framework. To create a new foundation for the regulation of financial institutions, we will promote more robust and consistent regulatory standards for all financial institutions. Similar financial institutions should face the same supervisory and regulatory standards, with no gaps, loopholes, or opportunities for arbitrage. We propose the creation of a Financial Services Oversight Council, chaired by Treasury, to help fill gaps in supervision, facilitate coordination of policy and resolution of disputes, and identify emerging risks in firms and market activities. This Council would include the heads of the principal Federal financial regulators and would maintain a permanent staff at Treasury. We propose an evolution in the Federal Reserve's current supervisory authority for BHCs to create a single point of accountability for the consolidated supervision of all companies that own a bank. All large, interconnected firms whose failure could threaten the stability of the system should be subject to consolidated supervision by the Federal Reserve, regardless of whether they own an insured depository institution. These firms should not be able to escape oversight of their risky activities by manipulating their legal structure. Under our proposals, the largest, most interconnected, and highly leveraged institutions would face stricter prudential regulation than other regulated firms, including higher capital requirements and more robust consolidated supervision. In effect, our proposals would compel these firms to internalize the costs they could impose on society in the event of failure.II. Establish Comprehensive Regulation of Financial Markets The current financial crisis occurred after a long and remarkable period of growth and innovation in our financial markets. New financial instruments allowed credit risks to be spread widely, enabling investors to diversify their portfolios in new ways and enabling banks to shed exposures that had once stayed on their balance sheets. Through securitization, mortgages and other loans could be aggregated with similar loans and sold in tranches to a large and diverse pool of new investors with different risk preferences. Through credit derivatives, banks could transfer much of their credit exposure to third parties without selling the underlying loans. This distribution of risk was widely perceived to reduce systemic risk, to promote efficiency, and to contribute to a better allocation of resources. However, instead of appropriately distributing risks, this process often concentrated risk in opaque and complex ways. Innovations occurred too rapidly for many financial institutions' risk management systems; for the market infrastructure, which consists of payment, clearing, and settlement systems; and for the Nation's financial supervisors. Securitization, by breaking down the traditional relationship between borrowers and lenders, created conflicts of interest that market discipline failed to correct. Loan originators failed to require sufficient documentation of income and ability to pay. Securitizers failed to set high standards for the loans they were willing to buy, encouraging underwriting standards to decline. Investors were overly reliant on credit rating agencies. Credit ratings often failed to accurately describe the risk of rated products. In each case, lack of transparency prevented market participants from understanding the full nature of the risks they were taking. The build-up of risk in the over-the-counter (OTC) derivatives markets, which were thought to disperse risk to those most able to bear it, became a major source of contagion through the financial sector during the crisis. We propose to bring the markets for all OTC derivatives and asset-backed securities into a coherent and coordinated regulatory framework that requires transparency and improves market discipline. Our proposal would impose record-keeping and reporting requirements on all OTC derivatives. We also propose to strengthen the prudential regulation of all dealers in the OTC derivative markets and to reduce systemic risk in these markets by requiring all standardized OTC derivative transactions to be executed in regulated and transparent venues and cleared through regulated central counterparties. We propose to enhance the Federal Reserve's authority over market infrastructure to reduce the potential for contagion among financial firms and markets. Finally, we propose to harmonize the statutory and regulatory regimes for futures and securities. While differences exist between securities and futures markets, many differences in regulation between the markets may no longer be justified. In particular, the growth of derivatives markets and the introduction of new derivative instruments have highlighted the need for addressing gaps and inconsistencies in the regulation of these products by the CFTC and SEC.III. Protect Consumers and Investors From Financial Abuse Prior to the current financial crisis, a number of Federal and State regulations were in place to protect consumers against fraud and to promote understanding of financial products like credit cards and mortgages. But as abusive practices spread, particularly in the market for subprime and nontraditional mortgages, our regulatory framework proved inadequate in important ways. Multiple agencies have authority over consumer protection in financial products, but for historical reasons, the supervisory framework for enforcing those regulations had significant gaps and weaknesses. Banking regulators at the State and Federal level had a potentially conflicting mission to promote safe and sound banking practices, while other agencies had a clear mission but limited tools and jurisdiction. Most critically in the run-up to the financial crisis, mortgage companies and other firms outside of the purview of bank regulation exploited that lack of clear accountability by selling mortgages and other products that were overly complicated and unsuited to borrowers' financial situation. Banks and thrifts followed suit, with disastrous results for consumers and the financial system. This year, Congress, the Administration, and financial regulators have taken significant measures to address some of the most obvious inadequacies in our consumer protection framework. But these steps have focused on just two, albeit very important, product markets--credit cards and mortgages. We need comprehensive reform. For that reason, we propose the creation of a single regulatory agency, a Consumer Financial Protection Agency (CFPA), with the authority and accountability to make sure that consumer protection regulations are written fairly and enforced vigorously. The CFPA should reduce gaps in Federal supervision and enforcement; improve coordination with the States; set higher standards for financial intermediaries; and promote consistent regulation of similar products. Consumer protection is a critical foundation for our financial system. It gives the public confidence that financial markets are fair and enables policy makers and regulators to maintain stability in regulation. Stable regulation, in turn, promotes growth, efficiency, and innovation over the long term. We propose legislative, regulatory, and administrative reforms to promote transparency, simplicity, fairness, accountability, and access in the market for consumer financial products and services. We also propose new authorities and resources for the Federal Trade Commission to protect consumers in a wide range of areas. Finally, we propose new authorities for the Securities and Exchange Commission to protect investors, improve disclosure, raise standards, and increase enforcement.IV. Provide the Government With the Tools It Needs To Manage Financial Crises Over the past 2 years, the financial system has been threatened by the failure or near failure of some of the largest and most interconnected financial firms. Our current system already has strong procedures and expertise for handling the failure of banks, but when a bank holding company or other nonbank financial firm is in severe distress, there are currently only two options: obtain outside capital or file for bankruptcy. During most economic climates, these are suitable options that will not impact greater financial stability. However, in stressed conditions it may prove difficult for distressed institutions to raise sufficient private capital. Thus, if a large, interconnected bank holding company or other nonbank financial firm nears failure during a financial crisis, there are only two untenable options: obtain emergency funding from the U.S. Government as in the case of AIG, or file for bankruptcy as in the case of Lehman Brothers. Neither of these options is acceptable for managing the resolution of the firm efficiently and effectively in a manner that limits the systemic risk with the least cost to the taxpayer. We propose a new authority, modeled on the existing authority of the FDIC, that should allow the government to address the potential failure of a bank holding company or other nonbank financial firm when the stability of the financial system is at risk. In order to improve accountability in the use of other crisis tools, we also propose that the Federal Reserve Board receive prior written approval from the Secretary of the Treasury for emergency lending under its ``unusual and exigent circumstances'' authority.V. Raise International Regulatory Standards and Improve International Cooperation As we have witnessed during this crisis, financial stress can spread easily and quickly across national boundaries. Yet, regulation is still set largely in a national context. Without consistent supervision and regulation, financial institutions will tend to move their activities to jurisdictions with looser standards, creating a race to the bottom and intensifying systemic risk for the entire global financial system. The United States is playing a strong leadership role in efforts to coordinate international financial policy through the G20, the Financial Stability Board, and the Basel Committee on Banking Supervision. We will use our leadership position in the international community to promote initiatives compatible with the domestic regulatory reforms described in this report. We will focus on reaching international consensus on four core issues: regulatory capital standards; oversight of global financial markets; supervision of internationally active financial firms; and crisis prevention and management. At the April 2009 London Summit, the G20 leaders issued an eight-part declaration outlining a comprehensive plan for financial regulatory reform. The domestic regulatory reform initiatives outlined in this report are consistent with the international commitments the United States has undertaken as part of the G20 process, and we propose stronger regulatory standards in a number of areas. CHRG-111shrg51290--11 Mr. Bartlett," Thank you, Chairman Dodd and Ranking Member Shelby and members of the Committee. To start with the obvious, it is true that many consumers were harmed by the mortgage-lending practices that led to the current crisis, but what is even more true is that even more have been harmed by the crisis itself. The root causes of the crisis, to overly simplify, are twofold: One, mistaken policies and practices by many, but not all, not even most, financial services firms; and two, the failure of our fragmented financial regulatory system to identify and to prevent those practices and the systemic failures that resulted. This crisis illustrates the nexus, then, between consumer protection regulation and safety and soundness regulation. Safety and soundness, or prudential regulation, is the first line of defense for protecting consumers. It ensures that financial services firms are financially sound and further loans that borrowers can repay with their own income are healthy both for the borrower and for the lender. In turn, consumer protection regulation ensures that consumers are treated fairly. Put another way, safety and soundness and consumer protection are self-reinforcing, each strengthening the other. Given this nexus, we do not support, indeed, we oppose proposals to separate consumer protection regulation from safety and soundness regulation. Such a separation would significantly weaken both. An example, Mr. Chairman, in real time, today, a provision in the pending omnibus appropriations bill that would give State attorneys general the authority to enforce compliance with the Federal Truth in Lending Act illustrates this problem. It would create additional fragmented regulation, and attempting to separate safety and soundness and consumer protection would harm both. My testimony has been divided into two parts. First, I address what went wrong, and second, I address how to fix the problem. What went wrong? The proximate cause of the current financial crisis was the nationwide collapse of housing values. The root cause of the crisis are twofold. The first was a breakdown, as I said, in policies, practices, and processes at many, but not all financial services firms. Since 2007, admittedly long after all the horses were out of the barn and running around in the pasture, the industry identified and corrected those practices. Underwriting standards have been upgraded. Credit practices have been reviewed and recalibrated. Leverage has been reduced as firms were rebuilt. Capital incentives have been realigned. And some management teams have been replaced. The second underlying cause, though, is our overly complex and fragmented financial regulatory structure which still exists today as it existed during the ramp-up to the crisis. There are significant gaps in the financial regulatory system in which no one has regulatory jurisdiction. The system does not provide for sufficient coordination and cooperation among regulators and does not adequately monitor the potential for market failures or high-risk activities. So how to fix the problem? The Roundtable has developed over the course, literally, of 3 years a draft financial regulatory architecture that is intended to close those gaps, and our proposed architecture, which I submit for the record, has six key features. First, we propose to expand the membership of the President's Working Group on Financial Markets and rename it the Financial Markets Coordinating Council, but key, to give it statutory authority rather than merely executive branch authority. Second, to address systemic risk, we propose that the Federal Reserve Board be authorized as a market stability regulator. The Fed would be responsible for looking across the entire financial services sector to identify interconnections that could pose a risk to the entire financial system. Third, to reduce the gaps in regulation, we propose a consolidation of several existing Federal agencies, such as OCC and OTS, into a single national financial institutions regulator. The new agency would be a consolidated prudential and consumer protection agency for three broad sectors: Banking, securities, and insurance. The agency would issue national prudential and consumer protection standards for mortgage origination. Mortgage lenders, regardless of how they are organized, would be required to retain some of the risk for the loans they originate, also known as keeping some skin in the game, and likewise, mortgage borrowers, regardless of where they live or who their lender is, would be protected by the same safety and soundness and consumer standards. Fourth, we propose the creation of a national capital markets agency with the merger of the SEC and the Commodities Futures Trading Commission. And fifth, to protect depositors, policy holders, and investors, we propose that the Federal Deposit Insurance Corporation would be renamed the National Insurance Resolution Authority and that it manage insurance mechanisms for banking, depository institutions, but also federally chartered insurance companies and federally licensed broker dealers. Before I close, Mr. Chairman, I have also included in my testimony two other issues of importance to this Committee and the policymakers and the industry. One, lending by institutions that have received TARP funds is a subject of great comment around this table. And second, the impact of fair value accounting in illiquid markets. I have attached to my statement a series of tables that the Roundtable has compiled on lending by some of the nation's largest institutions. These tables are designed to set the record straight. The fact is that large financial services firms have increased their lending as a result of TARP capital. And second, fair value accounting continues to be of gargantuan concerns for the industry and should be for the public in general. We believe that the pro-cyclical effects of existing and past policies, which have not been changed, are unnecessarily exacerbating the crisis. We urge the Committee to take up this subject and deal with it. We thank you again for the opportunity to appear. I yield back. " CHRG-111hhrg55811--279 Mr. Ferreri," Madam Chairwoman, members of the committee, thank you for inviting me to testify today on the reform of the over-the-counter derivatives market. My name is Chris Ferreri, and I am testifying today in my capacity as chairman of the Wholesale Markets Brokers Association, Americas, an independent industry body representing the largest wholesale and interdealer brokers operating in the North American markets across a broad range of financial products. I am also managing director at ICAP, one of the founding member firms of the WMBA. Interdealer brokers serve as intermediaries for broker-dealers and other financial institutions that facilitate access to a full range of OTC and exchange-traded products and their associated derivatives forms. For relevant markets interdealer brokers are registered broker-dealers and are regulated by numerous agencies, including the SEC, the Federal Reserve, and the CFTC. It is estimated that each day, IDBs handle on average 2 million OTC trades globally, corresponding to about $5 trillion in notional amounts across the range of FX securities, interest rate, credit, equity and commodity asset classes in both cash and derivative form. Mr. Chairman, the WMBA is supportive of the efforts to more effectively oversee the OTC markets for derivative financial products. We believe that our current practices will integrate smoothly with many of the requirements in the discussion draft as well as the Treasury Department's proposal. We support the efforts taken thus far by the Administration and Congress to broaden the roles of the CFTC and the SEC in increasing the safety and soundness of the OTC markets. Today, we would like to focus on two particular issues: the characteristics and responsibilities of the swap execution facilities; and the protection of open, neutral, and nondiscriminatory access to central clearing. It is clear that the interdealer brokers would currently fulfill many of the criteria of the swap execution facilities described under the draft legislation or the alternative swap execution facilities under the Treasury Department's proposal. Much of what is contemplated for these facilities is already well within the capabilities of our member firms. Our technology-based reporting systems can provide the relevant regulators with real-time trading information. The WMBA is concerned with the requirement that swap execution facilities must undertake certain SRO enforcement-type responsibilities, including discretionary supervision and approval of particular swap contracts as suitable for trading and the general oversight of the trading activities of our customers. This is not to diminish the capabilities we currently possess to monitor for suspicious or manipulative trading activity and to report such activity to regulators. This is consistent with our concerns about the requirements set forth in the Treasury Department's proposed legislation for alternative swap execution facilities to adopt position limitations or position accountability for our customers. We therefore appreciate the committee not including such a provision in the chairman's discussion draft, recognizing that each WMBA member firm can only monitor the activities taking place within its own execution facility. Multiple and competitive execution platforms have demonstrated their ability to create efficient, liquid and innovative markets. Yet with the expansion and requirement of central clearing, there is serious risk that central clearinghouses will create, modify, and ultimately favor their own execution facilities over competing execution facilities by access fees, access technologies or cross-subsidization of execution and clearing fees. The WMBA would respectfully ask that you consider whether this is sufficient to promote and protect competition among execution platforms. As the Justice Department observed in a 2008 comment letter to the Treasury Department, a vertically integrated derivatives market, where a central counterparty providing clearing services also provides trade execution services, will limit competition, increase costs, and ultimately hurt end-users and larger market participants. One only needs to look at the securities and options markets compared to the futures markets. The WMBA is encouraged that this is consistent with CFTC Chairman Gary Gensler, who remarked at a House Agriculture Committee several weeks ago that, ``A clearinghouse should not be vertically integrated in such a way with an exchange or trading platform so that the only product they accept is from that exchange or trading platform.'' Frankly, if the clearing entity also provides execution services, there is not only an opportunity, but also an incentive for them to structure their services to squeeze out competition. The WMBA would ask that the legislation include language to protect against such behavior. In closing, Madam Chairwoman, we congratulate you on your work on the discussion draft and the Treasury Department's proposed legislation. The WMBA looks forward to working with you to achieve these goals. Thank you for the invitation to participate in today's hearing. [The prepared statement of Mr. Ferreri can be found on page 79 of the appendix.] Ms. Bean. Thank you for your testimony. And our final witness is Rob Johnson, director of economic policy for the Roosevelt Institute in New York, on behalf of Americans for Financial Reform. STATEMENT OF ROB JOHNSON, DIRECTOR OF ECONOMIC POLICY FOR THE ROOSEVELT INSTITUTE IN NEW YORK, ON BEHALF OF AMERICANS FOR FOMC20070918meeting--282 280,MR. LACKER.," Thank you, Mr. Chairman. I’ve been thinking a lot about this since I heard about it last week. I want to start by complimenting the staff at New York and the Board who wrote the summary memo. I think it does a very good and balanced job of articulating the costs and benefits of this proposed facility. I was going to say that they undoubtedly did it in a compressed timeframe, but then I heard you guys have been working on it for weeks. [Laughter] But in any event, my hat is off to them. I very much agree with the staff that weighing the costs and benefits to reach an assessment about the desirability of this is inherently a difficult judgment. For me the critical question concerns the normative implications of what we’re seeing in the marketplace for term funding and the normative implications of this proposed intervention. Banks that are borrowing at term now are paying up for insurance against the eventuality that their funding costs rise—for example, because of a deterioration in their perceived creditworthiness. Banks that have viewed themselves as more at risk are naturally willing to pay more for such insurance, and some reports suggest, as Mr. Dudley did this morning, the presence of an adverse-selection problem in the sense that borrowing at term reveals oneself to be a borrower of high risk, and so only high-risk borrowers are willing to pay more. Banks that are reluctant to lend at term are placing a high value on being able to use their liquidity to accommodate assets that may come on their balance sheet soon. We had a lot of discussion about this in the morning. Balance sheet capacity appears genuinely to be a scarce valuable commodity these days. That’s consistent with the notion that raising bank capital is expensive in the current environment. I think the adverse-selection story is worth considering seriously in this context because it’s the interpretation of what we’re seeing that provides the best hope for this being an intervention that improves market functioning in the microeconomic sense of the term. But if adverse selection is what has impaired the functioning of the term market in this normative sense, then there must be lower-risk banks that are unwilling to borrow at the same high rates as high-risk banks but that are rationed because they’re unable to distinguish themselves from high-risk banks. Now, if this is the case, the only way to improve market efficiency by lending is to lend more than the current volume of term lending because otherwise we’re just going to lend it to the current term-lending borrowers and none of these rationed-out, lower-risk banks are going to get access to it. In other words, if we do lend through an auction facility to draw in disadvantaged borrowers to try to reach them with credit, we can do so only by subsidizing the high-risk borrowers as well. Now, I’ll mention that, from the discussion this morning, my understanding is that we have very little idea what the volume of that term lending is. So I don’t see how we chose this number and how we can be confident that it’s going to do this and reach through the high-risk borrowers to pick up the low-risk borrowers. More broadly, I’m not sure I see how this facility could improve the normative functioning in the market. We’re going to auction off only the same contracts that market participants are capable of offering now, only we’re also going to subject ourselves to the additional constraints imposed by our single-price auction format. So we’re not improving on any contract out there. The only unique attribute we would appear to bring is our ability to subsidize lending terms. We could conceivably improve market functioning if adverse selection is the right story here by doing something that market participants are incapable of doing, and that would be compelling borrowing by everybody or by a set of people to achieve a superior pooling allocation. But I don’t think we want to do that. Or we could conceivably improve market functioning by acting on information that’s superior to that of market participants—a knowledge of the creditworthiness of institutions, for example. But it isn’t clear that this is a key part of the proposal either, because institutions have to be rated 3 or above to get access and I think virtually all the currently affected institutions in these sorts of high-risk and low-risk categories are in the 3 or above categories already. A related point here is that, if we really think information constraints are at the heart of the problem, it might be better to address this problem by addressing those constraints directly by using our supervisory authority to encourage and facilitate greater transparency. So my sense is that this facility would just subsidize borrowing banks without doing anything to mitigate underlying informational asymmetries or any other type of market friction that I can think of. That means to me that this proposal raises the usual moral hazard concerns. The staff memo was very clear and articulate about those. I think there’s a danger with this facility of raising expectations that, in the future, significant increases in interbank funding spreads are going to be ameliorated by central bank intervention. If we raise that expectation, we’re going to undermine to some extent market mechanisms for assessing the relative risk of institutions. I’m a little worried that if this does not produce a demonstrable effect on relevant market conditions, it could erode confidence in us, and I feel so especially in light of our previous change in discount window policy, which I think is widely viewed as having had little substantive effect so far. I think that’s the view out there. I also worry that this could complicate the resolution of failing institutions whose condition, as Vice Chairman Geithner suggested, deteriorates while they’re borrowing from this auction facility. It would put us in a very awkward place. As Governor Kohn said, this isn’t like a one-day emergency kind of thing—it takes some time. But some institutions in questionable situations, some problem institutions, look for term funding and are willing to wait four days to get it and know enough about their condition to line it up ahead of time. I worry about this sounding like a cloak for the ECB, for us to give money to the ECB, and I worry about President Rosengren’s issues as well, and I’d be more comfortable with the swap line than I am with the domestic facility. If those foreign authorities want to extend credit and have the knowledge and capacity to do so, and it’s on their dime and they’re bearing the credit risk and they want to borrow the dollars from us, I see that as a reasonable step for a central bank to take. I also worry about valuing collateral. I don’t think that our mechanisms for doing that are robust and strong, especially in the current environment with at least standard haircuts. Now, I can appreciate the broader problem articulated by the staff and others that banks that are constrained in the term funding market might tighten borrowing terms for consumers and businesses and that might have real economic consequences. But if that’s the problem, I think it would be better for us to just cut the funds rate rather than alter the relative funding costs of different banks. This is essentially what we did today. We cut the funds rate to offset the macroeconomic effects of higher credit spreads. Just a final set of comments. More broadly, I’ve been hoping for some time that banking policy in our country was moving slowly but surely toward greater reliance on market discipline and away from forbearance and subsidization. I’ve been hoping that we as a central bank would gradually move away from things that are tainted with credit allocation. Times like these don’t come around very often—you know, once a decade—and my sense is that the precedent we set here is going to be remembered for a long time and it’s going to affect market behavior for a long time to come as well. In my opinion, we ought to look at these episodes of market stress as an opportunity to make some reputational progress on the time-consistency problem that is at the heart of moral hazard. So for me the balance of considerations weighs heavily against this proposal, Mr. Chairman." CHRG-111shrg51395--128 PREPARED STATEMENT OF DAMON A. SILVERS Associate General Counsel, AFL-CIO March 10, 2009 Good morning, Chairman Dodd and Senator Shelby. My name is Damon Silvers, I am an Associate General Counsel of the AFL-CIO, and I am the Deputy Chair of the Congressional Oversight Panel created under the Emergency Economic Stabilization Act of 2008 to oversee the TARP. While I will describe the Congressional Oversight Panel's report on regulatory reform, my testimony reflects my views and the views of the AFL-CIO unless otherwise noted, and is not on behalf of the Panel, its staff or its chair, Elizabeth Warren. The vast majority of American investors participate in the markets as a means to secure a comfortable retirement and to send their children to college. Most investors' goals are long term, and most investors rely on others to manage their money. While the boom and bust cycles of the last decade generated fees for Wall Street--in many cases astounding fees--they have turned out to have been a disaster for most investors. The 10-year nominal rate of return on the S&P 500 is now negative, and returns for most other asset classes have turned out to be more correlated with U.S. equity markets than anyone would have imagined a decade ago. While the spectacular frauds like the Madoff ponzi scheme have generated a great deal of publicity, the bigger questions are (1) how did our financial system as a whole become so weak how did our system of corporate governance, securities regulation, and disclosure-based market discipline fail to prevent trillions of dollars from being invested in value-destroying activities--ranging from subprime mortgages and credit cards, to the stocks and bonds of financial institutions, to the credit default swaps pegged to those debt instruments; and (2) what changes must be made to make our financial system a more reasonable place to invest the hard earned savings of America's working families? My testimony today will seek to answer the second question at three levels: 1 How should Congress strengthen the regulatory architecture to better protect investors; 2. How should Congress think about designing regulatory jurisdiction to better protect investors; and 3. What are some specific substantive steps Congress and the regulators should take to shore up our system of investor protections? Finally, I will briefly address how to understand the challenge of investor protection in globalized markets.Regulatory Architecture While there has been much discussion of the need for better systemic risk regulation, the Congressional Oversight Panel, in its Special Report on Regulatory Reform issued on January 29, 2009, observed that addressing issues of systemic risk cannot be a substitute for a robust, comprehensive system of routine financial regulation. \1\ There are broadly three types of routine regulation in the financial markets--(1) safety and soundness regulation for insured institutions like banks and insurance companies; (2) disclosure and fiduciary duty regulation for issuers and money managers in the public securities markets; and (3) substantive consumer protection regulation in areas like mortgages, credit cards, and insurance. These are distinct regulatory missions in significant tension with each other.--------------------------------------------------------------------------- \1\ Congressional Oversight Panel, Special Report on Regulatory Reform, at 3 (Jan. 29, 2009), available at http://cop.senate.gov/documents/cop-012909-report-regulatoryreform.pdf--------------------------------------------------------------------------- Investors, people who seek to put money at risk for the prospect of gains, really are interested in transparency, enforcement of fiduciary duties, and corporate governance. This is the investor protection mission. It is often in tension with the equally legitimate regulatory mission of protecting the safety and soundness of insured financial institutions. A safety and soundness regulator is likely to be much more sympathetic to regulated entities that want to sidestep telling the investing public bad news. At the same time, investor protection is not the same thing as consumer protection--the consumer looking for home insurance or a mortgage is seeking to purchase a financial service with minimal risk, not to take a risk in the hope of a profit. Because these functions should not be combined, investor protection should be the focus of a single agency within the broader regulatory framework. That agency needs to have the stature and independence to protect the principles of full disclosure by market participants and compliance with fiduciary duties among market intermediaries. Any solution to the problem of systemic risk prevention should involve the agency charged with investor protection, and not supersede it. Since the New Deal, the primary body charged with enforcing investor protections has been the Securities and Exchange Commission. Although the Commission has suffered in recent years from diminished jurisdiction and leadership failure, it remains an extraordinary government agency, whose human capital and market expertise needs to be built upon as part of a comprehensive strategy for effective reregulation of the capital markets. While I have a great deal of respect for former Treasury Secretary Paulson, there is no question that his blueprint for financial regulatory reform was profoundly deregulatory in respect to the Securities and Exchange Commission. \2\ He and others, like the self-described Committee on Capital Markets Regulation led by Harvard Professor Hal Scott, sought to dismantle the Commission's culture of arms length, enforcement-oriented regulation and to replace it with something frankly more captive to the businesses it regulated. \3\ While these deregulatory approaches have fortunately yet to be enacted, they contributed to an environment that weakened the Commission politically and demoralized its staff.--------------------------------------------------------------------------- \2\ Department of the Treasury, Blueprint for a Modernized Financial Regulatory Structure, at 11-13, 106-126 (Mar. 2008), available at http://www.treas.gov/press/releases/reports/Blueprint.pdf \3\ Committee on Capital Markets Regulation, Interim Report (Nov. 30, 2006), available at http://www.capmktsreg.org/pdfs/11.30Committee_Interim_ReportREV2.pdf; Committee on Capital Markets Regulation, The Competitive Position of the U.S. Public Equity Market (Dec. 4, 2007), available at http://www.capmktsreg.org/pdfs/The_Competitive_Position_of_the_US_Public_Equity_Market.pdf--------------------------------------------------------------------------- While there has been a great deal of attention paid to the Commission's failure to spot the Madoff ponzi scheme, there has been insufficient attention to the Commission's performance in relation to the public debt markets, where the SEC regulates more than $438.3 billion in outstanding securities related to home equity loans and manufactured housing loans, among the riskiest types of mortgages. Similarly, little attention has been paid to the oversight of disclosures by the financial and homebuilding firms investing in and trading in those securities, and perhaps most importantly, the lack of action by the Commission once the financial crisis began. \4\--------------------------------------------------------------------------- \4\ Securities Industry and Financial Markets Association, Market Sector Statistics: Asset Backed Securities--Outstanding By Major Types of Credit.--------------------------------------------------------------------------- But elections have consequences, and one of those consequences should be a renewed commitment by both Congress and the new Administration to revitalizing the Commission and to rebuilding the Commission's historic investor protection oriented culture and mission. The President's budget reflects that type of approach in the funding it seeks for the Commission, and the new Chair of the Commission Mary Schapiro has appeared to be focused on just this task in her recent statements. \5\--------------------------------------------------------------------------- \5\ See, e.g., Speech by SEC Chairman: Address to Practising Law Institute's ``SEC Speaks in 2009'' Program available at http://sec.gov/news/speech/2009/spch020609mls.htm--------------------------------------------------------------------------- A key issue the Commission faces is how to strengthen its staff. Much of what needs to be done is in the hands of the Commission itself, where the Chair and the Commissioners set the tone for better or for worse. When Commissioners place procedural roadblocks in the way of enforcing the law, good people leave the Commission and weak staff are not held accountable. When the Chair sets a tone of vigorous enforcement of the laws and demands a genuine dedication to investor protection, the Commission both attracts and retains quality people. Congress should work with the Commission to determine if changes are needed to personnel rules to enable the Commission to attract and retain key personnel. The Commission should look at more intensive recruiting efforts aimed at more experienced private sector lawyers who may be looking for public service opportunities--perhaps through a special fellows program. On the other hand, Congress should work with the Commission to restrict the revolving door--ideally by adopting the rule that currently applies to senior bank examiners for senior Commission staff--no employment with any firm whose matters the staffer worked on within 12 months.Regulating the Shadow Markets and the Problem of Jurisdiction The financial crisis is directly connected to the degeneration of the New Deal system of comprehensive financial regulation into a Swiss cheese regulatory system, where the holes, the shadow markets, grew to dominate the regulated markets. If we are going to lessen future financial boom and bust cycles, Congress must give the regulators the tools and the jurisdiction to regulate the shadow markets. In our report of January 29, the Congressional Oversight Panel specifically observed that we needed to regulate financial products and institutions, in the words of President Obama, ``for what they do, not what they are.'' \6\ We further noted in that report that shadow market products and institutions are nothing more than new names and new legal structures for very old activities like insurance (read credit default swaps) and money management (read hedge funds and private equity/lbo funds). \7\--------------------------------------------------------------------------- \6\ Senator Barack Obama, Renewing the American Economy, Speech at Cooper Union in New York (Mar. 27, 2008) (transcript available at http://www.nytimes.com/2008/03/27/us/politics/27text-obama.html?pagewanted=all); Congressional Oversight Panel, Special Report on Regulatory Reform, at 29. \7\ Congressional Oversight Panel, Special Report on Regulatory Reform, at 29.--------------------------------------------------------------------------- The Congressional Oversight Panel's report stated that shadow institutions should be regulated by the same regulators who currently have jurisdiction over their regulated counterparts. \8\ So, for example, the SEC should have jurisdiction over derivatives that are written using public debt or equity securities as their underlying asset. The Congressional Oversight Panel stated that at a minimum, hedge funds should also be regulated by the SEC in their roles as money managers by being required to register as investment advisors and being subject to clear fiduciary duties, the substantive jurisdiction of U.S. law, and periodic SEC inspections. \9\ To the extent a hedge fund or anyone else engages in writing insurance contracts or issuing credit, however, it should be regulated by the bodies charged with regulating that type of economic activity.--------------------------------------------------------------------------- \8\ Id. \9\ Id.--------------------------------------------------------------------------- Some have suggested having such shadow market financial products as derivatives and hedge funds simply regulated by a systemic regulator. This would be a terrible mistake. Shadow market products and institutions need to be brought under the same routine regulatory umbrella as other financial actors. To take a specific case, while it is a good idea to have public clearinghouses for derivatives trading, that reform by itself is insufficient without capital requirements for the issuers of derivatives and without disclosure and the application of securities law principles, generally, to derivatives based on public securities regulations. So, for example, the SEC should require the same disclosure of short positions in public equities that it requires of long positions in equities, whether those positions are created through the securities themselves or synthetically through derivatives or futures. The historic distinctions between broker-dealers and investment advisors have been eroding in the markets for years. In 2007, the Federal Appeals Court for the District of Columbia issued an opinion overturning Commission regulations seeking to better define the boundary between the two. \10\ The Commission should look at merging the regulation of the categories while ensuring that the new regulatory framework preserves clear fiduciary duties to investors. As part of a larger examination of the duties owed by both broker-dealers and investment advisors to investors, the Commission ought to examine the fairness and the efficacy of the use of arbitration as a form of dispute resolution by broker-dealers. Finally, part of what must be done in this area is to determine whether the proper regulatory approach will require Congressional action in light of the D.C. Circuit opinion.--------------------------------------------------------------------------- \10\ Fin. Planning Ass'n v. SEC, 482 F.3d 481 (D.C. Cir. 2007).--------------------------------------------------------------------------- But there is a larger point here. Financial reregulation will be utterly ineffective if it turns into a series of rifle shots at the particular mechanisms used to evade regulatory structures in earlier boom and bust cycles. What is needed is a return to the jurisdictional philosophy that was embodied in the founding statutes of federal securities regulation--very broad, flexible jurisdiction that allowed the SEC to follow the activities. By this principle, the SEC should have jurisdiction over anyone over a certain size who manages public securities, and over any contract written that references publicly traded securities. Applying this principle would require at least shifting the CFTC's jurisdiction over financial futures to the SEC, if not merging the two agencies under the SEC's leadership. Much regulatory thinking over the last couple of decades has been shaped by the idea that sophisticated parties should be allowed to act in financial markets without regulatory oversight. Candidly, some investors have been able to participate in a number of relatively lightly regulated markets based on this idea. But this idea is wrong. Big, reckless sophisticated parties have done a lot of damage to our financial system and to our economy. I do not mean to say that sophisticated parties in the business of risk taking should be regulated in the same way as auto insurers selling to the general public. But there has to be a level of transparency, accountability, and mandated risk management across the financial markets. Finally, while it is not technically a shadow market, the underregulation of the credit rating agencies has turned out to have devastating consequences. The Congressional Oversight Panel called particular attention to the dysfunctional nature of the issuer pays model, and recommended a set of options for needed structural change--from the creation of PCAOB-type oversight body to the creation of a public or non-profit NRSRO. \11\--------------------------------------------------------------------------- \11\ Id. at 40-44.---------------------------------------------------------------------------Substantive Reforms Beyond regulating the shadow markets, the Congress and the Securities and Exchange Commission need to act to shape a corporate governance and investor protection regime that is favorable to long term investors and to the channeling of capital to productive purposes. There is no way to look at the wreckage surrounding us today in the financial markets and not conclude we have had a regulatory regime that, intentionally or not, facilitated grotesquely short-term thinking and led to capital flowing in unheard of proportions to pointless or destructive ends. This is a large task, and I will simply point out some of the most important steps that need to be taken in three areas--governance, executive pay, and litigation. First, in the area of governance, once again the weakness of corporate boards, particularly in the financial sector, appears to be a central theme in the financial scandal. The AFL-CIO has interviewed the audit committees of a number of the major banks to better understand what happened. We found in general very weak board oversight of risk--evidenced in audit committee leadership who did not understand their companies' risk profiles, and in boards that tolerated the weakening of internal risk management. Strong boards require meaningful accountability to investors. Short-term, leveraged investors have been the most powerful voices in corporate governance in recent years, with destructive results. The AFL-CIO urges Congress to work with the SEC to ensure that there are meaningful, useable ways for long-term investors to nominate and elect psychologically independent directors to public company boards through access to the corporate proxy. I put the stress here on long-term--there must be meaningful holding time requirements for exercising this right. Recent statements by SEC Chair Mary Schapiro suggest she is focused on this area, and we urge the Congress to support her efforts. \12\--------------------------------------------------------------------------- \12\ Rachelle Younglai, SEC developing proxy access plans: sources, REUTERS, Mar. 6, 2009, at http://www.reuters.com/article/bernardMadoff/idUSTRE52609820090307--------------------------------------------------------------------------- Second, effective investor protection requires a comprehensive approach to reform in the area of executive pay. Proxy access is an important first step in this area, but we should learn from the financial crisis how destructive short-term oriented, asymmetric executive pay can be for long-term investors and for our economy. The focus of the Congressional Oversight Panel's recommendations in the area of executive pay were on ending these practices in financial institutions. \13\ Here Chairman Dodd's leadership has been very helpful in the context of the TARP.--------------------------------------------------------------------------- \13\ Congressional Oversight Panel, Special Report on Regulatory Reform, at 37-40.--------------------------------------------------------------------------- But Congress and the Administration should pursue a comprehensive approach to executive pay reform around two concepts--equity linked pay should be held beyond retirement, and pay packages as a whole should reflect a rough equality of exposure to downside risk as to upside gain. Orienting policy in this direction requires coordination between securities regulation and tax policy. But we could begin to address what has gone wrong in executive pay incentives by (1) developing measurements for both the time horizon and the symmetry of risk and reward of pay packages that could be included in pay disclosure; (2) looking more closely at mutual fund proxy voting behavior to see if it reflects the time horizons of the funds; (3) focusing FINRA inspections of broker dealer pay policies on these two issues; and (4) providing for advisory shareholder votes on pay packages. With respect to say on pay, any procedural approaches that strengthened the hand of long term investors in the process of setting executive compensation would be beneficial. Finally, Congress needs to address the glaring hole in the fabric of investor protection created by the Central Bank of Denver and Stoneridge cases. \14\ These cases effectively granted immunity from civil liability to investors for parties such as investment banks and law firms that are co-conspirators in securities frauds. It appeared for a time after Enron that the courts were going to restore some sanity in this area of the law on their own, by finding a private right of action when service providers were actually not just aiders and abetters of a fraud, but actual co-conspirators. In the Stoneridge decision, with the Enron case looming over them, the Supreme Court made clear Congress would have to act. The issue here of course is not merely fairness to the investors defrauded in a particular case--it is the incentives for financial institutions to police their own conduct. We seem to have had a shortage of such incentives in recent years.--------------------------------------------------------------------------- \14\ Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994); Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct. 761 (2008).---------------------------------------------------------------------------The International Context The Bush Administration fundamentally saw the internationalization of financial markets as a pretext for weakening U.S. investor protections. That approach has been discredited. It needs to be replaced by a commitment on the part of the Obama Administration to building a strong global regulatory floor in coordination with the world's other major economies. This effort is vital not only for protecting U.S. investors in global markets, but for protecting our financial sector from the consequences of a global regulatory race to the bottom that will inevitably end in the kind of financially driven economic crisis that we are living through today. Congress can play a part by seeking to strengthen its relationships with its counterpart legislative bodies in the major world markets, and should look for opportunities to coordinate setting regulatory standards on a global basis. The Administration needs to make this effort a priority, and to understand that it needs to extend beyond the narrow confines of systemic risk and the banking system to issues of transparency and investor protection. However, Congress must not allow the need for global coordination to be an impediment or a prerequisite to vigorous action to reregulate U.S. financial markets and institutions. That task is urgent and must be addressed if the U.S. is to recover from the blow this financial crisis has delivered to our private capital markets' reputation as the gold standard for transparency and accountability.Conclusion The task of protecting investors by reregulating our financial system and restoring vitality to our regulators is a large one. This testimony simply sketches the outline of an approach, and notes some key substantive steps Congress and the Administration need to take. This Committee has already taken a leadership role in a number of these areas, but there is much more to be done. Even in areas where the primary responsibility must lie with regulators, there is a much needed role for Congress to oversee, encourage, and support the efforts of the Administration. While I do not speak for the Congressional Oversight Panel, I think I am safe in saying that the Panel is honored to have been asked to assist Congress in this effort, and is prepared to assist this Committee in any manner the Committee finds useful. I can certainly make that offer on behalf of the AFL-CIO. Thank you.SUPPLEMENT--March 10, 2009 The challenge of addressing systemic risk in the future is one, but by no means the only one, of the challenges facing Congress as Congress considers how to reregulate U.S. financial markets following the extraordinary events of the last 18 months. Systemic crises in financial markets harm working people. Damaged credit systems destroy jobs rather than create them. Pension funds with investments in panicked markets see their assets deteriorate. And the resulting instability undermines business' ability to plan and obtain financing for new investments--undermining the long term growth and competitiveness of employers and setting the stage for future job losses. The AFL-CIO has urged Congress since 2006 to act to reregulate shadow financial markets, and the AFL-CIO supports addressing systemic risk, but in a manner that does not substitute for strengthening the ongoing day to day regulatory framework, and that recognizes addressing systemic risk both requires regulatory powers and financial resources that can really only be wielded by a fully public body. The concept of systemic risk is that financial market actors can create risk not just that their institutions or portfolios will fail, but risk that the failure of their enterprises will cause a broader failure of other financial institutions, and that such a chain of broader failures can jeopardize the functioning of financial markets as a whole. The mechanisms by which this broader failure can occur involve a loss of confidence in information, or a loss of confidence in market actors ability to understand the meaning of information, which leads to the withdrawal of liquidity from markets and market institutions. Because the failure of large financial institutions can have these consequence, systemic risk management generally is seen to both be about how to determine what to do when a systemically significant institution faces failure, and about how to regulated such institutions in advance to minimize the chances of systemic crises. Historically, the United States has had three approaches to systemic risk. The first was prior to the founding of the Federal Reserve system, when there was a reluctance at the Federal level to intervene in any respect in the workings of credit markets in particular and financial markets in general. The Federal Reserve system, created after the financial collapse of 1907, ushered in an era where the Federal Government's role in addressing systemic risk largely consisted of sponsoring through the Federal Reserve system, a means of providing liquidity to member banks, and thus hopefully preventing the ultimate liquidity shortage that results from market participants losing confidence in the financial system as a whole. But then, after the Crash of 1929 and the 4 years of Depression that followed, Congress and the Roosevelt Administration adopted a regulatory regime whose purpose was in a variety of ways to substantively regulate financial markets in an ongoing way. This new approach arose out of a sense among policymakers that the systemic financial crisis associated with the Great Depression resulted from the interaction of weakly regulated banks with largely unregulated securities markets, and that exposing depositors to these risks was a systemic problem in and of itself. Such centerpieces of our regulatory landscape as the Securities and Exchange Commission's disclosure based system of securities regulation and the Federal Deposit Insurance Corporation came into being not just as systems for protecting the economic interests of depositors or investors, but as mechanisms for ensuring systemic stability by, respectively, walling off bank depositors from broader market risks, and ensuring investors in securities markets had the information necessary to make it possible for market actors to police firm risk taking and to monitor the risks embedded in particular financial products. In recent years, financial activity has moved away from regulated and transparent markets and institutions and into the so-called shadow markets. Regulatory barriers like the Glass-Steagall Act that once walled off less risky from more risky parts of the financial system have been weakened or dismantled. So we entered the recent period of extreme financial instability with an approach to systemic risk that looked a lot like that of the period following the creation of the Federal Reserve Board but prior to the New Deal era. And so we saw the policy response to the initial phases of the current financial crisis primarily take the form of increasing liquidity into credit markets through interest rate reductions and increasingly liberal provision of credit to banks and then to non-bank financial institutions. However, with the collapse of Lehman Brothers and the Federal rescues of AIG, FNMA, and the FHLMC, the federal response to the perception of systemic risk turned toward much more aggressive interventions in an effort to ensure that after the collapse of Lehman Brothers, there would be no more defaults by large financial institutions. This approach was made somewhat more explicit with the passage of the Emergency Economic Stabilization Act of 2008 and the commencement of the TARP program. The reality was though that the TARP program was the creature of certain very broad passages in the bill, which generally was written with the view that the federal government would be embarking on the purchase of troubled assets, a very different approach than the direct infusions of equity capital that began with the Capital Purchase Program in October of 2008. We can now learn some lessons from this experience for the management of systemic risk in the financial system. First, our government and other governments around the world will step in when major financial institutions face bankruptcy. We do not live in a world of free market discipline when it comes to large financial institutions, and it seems unlikely we ever will. If two administrations as different as the Bush Administration and the Obama Administration agree that the Federal Government must act when major financial institutions fail, it is hard to imagine the administration that would do differently. Since the beginning of 2008, we have used Federal dollars in various ways to rescue either the debt or the equity holders or both at the following companies--Bear Stearns, Indymac, Washington Mutual, AIG, Merrill Lynch, Fannie Mae, Freddie Mac, Citigroup, and Bank of America. But we have no clear governmental entity charged with making the decision over which company to rescue and which to let fail, no clear criteria for how to make such decisions, and no clear set of tools to use in stabilizing those that must be stabilized. Second, we appear to be hopelessly confused as to what it means to stabilize a troubled financial institution to avoid systemic harm. We have a longstanding system of protecting small depositors in FDIC insured banks, and by the way policyholders in insurance companies through the state guarantee funds. The FDIC has a process for dealing with banks that fail--a process that does not always result in 100 percent recoveries for uninsured creditors. Then we have the steps taken by the Treasury Department and the Federal Reserve since Bear Stearns collapsed. At some companies, like Fannie Mae and Freddie Mac, those steps have guaranteed all creditors, but wiped out the equity holders. At other companies, like Bear Stearns, AIG, and Wachovia, while the equity holders survive, they have been massively diluted one way or another. At others, like Citigroup and Bank of America, the equity has been only modestly diluted when looked at on an upside basis. It is hard to understand exactly what has happened with the government's interaction with Morgan Stanley and Goldman Sachs, but again there has been very little equity dilution. And then there is poor Lehman Brothers, apparently the only non-systemic financial institution, where everybody lost. In crafting a systematic approach to systemically significant institutions, we should begin with the understanding that while a given financial institution may be systemically significant, not every layer of its capital structure should be necessarily propped up with taxpayer funds. Third, much regulatory thinking over the last couple of decades has been shaped by the idea that sophisticated parties should be allowed to act in financial markets without regulatory oversight. But this idea is wrong. Big, reckless sophisticated parties have done a lot of damage to our financial system and to our economy. This is not to say that sophisticated parties in the business of risk taking should be regulated in the same way as auto insurers selling to the general public. But there has to be a level of transparency, accountability, and mandated risk management across the financial markets. Fourth, financial markets are global now. Norwegian villages invest in U.S. mortgage backed securities. British bankruptcy laws govern the fate of U.S. clients of Lehman Brothers, an institution that appeared to be a U.S. institution. AIG, our largest insurance company, collapsed because of a London office that employed 300 of AIG's 500,000 employees. Chinese industrial workers riot when U.S. real estate prices fall. We increasingly live in a world where the least common denominator in financial regulation rules. So what lessons should we take away for how to manage systemic risk in our financial system? The Congressional Oversight Panel, in its report to Congress made the following points about addressing systemic risk: 1. There should be a body charged with monitoring sources of systemic risk in the financial system, but it could either be a new body, an existing agency, or a group of existing agencies; 2. The body charged with systemic risk managements should be fully accountable and transparent to the public in a manner that exceeds the general accountability mechanisms present in self- regulatory organizations; 3. We should not identify specific institutions in advance as too big to fail, but rather have a regulatory framework in which institutions have higher capital requirements and pay more on insurance funds on a percentage basis than smaller institutions which are less likely to be rescued as being too systemic to fail. 4. Systemic risk regulation cannot be a substitute for routine disclosure, accountability, safety and soundness, and consumer protection regulation of financial institutions and financial markets. 5. Ironically, effective protection against systemic risk requires that the shadow capital markets--institutions like hedge funds and products like credit derivatives--must not only be subject to systemic risk oriented oversight but must also be brought within a framework of routine capital market regulation by agencies like the Securities and Exchange Commisson. 6. There are some specific problems in the regulation of financial markets, such as the issue of the incentives built into executive compensation plans and the conflict of interest inherent in the credit rating agencies' business model of issuer pays, that need to be addressed to have a larger market environment where systemic risk is well managed. 7. Finally, there will not be effective reregulation of the financial markets without a global regulatory floor. I would like to explain some of these principles and at least the thinking I brought to them. First, on the issue of a systemic risk monitor, while the Panel made no recommendation, I have come to believe that the best approach is a body with its own staff and a board made up of the key regulators, perhaps chaired by the Chairman of the Board of Governors of the Federal Reserve. There are several reasons for this conclusion. First, this body must have as much access as possible to all information extant about the condition of the financial markets--including not just bank credit markets, but securities and commodities, and futures markets, and consumer credit markets. As long as we have the fragmented bank regulatory system we now have, this body would need access to information about the state of all deposit taking institutions. The reality of the interagency environment is that for information to flow freely, all the agencies involved need some level of involvement with the agency seeking the information. Connected with the information sharing issue is expertise. It is unlikely a systemic risk regulator would develop deep enough expertise on its own in all the possible relevant areas of financial activity. To be effective it would need to cooperate in the most serious way possible with all the routine regulators where the relevant expertise would be resident. Second, this coordinating body must be fully public. While many have argued the need for this body to be fully public in the hope that would make for a more effective regulatory culture, the TARP experience highlights a much more bright line problem. An effective systemic risk regulator must have the power to bail out institutions, and the experience of the last year is that liquidity provision is simply not enough in a real crisis. An organization that has the power to expend public funds to rescue private institutions must be a public organization--though it should be insulated from politics much as our other financial regulatory bodies are by independent agency structures. Here is where the question of the role of the Federal Reserve comes in. A number of commentators and Fed officials have pointed out that the Fed has to be involved in any body with rescue powers because any rescue would be mounted with the Fed's money. However, the TARP experience suggests this is a serious oversimplification. While the Fed can offer liquidity, many actual bailouts require equity infusions, which the Fed cannot currently make, nor should it be able to, as long as the Fed continues to seek to exist as a not entirely public institution. In particular, the very bank holding companies the Fed regulates are involved in the governance of the regional Federal Reserve Banks that are responsible for carrying out the regulatory mission of the Fed, and would if the current structure were untouched, be involved in deciding which member banks or bank holding companies would receive taxpayer funds in a crisis. These considerations also point out the tensions that exist between the Board of Governors of the Federal Reserve System's role as central banker, and the great importance of distance from the political process, and the necessity of political accountability and oversight once a body is charged with dispersing the public's money to private companies that are in trouble. That function must be executed publicly, and with clear oversight, or else there will be inevitable suspicions of favoritism that will be harmful to the political underpinnings of any stabilization effort. One benefit of a more collective approach to systemic risk monitoring is that the Federal Reserve Board could participate in such a body while having to do much less restructuring that would likely be problematic in terms of its monetary policy activity. On the issue of whether to identify and separately regulate systemically significant firms, another lesson of the last eighteen months is that the decision as to whether some or all of the investors and creditors of a financial firm must be rescued cannot be made in advance. In markets that are weak or panicked, a firm that was otherwise seen as not presenting a threat of systemic contagion might be seen as doing just that. Conversely, in a calm market environment, it maybe the better course of action to let a troubled firm go bankrupt even if it is fairly large. Identifying firms (ITAL)ex ante as systemically significant also makes the moral hazard problems much more intense. An area the Congressional Oversight Panel did not address explicitly is whether effective systemic risk management in a world of diversified institutions would require some type of universal systemic risk insurance program or tax. Such a program would appear to be necessary to the extent the federal government is accepting it may be in a position of rescuing financial institutions in the future. Such a program would be necessary both to cover the costs of such interventions and to balance the moral hazard issues associated with systemic risk management. However, there are practical problems defining what such a program would look like, who would be covered and how to set premiums. One approach would be to use a financial transactions tax as an approximation. The global labor movement has indicated its interest in such a tax on a global basis, in part to help fund global reregulation of financial markets. More broadly, these issues return us to the question of whether the dismantling of the approach to systemic risk embodied in the Glass-Steagall Act was a mistake. We would appear now to be in a position where we cannot wall off more risky activities from less risky liabilities like demand deposits or commercial paper that we wish to ensure. On the other hand, it seems mistaken to try and make large securities firms behave as if they were commercial banks. Those who want to maintain the current dominance of integrated bank holding companies in the securities business should have some burden of explaining how their securities businesses plan to act now that they have an implicit government guaranty. Finally, the AFL-CIO believes very strongly that the regulation of the shadow markets, and of the capital markets as a whole cannot be shoved into the category labeled ``systemic risk regulation,'' and then have that category be effectively a sort of night watchman effort. The lesson of the failure of the Federal Reserve to use its consumer protection powers to address the rampant abuses in the mortgage industry earlier in this decade is just one of several examples going to the point that without effective routine regulation of financial markets, efforts to minimize the risk of further systemic breakdowns are unlikely to succeed. We even more particularly oppose this type of formulation that then hands responsibility in the area of systemic risk regulation over to self-regulatory bodies. As Congress moves forward to address systemic risk management, one area that we believe deserves careful consideration is how much power to give to a body charged with systemic risk management to intervene in routine regulatory policies and practices. We strongly agree with Professor Coffee's testimony that a systemic risk regulator should not have the power to override investor or consumer protections. However, there are a range of options, ranging from power so broad it would amount to creating a single financial services superregulator, e.g., vesting such power in staff or a board chairman acting in an executive capacity, to arrangements requiring votes or supermajorities, to a system where the systemic risk regulator is more of scout than a real regulator, limited in its power to making recommendations to the larger regulatory community. The AFL-CIO would tend to favor a choice somewhere more in the middle of that continuum, but we think this is an area where further study might help policymakers formulate a well-founded approach. Finally, with respect to the jurisdiction and the reach of a systemic risk regulator, we believe it must not be confined to institutions per se, or products or markets, but must extend to all financial activity. In conclusion, the Congressional Oversight Panel's report lays out some basic principles that as a Panel member I hope will be of use to this Committee and to Congress in thinking through the challenges involved in rebuilding a more comprehensive approach to systemic risk. The AFL-CIO is very concerned that as Congress approaches the issue of systemic risk it does so in a way that bolsters a broader reregulation of our financial markets, and does not become an excuse for not engaging in that needed broader reregulation.AFL-CIO Executive Council Statement--Miami, Florida--March 5, 2009Bank Bailouts There has been a dramatic concentration of banking power since the Gramm-Leach-Bliley Act repealed New Deal bank regulation. More than 43 percent of U.S. bank assets are held by just four institutions: Citigroup, Bank of America, Wells Fargo and JPMorgan Chase. When these institutions are paralyzed, our whole economy suffers. When banks appear on the brink of collapse, as several have repeatedly since September, government steps in. The free market rules that workers live by do not apply to these banks. Since Congress passed financial bailout legislation in October, working people have seen our tax dollars spent in increasingly secretive ways to prop up banks that we are told are healthy, until they need an urgent bailout. In some instances, institutions that were bailed out need another lifeline soon after. The Congressional Oversight Panel, charged with overseeing the bailout, recently found that the Federal Government overpaid by $78 billion in acquiring bank stock. The AFL-CIO believes government must intervene when systemically significant financial institutions are on the brink of collapse. However, government interventions must be structured to protect the public interest, and not merely rescue executives or wealthy investors. This is an issue of both fairness and our national interest. It makes no sense for the public to borrow trillions of dollars to rescue investors who can afford the losses associated with failed banks. The most important goal of government support must be to get banks lending again by ensuring they are properly capitalized. This requires forcing banks to acknowledge their real losses. By feeding the banks public money in fits and starts, and asking little or nothing in the way of sacrifice, we are going down the path Japan took in the 1990s--a path that leads to ``zombie banks'' and long-term economic stagnation. The AFL-CIO calls on the Obama administration to get fair value for any more public money put into the banks. In the case of distressed banks, this means the government will end up with a controlling share of common stock. The government should use that stake to force a cleanup of the banks' balance sheets. The result should be banks that can either be turned over to bondholders in exchange for bondholder concessions or sold back into the public markets. We believe the debate over nationalization is delaying the inevitable bank restructuring, which is something our economy cannot afford. A government conservatorship of the banks has been endorsed by leading economists, including Nouriel Roubini, Joseph Stiglitz, and Paul Krugman. Even Alan Greenspan has stated it will probably be necessary. The consequences of crippled megabanks are extraordinarily serious. The resulting credit paralysis affects every segment of our economy and society and destroys jobs. We urge President Obama and his team to bring the same bold leadership to bear on this problem as they have to the problems of economic stimulus and the mortgage crisis.AFL-CIO Executive Council Statement--Miami, Florida--March 5, 2009Financial Regulation Deregulated financial markets have taken a terrible toll on America's working families. Whether measured in lost jobs and homes, lower earnings, eroding retirement security, or devastated communities, workers have paid the price for Wall Street's greed. But in reality, the cost of deregulation and financial alchemy are far higher. The lasting damage is in missed opportunities and investments not made in the real economy. While money poured into exotic mortgage-backed securities and hedge funds, our pressing need for investments in clean energy, infrastructure, education, and health care went unmet. So the challenge of reregulating our financial markets, like the challenge of restoring workers' rights in the workplace, is central to securing the economic future of our country and the world. In 2006, while the Bush administration was in the midst of plans for further deregulation, the AFL-CIO warned of the dangers of unregulated, leveraged finance. That call went unheeded as the financial catastrophe gathered momentum in 2007 and 2008, and now a different day is upon us. The costs of the deregulation illusion have become clear to all but a handful of unrepentant ideologues, and the public cast its votes in November for candidates who promised to end the era of rampant financial speculation and deregulation. In October, when Congress authorized the $700 billion financial bailout, it also established an Oversight Panel to both monitor the bailout and make recommendations on financial regulatory reform. The panel's report lays the foundation for what Congress and the Obama administration must do. First, we must recognize that financial regulation has three distinct purposes: (1) ensuring the safety and soundness of insured, regulated institutions; (2) promoting transparency in financial markets; and (3) guaranteeing fair dealing in financial markets, so investors and consumers are not exploited. In short, no gambling with public money, no lying and no stealing. To achieve these goals, we need regulatory agencies with focused missions. We must have a revitalized Securities and Exchange Commission (SEC), with the jurisdiction to regulate hedge funds, derivatives, private equity, and any new investment vehicles that are developed. The Commodity Futures Trading Commission should be merged with the SEC to end regulatory arbitrage in investor protection. Second, we must have an agency focused on protecting consumers of financial services, such as mortgages and credit cards. We have paid a terrible price for treating consumer protection as an afterthought in bank regulation. Third, we need to reduce regulatory arbitrage in bank regulation. At a minimum, the Office of Thrift Supervision, the regulator of choice for bankrupt subprime lenders such as Washington Mutual and IndyMac, should be consolidated with other federal bank regulators. Fourth, financial stability must be a critical goal of financial regulation. This is what is meant by creating a systemic risk regulator. Such a regulator must be a fully public agency, and it must be able to draw upon the information and expertise of the entire regulatory system. While the Federal Reserve Board of Governors must be involved in this process, it cannot undertake it on its own. We must have routine regulation of the shadow capital markets. Hedge funds, derivatives, and private equity are nothing new--they are just devices for managing money, selling insurance and securities, and engaging in the credit markets without being subject to regulation. As President Obama said during the campaign, ``We need to regulate institutions for what they do, not what they are.'' Shadow market institutions and products must be subject to transparency and capital requirements and fiduciary duties befitting what they are actually doing. Reform also is required in the incentives governing key market actors around executive pay and credit rating agencies. There must be accountability for this disaster in the form of clawbacks for pay awarded during the bubble. According to Bloomberg, the five largest investment banks handed out $145 billion in bonuses in the 5 years preceding the crash, a larger amount than the GDP of Pakistan and Egypt. Congress and the administration must make real President Obama's commitment to end short-termism and pay without regard to risk in financial institutions. The AFL-CIO recently joined with the Chamber of Commerce and the Business Roundtable in endorsing the Aspen Principles on Long-Term Value Creation that call for executives to hold stock-based pay until after retirement. Those principles must be embodied in the regulation of financial institutions. We strongly support the new SEC chair's effort to address the role played by weak boards and CEO compensation in the financial collapse. With regard to credit rating agencies, Congress must end the model where the issuer pays. Financial reregulation must be global to address the continuing fallout from deregulation. The AFL-CIO urges the Obama administration to make a strong and enforceable global regulatory floor a diplomatic priority, beginning with the G-20 meeting in April. The AFL-CIO has worked closely with the European Trade Union Congress and the International Trade Union Confederation in ensuring that workers are represented in this process. We commend President Obama for convening the President's Economic Recovery Advisory Board, chaired by former Federal Reserve Chair Paul Volcker, author of the G-30 report on global financial regulation, and we look forward to working with Chairman Volcker in this vital area. Reregulation requires statutory change, regulatory change, institutional reconstruction and diplomatic efforts. The challenge is great, but it must be addressed, even as we move forward to restore workers' rights and revive the economy more broadly. ______ CHRG-111hhrg46820--97 OF COMMERCE Ms. Dorfman. Chairwoman Velazquez, Ranking Member Graves, members of the committee, thank you again for the opportunity to speak on behalf of America's small business owners at this important time. The future of America small businesses are in your hands. Through your earnest work towards the promotion of economic recovery, you will profoundly influence the future of millions of small businesses and their employees and their families and communities. Literally, the future of the American dream is in your hands today. We all know too well the challenging economic times we are in and the need to act swiftly, strongly and with focused precision to bring about economic recovery. Time is of the essence for Congress and the incoming administration to act. Consumer spending is down. Many of the States, cities and counties have budget shortfalls which will cause local government spending to decline. Unemployment is up, business lending is in a free fall, commodities and health care costs are rising and business margins are declining. To promote an economic recovery, we encourage you to consider policies and investments that will energize consumer, business and government spending, jump start lending, and return liquidity to the lending markets, and bring down the cost of doing business. The Small Business Administration and targeted small business policies can have a great impact in these areas. First, I ask you to support targeted small business spending as we leverage investments in infrastructure, new energy technology and health technology. It is vitally important that we ensure an appropriate percentage of these investments be made with small businesses. It has been discussed that a sizeable amount of the investment in our economic recovery will come through the funding of State and local government infrastructure needs. This committee should assure that these funds at both Federal and local levels require the Federal mandated 23 percent participation by small business and that all socioeconomic goals be met without exception. Next, as small business lending is in a free fall, it will require very strong action to stop. Loan volume has dropped dramatically, thanks in large part to the collapse of the secondary market for small business loans. And this free fall has brought about other negatives as well. We strongly recommend that the SBA act as a catalyst, disburse small business lending. The SBA should directly process small business loans and, when necessary, provide high government guarantees. Let the SBA fully process and close loans, providing the loan as an asset for purchase by the bank. We recommend that funds allocated towards unfreezing secondary markets include appropriate requirements for inclusion of small business lending. There must be secondary market participation so that lenders can sell portions of these assets to make new funds available for additional loans. The SBA should also establish programs and guarantees to bolster confidence in the secondary markets so as to encourage investor participation and increased liquidity. To further drive liquidity and prevent against the potential of rising default, the SBA should be able to engage in refinancing and underwriting, enabling lenders and borrowers to leverage this option to save the loan relationship and prevent default or bankruptcy. The SBA should also relax the rules on refinancing and be able to raise their guarantee so as to bring greater elasticity and save loan relationships. For example, many small business owners have turned to credit cards to cover their cash flow shortfalls and in many instances the equity in their home that was leveraged to establish a loan may have declined. We also recommend that the SBA relax some of the rules that add cost and delays to securing a loan like life insurance requirements and job creation requirements. The final area of attention should be bringing down the cost of doing business. We recommend a combination of tools be used to decrease the cost of doing business generally and decrease the cost associated with keeping employees. We support the reduction in short-term suspension of payroll tax, the abolishment of self-employee tax on health insurance, giving small businesses the ability and incentives to form their own health insurance groups, and extending the net operating cost carry back rules for longer terms. In closing, I ask you to act now. As we watch the falling business lending statistics and the climbing unemployment numbers, I can assure you that the next fatality will be marked by a declining number of small businesses and increased number of business and personal bankruptcies. The majority of the recommendations I have outlined today are short-term positions aimed at getting small business lending moving quickly, improving small business cash flows, and assuring that the one-time big investment in infrastructure includes small businesses. As you complete the work on legislation to spur on economic recovery, please save the broader strategic moves for later. For now, just focus on specific steps to help small businesses get moving back into a positive direction. Thank you. [The statement of Ms. Dorfman is included in the appendix at page 97.] " CHRG-111hhrg55811--22 Mr. Hu," Thank you, Mr. Chairman. Chairman Frank, Ranking Member Bachus, and members of the committee, thank you for the opportunity to testify on behalf of the Securities and Exchange Commission concerning the Over-the-Counter Derivatives Markets Act of 2009 proposed in August by the Treasury Department, and the discussion draft recently circulated by the chairman. I am especially pleased to appear with CFTC Chairman Gary Gensler, with whom the SEC has worked closely over the last several months on a variety of issues. Both of our Commissions are eager to address these issues and ensure that remaining differences are justified by meaningful distinctions between markets and products. As you know, the recent financial crisis revealed serious weaknesses in the U.S. financial regulation, including gaps in the regulatory structure. Both the SEC and the CFTC are fully committed to filling gaps and shoring-up the regulatory system. One significant gap is the lack of regulation of OTC derivatives, which were largely excluded from the regulatory framework in 2000 by the Commodity Futures Modernization Act. OTC derivatives present a number of risks. They can facilitate significant leverage, enable concentrations of risk, and behave unexpectedly in times of crisis. And while some derivatives can reduce certain risks, they can also cause others. Importantly, these risks are heightened by the lack of regulatory oversight of dealers and other market participants--a combination that can lead to insufficient capital, inadequate risk management standards, and associated failures cascading through the global financial system. Lastly, the largely unregulated derivatives market can also undermine the regulated securities and futures markets by luring participants to a less-regulated alternative. The discussion draft is an important step forward in improving transparency and establishing the necessary regulatory framework. While it would go a long way towards improving the regulation of OTC derivatives, I believe it should be strengthened in several ways. First, to minimize regulation arbitrage, swaps should be regulated like their underlying references. Market participants often view derivatives and the underlying assets they reference as substitutes. Whether the participation is direct or indirect, the same or similar economic effects can often be achieved. As a result, even subtle differences in the regulation of economic substitutes can lead to gaming advantages for any one participant. But that participant's regulatory arbitrage activity, and a general migration to the less-regulated derivatives markets, can undermine the interest of other participants, as well as everyone's interest in minimizing fraud and systemic risk. The easiest way to achieve this goal is to move over the existing securities regime to securities-related swaps. If Congress decides to retain the bill's existing rulemaking framework, it should include these swaps within the definition of securities within the Federal securities laws. This will ensure that existing protections and authority can automatically flow through to these products. Exemptions could be provided where needed. I believe it is better to start from an existing framework for substantially similar products than to start from scratch not knowing what might be missed in some cross reference, not knowing what future financial innovation may bring. Second, it is essential that the legislation address anti-fraud authority matters and provide the tools needed to appropriately enforce anti-fraud authority. The discussion draft seeks to retain certain existing anti-fraud authority over, for instance, certain broad-based swaps, but may have inadvertently weakened that authority over certain other related swaps. The SEC should also have the tools needed to effectively exercise the anti-fraud authority. The discussion draft recognizes the importance of inspections and examinations of swap dealers and major participants to the SEC. We recommend that this authority be extended to central counterparties and swap repositories, so that regulators can have quick access to comprehensive data. Third, the discussion draft should clarify that the definition of ``securities-based swap'' includes not only single and narrow-based credit default swaps but broad-based credit default swaps where payment is triggered by a single security or small group of securities. Fourth, the legislation should narrow the ``risk management'' exclusion for major swap participants. Regulation of major swap participants and dealers is a vital part of the OTC regulatory regime. We do understand that there may be entities that use swaps that should not fall into this new framework. The discussion draft, however, effectively provides an exclusion for major participants who hold positions, ``for risk management purposes.'' The term ``risk management'' is ambiguous and could cause a large number of important entities to fall outside this new regime. Finally, the legislation should direct regulators to adopt stronger business conduct rules to protect less sophisticated investors and end-users. In closing, this proposal makes significant strides towards addressing current problems in the OTC derivatives marketplace. I look forward to continuing to work with this committee, the Congress, the Treasury, and the CFTC to enact strong legislation in this area. Thank you for the opportunity to testify here today. I look forward to answering your questions. [The prepared statement of Mr. Hu can be found on page 147 of the appendix.] " CHRG-111shrg56376--233 PREPARED STATEMENT OF RICHARD S. CARNELL Associate Professor, Fordham University School of Law September 29, 2009 Mr. Chairman, Senator Shelby, Members of the Committee: You hold these hearings in response to an extraordinary financial debacle, costly and far-reaching: a debacle that has caused worldwide pain and will saddle our children with an oversized public debt. ``And yet,'' to echo President Franklin D. Roosevelt's inaugural address, ``our distress comes from no failure of substance. We are stricken by no plague of locusts. . . . Plenty is at our doorstep.'' Our financial system got into extraordinary trouble--trouble not seen since the Great Depression--during a time of record profits and great prosperity. This disaster had many causes, including irrational exuberance, poorly understood financial innovation, loose fiscal and monetary policy, market flaws, regulatory gaps, and the complacency that comes with a long economic boom. But our focus here is on banking, where the debacle was above all a regulatory failure. Banking is one of our most heavily regulated industries. Bank regulators had ample powers to constrain and correct unsound banking practices. Had regulators adequately used those powers, they could have made banking a bulwark for our financial system instead of a source of weakness. In banking, as in the system as a whole, we have witnessed the greatest regulatory failure in history. Our fragmented bank regulatory structure contributed to the debacle by impairing regulators' ability and incentive to take timely preventive action. Reform of that structure is long overdue. In my testimony today, I will: 1. Note how regulatory fragmentation has grave defects, arose by happenstance, and persists not on its merits but through special-interest politics and bureaucratic obduracy; 2. Recommend that Congress unify banking supervision in a new independent agency; and 3. Reinforce the case for reform by explaining how regulatory fragmentation helps give regulators an unhealthy set of incentives--incentives that hinder efforts to protect bank soundness, the Federal deposit insurance fund, and the taxpayers.I. Fragmentation Impedes Effective SupervisionFragmentation Is Dysfunctional Our fragmented bank regulatory structure is needlessly complex, needlessly expensive, and imposes needless compliance costs on banks. It ``requires too many banking organizations to deal with too many regulators, each of which has overlapping, and too often maddeningly different, regulations and interpretations,'' according to Federal Reserve Governor John LaWare. It engenders infighting and impedes prudent regulatory action. FDIC Chairman William Seidman deplored the stubbornness too often evident in interagency negotiations: ``There is no power on earth that can make them agree--not the President, not the Pope, not anybody. The only power that can make them agree is the Congress of the United States by changing the structure so that the present setup does not continue.'' The current structure promotes unsound laxity by setting up interagency competition for bank clientele. It also blunts regulators' accountability with a tangled web of overlapping jurisdictions and responsibilities. Comptroller Eugene Ludwig remarked that ``it is never entirely clear which agency is responsible for problems created by a faulty, or overly burdensome, or late regulation. That means that the Congress, the public, and depository institutions themselves can never be certain which agency to contact to address problems created by a particular regulation.'' Senator William Proxmire, longtime Chairman of this Committee, called this structure ``the most bizarre and tangled financial regulatory system in the world.'' Treasury Secretary Lloyd Bentsen branded it ``a spider's web of overlapping jurisdictions that represents a drag on our economy, a headache for our financial services industry, and a source of friction within our Government.'' Chairman Seidman derided it as ``complex, inefficient, outmoded, and archaic.'' The Federal Reserve Board declared it ``a crazy quilt of conflicting powers and jurisdictions, of overlapping authorities, and gaps in authority'' (and that was in 1938, when the system was simpler than now). Federal Reserve Vice Chairman J.L. Robertson went further: The nub of the problem . . . is the simple fact that we are looking for, talking about, and relying upon a system where no system exists. . . . Our present arrangement is a happenstance and not a system. In origin, function, and effect, it is an amalgam of coincidence and inadvertence. Opponents of reform portray a unified supervisory agency as ominous and unnatural. Yet although the Federal Government regulates a wide array of financial institutions, no other type of institution has competing Federal regulators. Not mutual funds, exchange-traded funds, or other regulated investment companies. Not securities broker-dealers. Not investment advisers. Not futures dealers. Not Government-sponsored enterprises. Not credit unions. Not pension funds. Not any other financial institution. A single Federal regulator is the norm; competition among Federal regulators is an aberration of banking. Nor do we see competition among Federal regulators when we look beyond financial services--and for good reason. Senator Proxmire observed: Imagine for a moment that we had seven separate and distinct Federal agencies for regulating airline safety. Imagine further the public outcry that would arise following a series of spectacular air crashes while the seven regulators bickered among themselves on who was to blame and what was the best way to prevent future crashes. There is no doubt in my mind that the public would demand and get a single regulator. There is a growing consensus among experts that our divided regulatory system is a major part of the problem. There are many reasons for consolidating financial regulations, but most of them boil down to getting better performance.Fragmentation Is the Product of Happenstance Two forces long shaped American banking policy: distrust of banks, particularly large banks; and crises that necessitated a stronger banking system. Our fragmented regulatory structure reflects the interplay between these forces. As FDIC Chairman Irvine H. Sprague noted, this structure ``had to be created piecemeal, and each piece had to be wrested from an economic crisis serious enough to muster the support for enactment.'' Distrust of banking ran deep from the beginning of the Republic. John Adams, sober and pro-business, declared that ``banks have done more injury to the religion, morality, tranquility, prosperity, and even wealth of the Nation than they have done or ever will do good.'' Thomas Jefferson asserted that states ``may exclude [bankers] from our territory, as we do persons afflicted with disease.'' Andrew Jackson won reelection pledging to destroy the Nation's central bank, which he likened to a malicious monster. This powerful, longstanding distrust of banking shaped U.S. law in ways that, until recent decades, kept U.S. banks smaller and weaker (relative to the size of our economy) than their counterparts in other developed countries. Yet banking proved too useful to ignore or suppress. To cope with financial emergencies, Congress acted to strengthen the banking system. It created: National banks to finance the Civil War and the OCC to supervise national banks; The Federal Reserve in response to the Panic of 1907; The FDIC, its thrift-institution counterpart, and the Federal thrift charter to help stabilize the financial system during the Great Depression; and The Office of Thrift Supervision in response to the thrift debacle of the 1980s.These and other ad hoc actions gave us a hodgepodge of bank regulatory agencies unparalleled in the world. Each agency, charter type, and regulatory subcategory developed a political constituency resistant to reform. The Bank Holding Company Act, another product of happenstance, exacerbated this complexity. It ultimately gave most banking organizations of any size a second Federal regulator: the Federal Reserve Board. As enacted in 1956, the Act sought to prevent ``undue concentration of economic power'' by limiting banks' use of holding companies to enter additional businesses and expand across State lines. The Act reflected a confluence of three disparate forces: populist suspicion of bigness in banking; special-interest politics; and the Federal Reserve Board's desire to bolster its jurisdiction. Representative Wright Patman, populist chairman of the House Banking Committee, sought to prevent increased concentration in banking and the broader economy. Small banks sought to keep large banks from expanding into new products and territory. A variety of other firms sought to keep banks out of their businesses. The Fed gained both expanded jurisdiction and a respite from Chairman Patman's attempts to curtail its independence in monetary policy. \1\ The Act originally applied only to companies owning two or more banks. But in 1970 Congress extended the Act to companies owning a single bank.--------------------------------------------------------------------------- \1\ Mark J. Roe, ``Strong Managers, Weak Owners: The Political Roots of American Corporate Finance'', 99-100 (1994).---------------------------------------------------------------------------Special-Interest Politics Perpetuate Fragmentation Regulatory fragmentation leaves individual agencies smaller, weaker, and more vulnerable to pressure than a unified agency would be. It can also undercut their objectivity. Fragmentation played a pivotal role in the thrift debacle. Specialized thrift regulators balked at taking strong, timely action against insolvent thrifts. Regulators identified with the industry and feared that stern action would sharply shrink the industry and jeopardize their agencies' reason for being. In seeking to help thrifts survive, the regulators multiplied the ultimate losses to the deposit insurance fund and the taxpayers. For example, they granted sick thrifts new lending and investment powers for which the thrifts lacked the requisite competence (e.g., real estate development and commercial real estate lending). By contrast, bank regulators who also regulated thrifts took firmer, more appropriate action (e.g., limiting troubled institutions' growth and closing deeply insolvent institutions). These policies bore fruit in lower deposit insurance losses. State-chartered thrifts regulated by State banking commissioners were less likely to fail--and caused smaller insurance losses--than thrifts with a specialized, thrift-only regulator. Likewise, thrifts regulated by the FDIC fared far better than those regulated by the thrift-only Federal Home Loan Bank Board.II. Unifying Federal Bank Supervision Fragmentation problems have a straightforward, common-sense solution: unifying Federal bank regulation. Treasury Secretary Lloyd Bentsen offered that solution here in this room 15 years ago. As Assistant Secretary of the Treasury for Financial Institutions, I worked with him in preparing that proposal. He made a cogent case then, and I'll draw on it in my testimony now. Secretary Bentsen proposed that we unify the supervision of banks, thrifts, and their parent companies in a new independent agency, the Federal Banking Commission. The agency would have a five-member board, with one member representing the Treasury, one member representing the Federal Reserve, and three independent members appointed by the President and confirmed by the Senate. The President would designate and the Senate confirm one of the independent members to head the agency. The commission would assume all the existing bank regulatory responsibilities of the Comptroller of the Currency, Federal Reserve Board, FDIC, and Office of Thrift Supervision. The Federal Reserve would retain all its other responsibilities, including monetary policy, the discount window, and the payment system. The FDIC would retain all its powers and responsibilities as deposit insurer, including its power to conduct special examinations, terminate insurance, and take back-up enforcement action. The three agencies' primary responsibilities would correspond to the agencies' core functions: bank supervision, central banking, and deposit insurance. This structure would promote clarity, efficiency, accountability, and timely action. It would also help the new agency maintain its independence from special-interest pressure. The agency would be larger and more prominent than its regulatory predecessors and would supervise a broader range of banking organizations. It would thus be less beholden to a particular industry clientele--and more able to carry out appropriate preventive and corrective action. Moreover, a unified agency could do a better job of supervising integrated banking organizations--corporate families in which banks extensively interact with their bank and nonbank affiliates. The agency would look at the whole organization, not just some parts. Secretary Bentsen put the point this way: Under today's bank regulatory system, any one regulator may see only a limited piece of a dynamic, integrated banking organization, when a larger perspective is crucial both for effective supervision of the particular organization and for an understanding of broader industry conditions and trends.Having the same agency oversee banks and their affiliates both simplifies compliance and makes supervision more effective. We have no need for a separate holding company regulator. Under the Bentsen proposal, the Fed and FDIC would have full access to supervisory information about depository institutions and their affiliates. Their examiners could participate regularly in examinations conducted by the commission and maintain their expertise in sizing up banks. As members of a Federal Banking Commission-led team, Fed and FDIC examiners could scrutinize the full spectrum of FDIC-insured depository institutions, including national banks. The two agencies would have all the information, access, and experience needed to carry out their responsibilities. The Treasury consulted closely with the FDIC in developing its 1994 reform proposal. The FDIC supported regulatory consolidation in testimony before this Committee on March 2, 1994. It stressed that in the context of consolidation it had five basic needs. First, to remain independent. Second, to retain authority to set insurance premiums and determine its own budget. Third, to have ``timely access'' to information needed to ``understand and stay abreast of the changing nature of the risks facing the banking industry . . . and to conduct corrective resolution and liquidation activities.'' Fourth, to retain power to grant and terminate insurance, assure prompt corrective action, and take back-up enforcement action. Fifth, to retain its authority to resolve failed and failing banks. A regulatory unification proposal can readily meet all five of those needs. Indeed, Secretary Bentsen's proposal dealt with most of them in a manner satisfactory to the FDIC. The Treasury and FDIC did disagree about FDIC membership on the Federal Banking Commission. The FDIC regarded membership as an important assurance of obtaining timely information. The Treasury proposal did not provide for an FDIC seat, partly out of concern that it would entail expanding the commission to seven members. Now as then, I believe that the agency's board should include an FDIC representative. The Federal Reserve and FDIC complain that they cannot properly do their jobs unless they remain the primary Federal regulator of some fraction of the banking industry. These complaints ignore the sort of safeguards in Secretary Bentsen's proposal. They also exaggerate the significance of the two agencies' current supervisory responsibilities. FDIC-supervised banks hold only 17 percent of all FDIC-insured institutions' aggregate assets; Fed-supervised banks, only 13 percent. Nor does the Fed's bank holding jurisdiction fundamentally alter the picture: the Fed as holding company regulator neither examines nor supervises other FDIC-insured institutions. The Fed and FDIC, in carrying out their core responsibilities, already rely primarily on supervisory information provided by others. Thus it strains credulity to suggest that the FDIC cannot properly carry out its insurance and receivership functions unless it remains the primary Federal regulator of State nonmember banks. These banks, currently numbering 5,040, average $460 million in total assets. How many community banks must the FDIC supervise to remain abreast of industry trends and remember how to resolve a community bank? Likewise, the Fed cannot plausibly maintain that its ability to conduct monetary policy, operate the discount window, and gauge systemic risk appreciably depends on remaining the primary Federal regulator of 860 State member banks (only 10 percent of FDIC-insured institutions), particularly when those banks average less than $2 billion in total assets. Moreover, according to the most recent Federal Reserve Flow of Funds accounts, the entire commercial banking industry (including U.S.-chartered commercial banks, foreign banks' U.S. offices, and bank holding companies) holds only some 18 percent of our Nation's credit-market assets. In sum, the two agencies' objections to reform ring false. They are akin to saying, ``I can't do my job right without being the supreme Federal regulator for some portion of the banking industry, small though that portion may be. Nothing else will do.'' Nor do regulatory checks and balances depend on perpetuating our multiregulator jumble. ``Regulatory power is not restrained by creating additional agencies to perform duplicate functions,'' Secretary Bentsen rightly declared. A unified banking supervisor would face more meaningful constraints from ``congressional oversight, the courts, the press, and market pressures.'' Its decision making would also, under my recommendations, include the insights, expertise, and constant participation of the Federal Reserve Board and FDIC.III. Regulatory Fragmentation Promotes Unsound Laxity Most debate about banking regulation pays little heed to bank regulators' incentives. That's a serious mistake, all the more so given the recent debacle. As noted at the outset, regulators had ample powers to keep banks safe but failed to do so. This failure partly involved imperfect foresight (an ailment common to us all). But it also reflected an unhealthy set of incentives--incentives that tend to promote unsound laxity. These incentives discouraged regulators from taking adequate steps to protect bank soundness, the Federal deposit insurance fund, and the taxpayers. Economists refer to such incentives as ``perverse'' because they work against the very goals of banking regulation. These incentives represent the regulatory counterpart of moral hazard. Just as moral hazard encourages financial institutions to take excessive risks, these incentives discourage regulators from taking adequate precautions. To improve regulation, we need to give regulators a better set of incentives--incentives more compatible with protecting the FDIC and the taxpayers. Several key factors create perverse incentives for bank regulators. First, we have difficulty telling good regulation from bad--until it's too late. Second, lax regulation is more popular than stringent regulation--until it's too late. Third, regulators' reputations suffer less from what goes wrong on their watch than from what comes to light on their watch. This is the upshot: Bank Soundness Regulation Has No Political Constituency--Until It's Too Late. To make the incentive problem more concrete, put yourself in the position of a regulator who, during a long economic boom and a possible real estate bubble, sees a need to raise capital standards. The increase will have short-term, readily identifiable consequences. To comply with the new standards, banks may need to constrain their lending and reduce their dividends. Prospective borrowers will complain. Banks' return on equity will decline because banks will need more equity per dollar of deposits. Hence bankers will complain. You'll feel immediate political pain. Yet the benefits of higher capital standards, although very real, will occur over the long run and be less obvious than the costs. Raising capital levels will help protect the taxpayers, but the taxpayers won't know it. Moreover, in pressing weaker banks to shape up and in limiting the flow of credit to real estate, you may get blamed for causing problems that already existed. From the standpoint of your own self-interest, you're better off not raising capital standards. You can leave office popular. By the time banks get into trouble, you'll have a new job and your successor will have to shoulder the problem. Similar incentives encourage too-big-to-fail treatment. Bailouts confer immediate, readily identifiable benefits. By contrast, the costs of intervention (such as increased moral hazard and potential for future instability) are long-term, diffuse, and less obvious. But you can leave those problems for another day and another regulator. You risk criticism whether or not you intervene. But on balance you run a greater risk of destroying your reputation if you let market discipline take its course. Unwarranted intervention may singe your career; a seemingly culpable failure to intervene will incinerate it. Bank regulators need better incentives far more than they need new regulatory powers. Creating a unified regulator will make for a healthier set of incentives.Conclusion Now is the right time to fix the bank regulatory structure: now, while we're still keenly aware of the financial debacle; now, while special-interest pressure and bureaucratic turf struggles are less respectable than usual. Reform should promote efficiency, sharpen accountability, and help regulators withstand special-interest pressure. Speaking from this table in 1994, Secretary Bentsen underscored the risk of relying on ``a dilapidated regulatory system that is ill-designed to prevent future banking crises and ill-equipped to cope with crises when they occur.'' He observed, in words eerily applicable to the present, that our country had ``just emerged from its worst financial crisis since the Great Depression,'' a crisis that our cumbersome bank regulatory system ``did not adequately anticipate or help resolve.'' He also issued this warning, which we would yet do well to heed: ``If we fail to fix [the system] now, the next financial crisis we face will again reveal its flaws. And who suffers then? Our banking industry, our economy, and, potentially, the taxpayers. You have the chance to help prevent that result.'' PREPARED STATEMENT OF RICHARD J. HILLMAN Managing Director, Financial Markets and Community Investment Team, Government Accountability Office September 29, 2009" FOMC20070628meeting--158 156,MR. LACKER.," Thank you, Mr. Chairman. Before I talk about policy, let me just note that it has been a tremendous pleasure being a colleague of President Minehan over the years and being an immediate neighbor of hers—[laughter]—at Federal Open Market Committee meetings. For one thing, she has done a great job as buffer between me and the President of the New York Bank. [Laughter]" FOMC20080430meeting--172 170,MR. EVANS.," Thank you, Mr. Chairman. I, too, favor maintaining the federal funds rate at 2� percent today. The current real interest rate provides accommodative monetary conditions for an economy that is struggling near recession or is in mild recession. Our lending facilities are probably doing as much as can be expected to mitigate the serious and necessary financial adjustments that must be accomplished by the private markets. If the economy takes another serious leg down, our current funds rate setting is well positioned for us to respond promptly, appropriately, and aggressively, if circumstances warrant. A pause today affords us a unique opportunity to wait and see how our recent aggressive actions are influencing the trajectory of real activity. Since markets are putting substantial weight on a 25 basis point easing today, a pause will be a relatively small disappointment. As President Plosser pointed out, that was similar to our March disappointment, which seemed to be all right. I think it is important for us to understand how the economy will respond to a pause in rate-cutting when it does occur. With high food, energy, and commodity prices, the extended positive differential of headline inflation over core measures risks an increase in the public's inflation expectations. I agree with President Plosser's discussion of relative prices on that front. From a longer-term perspective, which we don't really talk about very often, I worry about the asymmetric response of policy to high inflation as opposed to when it is low. When headline inflation is above core inflation, we take on board the relative price adjustment, and then we are content, I would guess, to bring inflation down to our perceived inflation targets. But on the downside, when inflation gets low, we become uncomfortable with certain low inflation settings, and so I fear that we would respond more aggressively, as we did in 2003, which really was a positive productivity environment. If you have an asymmetric type of response, you are going to take on board increases in the price level because of that asymmetry. That's one reason that I am concerned about these types of behaviors. Although I expect emerging resource slack to temper any adverse inflation developments, the risk is simply growing in importance with every additional policy easing, compared with the economic risks, which presumably are abating as we respond to them with such easings. Calibrating the current policy stance against these divergent economic and inflation risks is important and challenging, as you pointed out yesterday, Mr. Chairman. I think that comparisons to the rate troughs in the previous cycles of recession policy are instructive. The current real fed funds rate is somewhere in the neighborhood of zero, or it could be lower if you choose a different way to deflate the funds rate by total inflation. I was very impressed with Dave Stockton's response to my question about what types of factors from financial market stress are embodied in the Greenbook-consistent real interest rate. It seems as though a tremendous amount of care has been taken to introduce some of these special factors in innovative ways, and while they may not capture all facets of that, I thought that they did quite a good job. So I feel a bit more comfortable in making those comparisons, but I do recognize that it is a treacherous period. That said, this is about the same place the real funds rate bottomed out during the jobless recovery with financial headwinds in the 1990�91 recession, and with the data we had in hand at the time during the disinflation concerns in 2003. Both periods were unique in suggesting a high degree of accommodation, and the factors that were at work in each of those episodes were unique. Our attempt to incorporate these factors has been quite useful, and so it's a reasonable, if not definitive, comparison. With our current lending facilities addressing financial stress, I think our current policy accommodation, now at 2� percent, is appropriately similar to those episodes. My final observation has to do with these end-of-cycle expectations and what they might mean for long-term interest rates. If 25 basis points is viewed as additional insurance against downside risks, I just don't think this action is significant enough to have much of an effect. We expect to take back some portion of the aggressive cuts, especially the ones that have been an attempt to respond to the financial stress. If the financial stress is mitigated to some extent, we should be expected to take that back. Expectations, as in the fed funds futures market, should limit the effect of those actions on long-term interest rates. After all, by the expectations hypothesis, you are going to be averaging these short-term paths into long-term rates. That is one reason that the Committee injected the language ""considerable period"" back in 2003, to try to convince people that we would do this for a longer period of time and affect long-term rates. So if there is an expectation of some type of rebound, these last insurance cuts might not have that large an effect. Again, I think our lending facilities are better geared for the financial stress. I think we have clearly demonstrated our willingness to provide appropriately accommodative policies in a timely fashion when the economic situation demanded it. For me, the public's expectation of these actions in that event argues against one further small insurance move. Because we are concerned about inflation risks and have indicated that we must flexibly move toward more-neutral policy stances once the economy and financial markets improve, a pause today is a small down payment on those difficult future actions. In terms of language, if it came to that, I would be comfortable with the language of alternative B with this particular rate action. Thank you, Mr. Chairman. " FOMC20060131meeting--31 29,MR. KOS.,"Richmond Bank is dissenting. Dino Kos. 1 Thank you, Mr. Chairman. With the start of the new year, domestic markets were preoccupied with the same set of questions that occupied market participants in 2005. How much longer would the tightening cycle continue? What is the shape of the yield curve telling us? Are there signs of a slowdown? And are inflation pressures increasing, or are they likely to ebb? The top panel on the first page graphs the three-month deposit rate in black and the three-month rate three and nine months forward in red since June 2005. As the market began to anticipate an end to the tightening cycle, the cash and forward rates began to converge in recent weeks. With three- and nine-month forwards essentially trading on top of each other, and allowing for term premiums, taken at face value forward rates suggest some more modest tightening but also some probability of an ease later this year. Those market participants that are bearish on interest rates and the economy point to data hinting at softness, such as signs of a slowdown in housing. The bleak view was given a lift on Friday by the weaker-than-forecast fourth-quarter GDP report. These market participants see either a quick end to the tightening cycle or a swift reversal toward policy easing later this year. The counter view is that inflationary pressures will forestall an early end to the tightening, much less usher in a new easing cycle. Ironically those with that view took comfort from the price data in Friday’s GDP report. The compression we see in cash and forward rates at the short end of the curve is also visible for longer maturities. The middle panel graphs the target fed funds rate in green along with yields on two- and ten-year Treasury notes. Yields have slowly been grinding upward the past few days toward 4½ percent as the market, on balance, has come to discount further tightening beyond today’s meeting. In the past week, the yield on the two-year note has risen from about 4.35 percent to 4.5 percent. Given the mixed data, it’s difficult to make the case that the upward move was driven by data alone. Indeed, for the first time in a while, traders were talking about looming supply given fiscal needs. Yesterday the Treasury announced a somewhat higher-than-expected borrowing need for the first quarter. And at last week’s two- year auction, the low level of participation by indirect bidders was taken as a signal 1 The materials used by Mr. Kos are appended to this transcript (appendix 1). that foreign demand was waning. Perhaps market participants are finally coming to the view that yields are too low given the likely prospect that the cost of financing positions will continue to rise at least a while longer. With the convergence of yields along the curve, last summer’s chatter about yield curve inversions flared up anew. The bottom panel graphs two views of the yield curve going back to 1977. The red line graphs the spread between the ten-year note and the three-month bill. The blue line graphs the yield spread between the ten-year and the two-year notes. These are monthly averages, and the last data point is from January 2006 through last Friday. The gray areas denote recessions. Looking at this chart and similar charts, it’s easy to see why the curve flattening has received so much attention. In recent decades, recessions have tended to be preceded by curve inversions. Of course, markets are now so much more developed and sophisticated that maybe it’s different this time. Changes in markets, such as the role of pension funds or central bank reserve accumulation, may be distorting the curve. And maybe that argument is right. But a cautionary point is in order. After all, the inversion in 2000 was dismissed by most analysts as technically inspired given the shrinking stock of federal debt and the Treasury’s buyback program at the long end of the curve. On the other hand, the pessimists may be overplaying their hand too early in the game. We haven’t had much of an inversion as yet. You need a magnifying glass to see the inversion, which is very small and so far very brief. The curve has merely gone flat. As I noted last summer, the curve can be flat for years— as was the case in the late 1990s—without adverse effects on the broader economy. The Chairman has talked about the conundrum, which most private-sector commentators have used as a jumping off point to talk about low nominal yields at the long end of the curve. Until recently, less attention was focused on trends in real rates both here and abroad. The top of page 2 graphs the yield of ten-year inflation-linked securities for the United States, the United Kingdom, and France for the past seven months. The ten- year TIPS yield in the United States (the green line) has traded at about 2 percent. That’s up from about 1 percent briefly observed in 2004 but well below the 4 percent earlier in this decade, when the market was still maturing. U.K. and French real rates have also fallen since the beginning of the decade. The United Kingdom probably has the most developed inflation-linked market, with maturities going as far out as fifty years. The middle panel graphs the real rate on ten-, thirty-, and fifty-year inflation-linked bonds since September 2005. Note that thirty- and fifty-year yields have gone down faster than the yields at the ten-year maturity. The fifty-year real yield traded below ½ percent, and the fifty-year security issued just last week traded under 40 basis points. What accounts for such low rates? Well maybe institutions are worried about the United Kingdom’s long-term inflation prospects. But that does not seem to be borne out by anecdotal or other indicators. Two intertwined trends in the United Kingdom related to the insurance and pension fund businesses are frequently cited. First, after the decline in equity prices earlier in the decade, U.K. and other European insurers lowered allocations to equity and shifted toward fixed income. Second, in the United Kingdom, pension rules now require fund managers to match the duration of liabilities with similar-duration assets. But the shortage of supply relative to demand has pushed bond prices up and yields down. As a result, the very long end of the U.K. real yield curve has been inverted. The long end of the nominal curve, as shown in the bottom left panel, has also inverted. To fill out the picture, the bottom right panel graphs ten-, thirty-, and fifty-year break-even rates; but given the distortions, it’s not clear how much should be read into these numbers. Such movements in U.K. real yields have caught the attention of U.S. portfolio managers. With continued talk about the prospect for changes to pension fund rules here, there are those who believe that the United States will gravitate toward the U.K. approach of requiring the matching of duration for assets and liabilities. If so, then the prospect of a steady bid for long-dated assets may both damp yield volatility at the long end and lower yields from what they might have been. That would truly make the curve very suspect as an indicator of future economic performance. If the shape of the U.S. yield curve is bearish for the economy, there is no shortage of indicators pointing the other way. I will note that in 2000, when the curve last inverted, the stock market soon slumped, credit spreads began a sudden widening, and the dollar was appreciating. In this cycle, these other indicators are not flashing warning lights just yet. The dollar tripped up many forecasters in 2005 by appreciating. But as shown in the top panel on page 3, more recently the dollar has depreciated against most currencies, including a few Asian currencies whose exchange rates against the dollar had been somewhat sticky in the past. Equities have been rallying globally, especially in countries leveraged to the global economy, such as Korea in technology and Brazil in commodities. Even the Nikkei has recovered from its Livedoor-inspired swoon and the curtailment of trading on the Tokyo Stock Exchange due to problems in processing large volumes. Credit markets continue to be favorable. As shown in the bottom left chart, the volatility on the S&P 100 rose from very low levels recently but has already come back. And Treasury volatility— shown on the bottom right—is low and recently has drifted still lower. Moving to page 4, the top panel graphs the high-yield and emerging market debt spreads. These two spreads essentially moved together for several years and were viewed as being of similar riskiness. As shown in the top panel, there was a divergence in mid-2004 when emerging-market yields blew out about 150 basis points. In mid-2005, the divergence cut the other way, with emerging markets outperforming and spreads narrowing to new record lows. While some commentators ascribed the narrowing of emerging-market debt to the search for yield, rising risk appetite, and “excess liquidity,” others pointed to improving fundamentals driven by higher commodity prices, better fiscal performance, lower inflation, and higher reserve levels that insulated these countries from external shocks. The pie charts below attempt to explain, if not justify, the benign explanation. The two middle pie charts show the ratings distribution of the high-yield index as of October 2002 and again as of year-end 2005. The rating distribution of the high-yield index is nearly identical. The two pie charts at the bottom of the page show the rating composition of the emerging-market index as of the same two dates. Note that the share of higher- rated BBB or investment-grade assets in blue grew from 29 to 38 percent. Meanwhile, the share of low-rated B and CCC paper, which accounted for 33 percent of the index in October 2002, shrunk to only 11 percent at year-end. In short, the ratings composition is higher for the emerging-market index relative to the high-yield index in absolute terms, and the trend has been toward relative ratings improvement. Of course, ratings are not the only factor. In a default situation, bondholders of a corporation can often assert their rights and recover meaningful amounts in a bankruptcy process overseen by the courts. In contrast, while countries have the power to tax, the ability of the creditors in a default to recover in negotiations—as we saw with Argentina—may not be as favorable. Finally, a few words about domestic reserves management. On page 5, the top panel graphs the fed funds target in blue, the highs and lows for each day in gray, and the daily effective rate in red. You’ll note that, although the effective rate was generally close to the target in the maintenance period that covered the year-end, there was a bit more variability of rates, usually late in the day, with some tendency for rates to soften. Part of this was related to normal year-end noise. Note also the drift higher in the effective rate ahead of the December FOMC meeting. This reflected the market’s anticipation of the new target rate and the tendency to move the funds rate from the old to the new target rate days before the meeting. The middle panel looks at this phenomenon more closely. It graphs the difference between the market (effective) rate and the target fed funds rates in the days before an FOMC meeting. To make a cleaner comparison, the sample includes only those periods in which the FOMC meeting fell on the first Tuesday of the two-week reserve maintenance period and periods in which there were no high-payment days through the meeting date that might have influenced market conditions. It should be noted that, in all these maintenance periods, the market had come to fully expect a 25 basis point tightening move by the start of the period. The blue line shows, for the 2004 sample dates, the drift higher in the funds rate as the FOMC meeting date gets closer. On average, the funds rate was about 7 basis points firm on the Thursday preceding the meeting and rose to be 21 basis points firm to the old target on the Tuesday meeting date itself. In our 2005 sample, the anticipation effect was even more pronounced in the days ahead of the meeting, with the funds rate 15 basis points firm on the Thursday and the expected move almost fully priced in on the day before the meeting. The bottom panel underscores the difficulty that the Desk faces when it tries to lean against expectations that are so widely held. This graph shows, for the same sample of periods, the amount of average excess reserves in the days leading up to the FOMC meeting. It also shows what more-typical levels of excess reserves look like over the first four days of a maintenance period, based on reserve levels from periods in 2004 and 2005 in which there was no policy change and in which there were no high-payment dates in the first four days. In 2004, the Desk was already providing much higher levels of excess reserves than normal in the days leading up to the FOMC meeting during these periods, in order to mitigate the anticipation effects. And these anticipation effects became even more pronounced in 2005, despite our having increased the levels of excess reserves even further. We tend to believe that the higher anticipation effects seen in 2005 reflected a learning process on the part of market participants since the start of the tightening cycle in mid-2004, as buyers and sellers tested their ability to arbitrage their reserve holdings over more days in the maintenance period around the expected policy change. It’s not clear what the natural limit is to this process. Mr. Chairman, I am happy to report once again that there were no foreign operations in the period. I will need a vote to approve domestic operations. Debby and I are happy to take any questions." CHRG-111shrg54589--140 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM GARY GENSLERQ.1.a. Do you believe the existence of an actively traded cash market is or should be a necessary condition for the creation of a derivative under law and regulation?A.1.a. Answer not received by time of publication.Q.1.b. If not, what specific, objective means besides a cash basis market could or should be used as the underlying relationship for a derivative?A.1.b. Answer not received by time of publication.Q.2. Why should the models to price OTC derivatives not be published? If there is no visible cash basis for a derivative, and the model is effectively the basis, why should the models not be public?A.2. Answer not received by time of publication.Q.3. What is the best way to draw the line between legitimate hedges and purely speculative bets? For example, should we require an insurable interest for purchasers of credit protection, require delivery of the reference asset, or something else?A.3. Answer not received by time of publication.Q.4. Is the concern that increased regulation of derivatives contracts in the United States will just move the business overseas a real issue? It seems to me that regulating the contracts written in the U.S. and allowing American firms to only buy or sell such regulated contracts would solve the problem. What else would need to be done?A.4. Answer not received by time of publication.Q.5. Should parties to derivative contracts be required to post cash collateral, or is other collateral acceptable? And is there any reason not to require segregation of customer collateral?A.5. Answer not received by time of publication.Q.6. Is there any reason standardized derivatives should not be traded on an exchange?A.6. Answer not received by time of publication.Q.7. It seems that credit default swaps could be used to manipulate stock prices. In a simple example, an investor could short a stock, and then purchase credit default swaps on the company. If the swaps are not heavily traded, the purchase would likely drive up the price of the swaps, indicating higher risk of default by the company, and lead to a decline in the stock price. Is there any evidence that such manipulation has taken place? And more generally, what about other types of manipulation using derivatives?A.7. Answer not received by time of publication.Q.8. Credit default swaps look a lot like insurance when there are unbalanced, opportunistic sellers. However, life and property insurance requires an insurable interest for the buyer and reserves for the seller. Why should we not regulate these swaps like traditional insurance?A.8. Answer not received by time of publication.Q.9. How do we take away the incentive for credit default swap holders to force debtors into bankruptcy to trigger a credit event rather than renegotiate the debt?A.9. Answer not received by time of publication.Q.10. How do we reduce the disincentive for creditors to perform strong credit research when they can just buy credit protection instead?A.10. Answer not received by time of publication.Q.11. In her testimony Chairman Schapiro mentioned synthetic exposure. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.11. Answer not received by time of publication.Q.12. Regarding synthetic exposure, if there is greater demand for an asset than there are available assets, why shouldn't the economic benefit of that demand--higher value--flow to the creators or owners of that asset instead of allowing a dealer to create and profit from a synthetic version of that asset?A.12. Answer not received by time of publication.Q.13. One of the arguments for credit default swaps is that they are more liquid than the reference asset. That may well be true, but if there is greater demand for exposure to the asset than there is supply, and synthetic exposure was not allowed, why wouldn't that demand lead to a greater supply and thus more liquidity?A.13. Answer not received by time of publication.Q.14. Is there any justification for allowing more credit protection to be sold on a reference asset than the value of the asset?A.14. Answer not received by time of publication.Q.15. Besides the level of regulation and trading on an exchange, there seems to be little difference in swaps and futures. What is the need for both? In other words, what can swaps do that forward contracts cannot?A.15. Answer not received by time of publication.Q.16. One of the arguments for keeping over-the-counter derivatives is the need for customization. What are specific examples of terms that need to be customized because there are no adequate substitutes in the standardized market? Also, what are the actual increased costs of buying those standard contracts?A.16. Answer not received by time of publication.Q.17. On the second panel, Mr. Whalen suggests that Congress should subject all derivatives to the Commodity Exchange Act, at least as an interim step. Is there any reason we should not do so?A.17. Answer not received by time of publication.Q.18. There seems to be agreement that all derivatives trades need to be reported to someone. Who should the trades be reported to, and what information should be reported? And is there any information that should not be made available to the public?A.18. Answer not received by time of publication.Q.19. Is there anything else you would like to say for the record?A.19. Answer not received by time of publication. ------ FOMC20080625meeting--118 116,MR. EVANS.," Thank you, Mr. Chairman. I'd like to start by saying that I agree with your comments yesterday about how we should proceed with the Committee approach and think very collaboratively about the policies and delicate strategies that we're facing. Although we disagree on a number of the elements of the outlook, I think that bringing everything together is a very important part of this. I have fully endorsed funds rate cuts that we have taken so far in large part as insurance against tail risks to growth. I think that policy last summer was much too restrictive given what we were facing and that, along the way, a lot of these cuts have been motivated by tail risks to growth. The funds rate at 2 percent is pretty ample insurance to my mind--more so given the improvement in the outlook for growth that we've seen as second-quarter growth has been marked up so much and even more so given the inflation risks that we're facing, the risks to inflation expectations, and the potentially very low real interest rates that we might be looking at, depending on the measure. If we had the opportunity to recalibrate things a bit, I probably would prefer something more like a 2� percent fed funds rate to be positioned against the different risks that we're facing, but I understand that we're at 2 percent, and no change seems like the right move for today. I do have a few concerns about the way we're thinking about this, more in the line of risks. One is that, as we take insurance against tail risk, we're positioning the funds rate against an event that we think is not the most likely and is negative compared with where we are. Unless and until that event happens, policy is somewhat accommodative because it hasn't happened, and we're thinking that it is closer to where it ought to be if that should happen. Unless you think that we haven't taken out insurance, then I think that we have more accommodation than we might like. The second concern is whether it is possible to be more precise about what we mean by this tail risk. I mean, it's really a catch-all. Nobody is very comfortable with all of this. What are the markers that we could look at for improvement if we could quantify this somehow? Is it that financial markets should be functioning better? I think surely that is the case. Is there a way that we could describe that? I'm sure we'll disagree on many elements of this. Labor market improvement--we should expect that, if the labor market does better than we were thinking, then that would tend to bolster consumption spending a bit better in the face of all the shocks that we're looking at. So the extent to which the labor market doesn't continue to deteriorate, at least in line with some of the recession scenarios and the tail risk scenarios that we were thinking about, is a potential marker. As we keep pushing out our expectation that the economy is going to weaken--and we've done this a number of times--and if we're looking at the third quarter being revised up--and I agree that we're facing a lot of risks there--but if we start marking that one up, I think that's a marker that we have to be concerned about. Obviously, if oil prices and commodity prices were to decline and free up purchasing power for consumers, that would help out, too. So these are just some of the things that come to mind. Is there a way to think about the details a little better, with a bit less of a SWAG? Another risk relates to financial markets. Here I'm thinking about the really influential work of yours, in 1983, on nonmonetary influences on the Great Depression. A lot of the actions that we have taken are defenses against those types of issues, right? In the 1930s, when the economy was doing very badly and banks were failing--I'm telling this to you, and you've described it to everyone--then the knock-on effect was that the banks weren't there anymore and important resources for evaluating credit were lost, and so it was more expensive and very difficult to do. We have some of that going on now, right? We've moved from the banks making mortgages and holding them to the ""originate to distribute"" model. Those resources have been dispersed, and now that securitization market is closed. I heard that very clearly yesterday. Those important resources aren't there to originate mortgages, so if we get to the point that buyers are willing to purchase these houses, that could be a concern. What happens if there's a true impairment to the financial capital stock, and real resources aren't there anymore to help out with this? We're probably looking at a reallocation of resources from that sector of the financial market either back to banks or to somewhere else. But as we see those resources reallocated and as we think about unemployment being higher, we can talk ourselves into thinking that a lot of slack is in the economy when, in fact, there may not be so much slack. At some point it may be slack, and at other times it won't be, until those resources are reallocated most efficiently. I think this could reduce potential growth rates and have structural elements to it, not just cyclical elements. So there's not a slam-dunk for this. There is just a risk that an element of that is playing out throughout this, and other factors are superimposed on that. But it's something that I worry about. In a robust type of policy development, I think we should be considering things like that. It's just the case that, in the current situation that we're looking at, there might be a limited role for monetary policy to repair real capital stocks. Another concern is that anytime we've engaged in substantial risk-management policies, there has always been difficulty in taking them back. That's part of the delicate strategy that you are referring to, I think. That's how I heard it. So we have to be very careful. There's a lot of art to this clearly, but it would be good if we could offer a few more bright lines about how we'll approach that. Still, I certainly agree. I think we need to seek consensus. It's our role to raise these issues and then come to the best judgment. So I'm quite comfortable with no change today. I'm quite comfortable with the language in alternative B, although in the third paragraph we say, ""However, in light of the continued increases in the prices of energy,"" and I think it would be better if we didn't say ""continued."" I think it's enough to say ""the increases."" In part, I don't know if this is a marker that, if prices level out, we'd still be comfortable with the inflation risk. I think that there will be a lagged effect of all the very large increases that we've seen for oil as they work their way through. If prices just level out, we still have risks to inflation expectations. So I prefer taking that out. Thank you, Mr. Chairman. " CHRG-111shrg54589--71 Mr. Pickel," Chairman Reed, Ranking Member Bunning, and Members of the Subcommittee, thank you very much for inviting ISDA to testify today. We are grateful for the opportunity to discuss public policy issues regarding the privately negotiated, or OTC, derivatives business. Our business provides essential risk management and cost reduction tools for many users. Additionally, it is an important source of employment, value creation, and innovation for our financial system. In my remarks today, I would briefly like to underscore ISDA and the industry's strong commitment to identifying and reducing risks in the privately negotiated derivatives business. We believe that OTC derivatives offer significant value to the customers who use them, to the dealers who provide them, and to the financial system in general by enabling the transfer of risk between counterparties. OTC derivatives exist to serve the risk management and investment needs of end users. They include over 90 percent of the Fortune 500, 50 percent of mid-size companies, and thousands of other smaller American companies. The vast majority of these transactions are interest rate and currency swaps and equity and commodity derivatives. These are privately negotiated, bilateral contracts that address specific needs of thousands of companies. We recognize, however, that the industry today faces significant challenges and we are urgently moving forward with new solutions. We have delivered and are delivering on a series of reforms in order to promote greater standardization and resilience in the derivatives markets. These developments have been closely overseen and encouraged by regulators who recognize that optimal solutions to market issues are usually achieved through the participation of market participants. As ISDA and the industry work to reduce risk, we believe it is essential to preserve flexibility to tailor solutions to meet the needs of customers, and the recent Administration proposals and numerous end users agree. Mr. Chairman, let me assure you that ISDA and our members clearly understand the need to act quickly and decisively to implement the important measures that I will describe in the next few minutes. Last week, President Obama announced a comprehensive regulatory reform proposal for the financial industry. The proposal is an important step toward much-needed reform of financial industry regulation. The reform proposal addressed OTC derivatives in a manner consistent with the proposals announced on May 13 by Treasury Secretary Geithner. ISDA and the industry welcomed in particular the recognition of industry measures to safeguard smooth functioning of our markets and the emphasis on the continuing need for the companies to use customized derivatives tailored to their specific needs. The Administration proposes to require that all derivative dealers and other systemically important firms be subject to prudential supervision and regulation. ISDA supports the appropriate regulation of financial and other institutions that have such a large presence in the financial system that their failure could cause systemic concerns. Most of the other issues raised in the Administration's proposal have been addressed in a letter from ISDA that ISDA and various market participants delivered to the Federal Reserve Bank of New York earlier this month. As you may know, a Fed-industry dialogue was initiated under Secretary Geithner's stewardship of the New York Fed nearly 4 years ago. Much has been achieved and much more has been committed to, all with the goal of risk reduction, transparency, and liquidity. These initiatives include increased standardization of trading terms, improvements in the trade settlement process, greater clarity in the settlement of defaults, significant positive momentum central counterparty clearing, enhanced transparency, and a more open industry governance structure. In our letter to the New York Fed this month, ISDA and the industry expressed our firm commitment to strengthen the resilience and robustness of the OTC derivatives markets. As we stated, we are determined to implement changes to risk management, processing, and transparency that will significantly transform the risk profile of these important financial markets. We outlined a number of steps toward that end, specifically in the areas of information transparency and central counterparty clearing. ISDA and the OTC derivatives industry are committed to engaging with supervisors globally to expand upon the substantial improvements that have been made in our business since 2005. We know that further action is required and we pledge our support in these efforts. It is our belief that much additional progress can be made within a relatively short period of time. Our clearing and transparency initiatives, for example, are well underway with specific commitments aired publicly and provided to policy makers. As we move forward, we believe the effectiveness of future policy initiatives will be determined by how well they answer a few fundamental questions. First, will these policy initiatives recognize that OTC derivatives play an important role in the U.S. economy? Second, will these policy initiatives enable firms of all types to improve how they manage risk? Third, will these policy initiatives reflect an understanding of how the OTC derivatives markets function and their true role in the financial crisis? Finally, will these policy initiatives ensure the availability and affordability of these essential risk management tools to a wide range of end users? Mr. Chairman and Committee Members, the OTC derivatives industry is an important part of the financial services business in this country and the services we provide help companies of all shapes and sizes. We are committed to assisting this Committee and other policy makers in its considerations of these very important policy initiatives. I look forward to your questions. Thank you. " FOMC20070918meeting--124 122,MR. KOHN.," Thank you, Mr. Chairman. The repricing of risk and rechanneling of credit flows under way I believe will exert restraint on spending, especially in the near term, but over the longer run as well. A critical channel of contagion that came into play in the intermeeting period was the involvement of the banks as providers of credit and liquidity backstops in the ABCP market. As a consequence, uncertainties about real estate markets, the performance of nonprime mortgages, and structured-credit products came to rest as greater uncertainty about bank exposures. The classic flight to safety under way—the desire to protect capital and liquidity—has caused banks and those providing them credit to become more cautious. This has resulted in greatly reduced funding in term markets spreading the constriction of credit potentially well beyond the mortgage and leveraged-loan markets we talked about in early August. Like so many around the table, I feel that I can honestly say that the uncertainties around the output forecast were indeed larger than usual this time. Fortunately, we don’t have many degrees of freedom to test hypotheses about the sorts of relationships that we’re talking about here. I think we can expect effects on spending to be greatest in the short and intermediate terms, while markets are disrupted and while participants are struggling to find new ways of intermediating credit that address the perceived shortcomings of the previous practices. In the short run, to preserve capital and liquidity while secondary markets are impaired, banks have tightened terms and standards for loans. You can see this directly in the rise in spreads in the prime jumbo market, but it must be true for other less easily observed credits as well. Some credits, such as nonprime mortgages and leveraged loans, just haven’t been available for a while. An already weak housing market has been most directly affected, and construction sales and prices will probably fall substantially further because of the reduced demand along with a large overhang of unsold homes. Consumption spending is also likely to be trimmed. Tighter terms for home equity lines of credit and second mortgages mean not only that housing wealth is declining but also that it is probably less liquid and more expensive. To the extent that asset- backed security markets are affected and lenders have questions about consumer balance sheets, the cost of consumer credit could well rise also. Household confidence has apparently been affected by the adverse financial market news. Investment spending may also be held down by uncertainty, by a sense that consumer demand will be growing less rapidly. I have been struck in listening to presidents around the table report about their Districts that the tone has shifted noticeably toward less optimism, slower growth, and more caution on the part of our business respondents. It has been one of those shifts that you hear every couple of years around the table that are different from what might have been anticipated, say, from reading the Beige Book. There is also some tightening of credit conditions in the business sector—for example, for commercial real estate credit, as some have noted, and for credit for below-investment-grade firms. As a consequence, some downshift in GDP is highly likely over the next few quarters, and without policy action, we would most likely end up with a substantially lower GDP a few quarters out. Indeed, in the Greenbook, the output gap is noticeably wider at the end of ’08 despite near-term policy easing of 50 basis points. I also noted downside risk to my output forecast. It seems to me that, in this period when markets are adjusting, those risks are most skewed. The potential for adverse interactions seems large, as nervous creditors assess the implications of declines in house prices, volatile earnings of commercial and investment banks, and setbacks in overall confidence. I think there is a non-negligible risk that the constrictions in credit availability would feed back on the economy and, in turn, feed back on credit supply. As market participants are better able to distinguish and assess risk, liquidity will be re-established in many markets. Although we have seen some improvement in the past week or two, markets are still quite dysfunctional in many regards. Like others, I think it could take a while to discover how to structure securitizations that have the requisite transparency and appropriate principal-agent incentives to restore investor confidence and to recalibrate the roles of securities markets and banks. The process could be particularly drawn out in mortgage and related markets, which are likely to be affected for some time by uncertainties about the prices of houses and about the performance of mortgages. Moreover, some effects of the recent turmoil will be longer lasting. Risk spreads in a great variety of markets are likely to be at higher, more- realistic, and more-sustainable levels; banks should be charging more for credit liquidity backstops; less leverage in the financial sector implies a need for return on the greater amount of capital involved in intermediation, including at banks; and some credit conditions at any given fed funds rate will be tighter one year from now than they were a few months ago. I have concentrated on problems for growth, but the upside inflation risks have not disappeared. Unit labor costs have been rising. Markups, while still high, have come in, affording a reduced cushion for absorbing labor costs. Resource utilization remains high by historical standards. Import prices may prove problematic. Although commodity prices may level out as in the staff forecast, foreign economies also are producing at high levels. Pressures on the costs of finished goods could increase, especially if the dollar declines further. My expectations for the most likely path for inflation have been revised just a tick lower, given the favorable incoming data and the lower path for economic activity relative to potential, which will increase competitive pressures in labor and product markets. For now, given this outlook, we need to concentrate on the potential effects of the disruptions to financial markets on the real economy when we consider policy in the next portion of this meeting. Thank you, Mr. Chairman." FOMC20070321meeting--137 135,MR. POOLE.," Okay. But then, does that have much bearing on, let’s say, Eurodollar futures a year or a year and a half out?" CHRG-109shrg26643--132 FROM BEN S. BERNANKE Chairman Bernanke, you wrote in your macroeconomic textbook about the consequences of budget deficits. The Congressional Budget Office estimates that the deficit for 2006 will be $337 billion--even before including the cost of an anticipated supplemental appropriation for Iraq and Afghanistan expected early this year. The deficits for 2003, 2004, 2005, and 2006 are the four largest deficits in American history. Because of these deficits, the long-term attractiveness of the United States as an investment destination could be hurt as investors worry about our Nation's ability to manage its debts. And the deficits could also cause consumers problems if foreign investors stop buying U.S. assets, forcing interest rates to rise sharply. Finally with the ongoing wars in Iraq and Afghanistan, our budget is going to be under continued pressures in the future. Over time, large deficits and debt will raise interest rates, crowd out private sector investment, and slow long-term economic growth.Q.1. How much importance do you put on paying down the publicly held debt that our Nation currently holds?A.1. I am quite concerned about the intermediate to long-term Federal budget outlook. In particular, the budget is expected to come under severe pressure as impending demographic changes fuel rapid increases in entitlement spending. By holding down the growth of national saving and real capital accumulation, the prospective increase in the budget deficit will place at risk future living standards of our country. As a result, I think it would be very desirable to take concrete steps to lower the prospective path of the deficit. Such actions would boost national saving and ultimately the future prosperity of our country, as our children and grandchildren would inherit a larger capital stock that would support greater productivity and higher income. Moreover, steps should be taken soon to address the long-term budget pressures so that people have adequate time to prepare for whatever changes might occur, especially to entitlement programs. Although the stock of debt held by the public would decline in absolute magnitude only if budget surpluses are run, fiscal actions that result in smaller deficits can slow the growth in the stock of debt held by the public and reduce the Federal debt relative to the size of the economy. The key is not so much the absolute level of Federal debt, but rather that we take deficit-reducing steps to increase national saving and, hence, future living standards. As you know, the pay-as-you-go budget provisions of the 1990's required lawmakers to pay for any increases in entitlement spending or decreases in revenues (that is, tax cuts); such changes had to be offset either by equivalent budget cuts or by revenue increases elsewhere. Since those rules expired in 2002, Congress has strived and did enact a variation on PAYGO that completely exempts taxes from the equation: No tax cuts would require offsetting, and spending increases could only be offset by entitlement cuts elsewhere--never by tax increases. This despite the fact our Federal budgets over the last few years have run recorded deficits. This one-sided PAYGO passed despite the recommendations of people like Federal Reserve Chairman Alan Greenspan, Congressional Budget Office Director Douglas Holtz-Eakin, and Government Accountability Office Comptroller General David Walker, who all strongly and repeatedly urged Congress to adopt full PAYGO rules.Q.2.a. Chairman Bernanke, do you support full PAYGO rules over spending-only ones?A.2.a. As I noted in response to the previous question, I believe reducing the Federal deficit is very important, especially in light of the need to prepare for the retirement of the baby-boom generation. I urge the Congress to proceed on that effort in a timely manner and to pay particular attention to how its decisions on spending and tax programs will affect the U.S. economy over the long-term. However, I also believe that in my role as head of the Federal Reserve, I should not be involved in making specific recommendations about the internal decisionmaking process of the Congress and the structure of its budget procedures.Q.2.b. The Treasury Department recently issued its first 30-year bonds in over 4 years. Do you support this decision to bring back the long bond?A.2.b. The responsibility for Federal debt management, of course, rests with the Treasury Department. However, I do support the Treasury's decision to resume issuance of 30-year bonds. Given the large current and prospective Federal financing needs, it is prudent to distribute the Treasury's borrowing across the yield curve. Moreover, long-term interest rates are currently quite low, apparently reflecting in part strong demand among investors for long-term issues. In these circumstances, it is sensible for the Treasury to accommodate this demand in part by issuing 30-year securities. Last week, when the Treasury issued its first 30-year bond since 2001, there was $28 billion in bids for $14 billion of bonds being offered. This in turn made it cheaper for the Treasury to borrow for 30 years than 6 months.Q.3. Do you have any concern that this will contribute to the creation of a bond market bubble, which has the potential effect of lowering inflation-adjusted interest rates to incredibly low levels?A.3. I do not have any such concerns. I should note that I do not see particular significance to the level of bids relative to the size of the recent auction. I attribute the relatively low level of long-term interest rates generally to several factors, including a tendency in recent years for global saving to exceed the amount of potential capital investments, yielding historically normal rates of return as well as relatively low-term premiums in interest rates to compensate investors for interest rate risk. In the unlikely event that any of these factors tended to push real long-term yields to levels that appeared to be incompatible with our macroeconomic objectives, the Federal Reserve would respond by adjusting the stance of monetary policy appropriately.Q.4. What impacts could this have on our economy?A.4. No significant adverse effects are likely. Last week, the Commerce Department reported that our trade deficit rose 17.5 percent to $725.8 billion in 2005, a new record for the fourth consecutive year. You have stated in the past your belief that what you call a ``global savings glut'' is the main driver behind America's record trade deficit, and that the ability to reduce our trade deficit is largely beyond our control.Q.5. Is there nothing we can do to alleviate the pressure building up in the global financial system?A.5. The emergence of large U.S. trade deficits and corresponding surpluses on the part of our trading partners is, to an important extent, the outcome of market forces. Several factors, including the lingering effects of financial crises in emerging market economies and concerns about the outlook for growth in some industrial economies, have led saving abroad to exceed investment. This excess saving has been attracted to the United States by our favorable investment climate, strong productivity growth, and deep financial markets. Although the U.S. net external debt has been growing as a consequence of these inflows, as a fraction of our Nation's income it remains within international and historical norms. Given the strength and flexibility of our economy, there is every reason to believe that, if changes in the foreign outlook or in the tone of financial markets were to cause a reduction in capital inflows and the trade deficit, economic activity, and employment would stay strong.Q.6. Wouldn't reducing our budget deficit and getting tough on currency manipulators help?A.6. All that said, as our net external debt rises, the cost of servicing that debt increasingly will subtract from U.S. income. Accordingly, it would be helpful to raise our domestic saving and reduce our trade deficit while maintaining an environment conducive to investment and growth. Reducing the budget deficit would release resources for private investment and reduce the future burden of repaying the public debt, although studies indicate a relatively modest effect of budget-cutting on the trade deficit. Pro-growth policies among our trading partners would also contribute to some adjustment of external imbalances. Finally, more flexible exchange rate regimes in some countries would provide greater scope for market forces to reduce our trade deficit, and would be in the interests of the countries implementing these regimes as well. Nevertheless, in the absence of a shift in market perceptions of the relative attractiveness of United States and foreign assets, government policies would likely have only limited effects on the trade balance. Chairman Bernanke, under the fiscal year 2006 Congressional budget resolution and the two related reconciliation bills, Congress has cut Medicaid by $6.9 billion while spending up to $70 billion over the next 5 years to repeal some of the sunsets of President Bush's 2001 and 2003 tax cut packages. According to the Urban-Brookings Tax Policy Center, more than 70 percent of the benefits of those tax breaks have gone to the 20 percent of taxpayers with the highest incomes, and more than 25 percent of the benefits to the top 1 percent. Medicaid's benefits, by contrast, go almost entirely to those at the bottom of the income scale.Q.7. Don't these additional tax breaks (from the fiscal 2006 reconciliation bills), when combined with the Medicaid cuts, amount to a massive redistribution of income from those at the bottom to those at the top?A.7. As I stated in my testimony on the Monetary Policy Report, the Federal Government has an important role to play in boosting national saving as a share of national income over time. Of particular concern to me is the mismatch between taxes and spending in long-term budget projections. This mismatch means that over time either taxes will have to be raised or the spending increases embedded in current laws will need to be scaled back, or some combination of the two. Deciding on the mix of policy actions to be implemented will require the difficult balancing of sometimes conflicting goals regarding the provision of public services, the effects on economic efficiency of increasing taxes, and the distribution of fiscal burdens among various groups. The judgments about how to balance these priorities are ultimately political judgments and not ones that I believe I should address in my role as Chairman of the Federal Reserve. Chairman Bernanke, the 1991 edition of your Macroeconomics textbook contains a policy debate on the minimum wage. At the end of the debate, the textbook concludes: ``Therefore, the total labor income of unskilled workers does increase when the minimum wage rises . . . . Overall, taking these various effects into account, a recent study finds that raising the minimum wage from $3.35 per hour to $4.25 per hour [note: those were the amounts under discussion at that time] could reduce the number of families in poverty by about 6 percent, on balance a reasonably substantial effect.'' The textbook goes on to find: ``Thus, the inflationary effects of an increase in the minimum wage are relatively small . . . As a result, an increase in the minimum wage has negligible effects on aggregate employment and output.'' Your textbook was written in 1991 when the minimum wage was $4.25 an hour. Today, in real terms it is below that level ($4.25 in 1991 would be $5.89 today).Q.8. Do you believe that increasing the minimum wage above its current level of $5.15 an hour--where it has been stuck for over 8 years--would be good economic policy, along the lines that your textbook concluded?A.8. I am reluctant to comment on specific proposals regarding the minimum wage, but I can offer some general comments. In particular, I would note that the minimum wage is a very controversial issue among economists. Clearly, if the minimum wage were raised, then those workers who retain their jobs will benefit from the higher income associated with the higher minimum wage. However, economists have raised two concerns about minimum wages. The first is whether minimum wages have adverse employment effects; that is, do higher wages lower employment of low-skilled workers? The second is whether the minimum wage is as well targeted as it could be; that is, to what extent is the increase benefiting workers other than those from low-income families? My own view is that an increase in the minimum wage probably does lower employment. However, I would note that while this is the consensus view among economists, there is some research indicating that any such disemployment effects could be negligible. In any event, it does seem likely that the employment losses from a modest increase in the minimum wage would be relatively small from a macroeconomic standpoint and thus, at the levels of the minimum wage prevailing in the United States, a modest increase would not have sizable negative effects on aggregate output. The effect of a higher minimum wage on poverty is also a hotly debated topic among economists. However, my reading of the research that has become available over the past 10 years or so is that if there is any reduction in poverty associated with a higher minimum wage, it is likely to be quite small. In this context, one might consider alternative ways of helping low-income workers, such as the Earned Income Tax Credit, which delivers money directly to working families and is thus better targeted toward poverty reduction than is the minimum wage. FOMC20070807meeting--41 39,CHAIRMAN BERNANKE.," We want to acknowledge your final meeting, Vincent. It has been six years since Vincent was elected Secretary and Economist to the Committee. You took that role only three or four weeks before September 11, and your steady hand during that crisis was invaluable. Unfortunately, against all good advice and after only eighty-two FOMC meetings—a record which to his credit he has achieved without prompting accusations of steroid use—[laughter] Vincent is insisting upon returning to civilian life. So today is an appropriate occasion upon which to express our gratitude, Vincent, for your sage advice, your thoughtful guidance, and your undoubtedly well-deserved admonitions to the Committee over the years. Vincent’s legacy, of course, will live on in the meeting transcripts from his tenure, as the transcripts become public over the next few years. For example, in the May 2004 transcript, Vincent is caught using the words “cattle prods” in reference to a possible experiment involving bond market traders. [Laughter] In 2005, he suggested that the FOMC as a group was incapable of agreeing on something as straightforward as the color of an orange. [Laughter] Notwithstanding that, Vincent, the Committee does agree on this: You have our heartfelt thanks and our best wishes for the next stage of your career. Congratulations and many thanks. [Applause] Is there a rebuttal? [Laughter] If not, we can go to the economic situation, and I will call on David Wilcox." FOMC20080130meeting--201 199,MR. WARSH.," Thank you, Mr. Chairman. I will endeavor to stay out of the growing, creeping pessimism caucus. [Laughter] You can judge for yourselves whether I've been successful doing so. Let me talk briefly about two economies that are in a tug-of-war, and rather than reference the housing and nonhousing economies, let me try to talk about it in the context of the economy of financial services versus the real economy. On one level, of course, financial services are not so large a share of GDP that they could threaten the macroeconomy. But the transmission mechanism between credit markets and the real economy, whether it be through the credit channel or other channels, while imperfectly understood, is having very negative effects on the cost and availability of credit for real businesses and households, with the risks there to the downside. Financial institutions, as many of you said, are open for business, but I would say somewhat less so than when we met in December. As we approach the credit line renewal season, that is happening amid a period of depleted credit availability and significantly tighter lending standards. In addition, financial institutions as a group are, in my view, undercapitalized, even with the recent capital infusions. Finally, the dynamism that I would be hoping to see among financial institutions is clearly lacking; and while I think, as President Pianalto referenced, that there are new market entrants like hedge funds that are pretty keen to provide mezzanine financing, it's a pretty slow process to match providers and users of capital. So at least for the near-term forecast, I wouldn't expect that to come much to our rescue. If the U.S. financial institutions were an economy all to themselves, they would probably already be in a recession. While that doesn't necessarily equate to a recession for the broader economy, it sure doesn't help. The repair process that President Geithner referenced among financial institutions strikes me as very fragile and quite incomplete. Income statement shortfalls due to falling profits, poor visibility, weaker pipelines, and the need to reduce headcounts very meaningfully strike me in some ways as a more urgent and troublesome issue for large financial institutions than their balance sheet weakness. On the balance sheet front, however, I'm also concerned that more impairments are to come for large financial institutions and more dilution is expected for current shareholders. Although the window for foreign investment is open now, I wouldn't expect that window to stay open throughout 2008. So even though I'd say that income statement concerns should be more pressing for them, these balance sheet issues are very real. In some way these institutions have been built, or I should say rebuilt, over the past six years to prepare themselves for a low volatility, high liquidity world, and what they found is the exact opposite. They are at different levels of understanding the new world, and it will take them quite some time to rebuild their businesses to be profitable in it. Rolling capital calls across financial institutions are continuing. Many are hoping to play for time, but I think there's a risk that time will run away from them as new events find their way into the front pages. Virtually no financial institution strikes me as immune to these pressures, and while we see that new problems and new acronyms are emerging daily, they strike me as having the same underlying problems affecting different asset classes. Regional banks have begun to fund their balance sheets successfully--certainly a good sign--but I suspect that they are also in the early stages of needing to raise considerably more capital. As Governor Kohn said, there is a hope and an expectation that global institutions would be a source of strength, at least in financial services. Again, in financial services, my sense is that nonU.S. financial institutions, especially those in the United Kingdom and Europe, are in the midst of playing catch-up to their U.S. counterparts. I expect the year-end reporting process for them, which really begins now but will be at full speed by mid-February through early March, will find many of the Landesbanks needing to be recapitalized. I think we're going to find that both large and small institutions are having a hard time getting through the bank reporting season in Europe. Equity prices in Europe and CDS spreads are already giving us some indication of what's on the horizon. It's not just about subprime in Europe, contrary to some of the indications we received. Perhaps even more than U.S. institutions, many European financial institutions have incorrectly believed that high credit ratings across asset classes would in and of themselves serve as protection. The overreliance on credit ratings that we see in the United States strikes me as even more pronounced in Europe. The shocks caused by these financial institutions could have a dramatic impact on their economies, probably more so than the effect of U.S. financial institutions here in the United States. That obviously has a consequence in terms of a further shock and also a consequence on the real side in terms of U.S. exports. Let me turn to the other side of that, that is, the real economy itself, excluding financials. I think many of you referred to the labor market data, which strike me as mixed. I'm perhaps a touch more optimistic that we're going to see some improvement at least in the short term there, but I can't have the conviction that I'd like. The real economy is doing its best to resist these financial shocks. We can see that fight playing out around E&S spending, around business fixed investment, and around cap-ex more generally. You have nonfinancials with strong corporate balance sheets, excess cash, and high profit levels that are debating in corporate boards about the uncertainty posed by the macroeconomy. It's hard to say which side is going to prevail in that battle. The backdrop, as many of you mentioned, has weakened, with risk premiums widening across the board. Real PCE for January is not showing much of a snapback from a weak December but also, I would say, not much more deterioration from December levels according to the credit card companies that I spoke to. The bottom line on the real economy--the trends in the real economy may be a bit more positive coming into the first quarter from the fourth quarter than the Greenbook projections, but I would say I am a little less optimistic that the fiscal stimulus package is as likely to be as constructive as the Greenbook would have us believe. The forecast, as a result, overall depends on the ability of nonfinancial corporations to hire and invest despite this macroeconomic uncertainty. I have some confidence that the Fortune 500 will be willing to continue to push along this path of moderate growth; but small companies, particularly those that are really the source of job creation, may be more negatively affected while the credit channel is impaired, and this is happening at a critical time. The Greenbook base case or the ""faster recovery"" pace depends to a degree on improvement in credit intermediation or at least not another shock, and it's that other shock that worries me. If deterioration among credit intermediaries continues, the real economy will suffer. Of course, the correlation is hard to pin down. Finally, on the inflation front, I share the concerns expressed by several of you that the persistence of recent inflation information coming into this period is a cause for concern. I'm less sanguine than the Greenbook that we're going to see the power of that inflation fade in the event that the economy softens some. The backdrop of stubbornly high commodity prices, despite lower global demand in recent weeks, and a lower exchange value of the dollar are likely to put pressure on the inflation front. The data, as we have all talked about, on core and total inflation are not promising, so I would consider that also to be an upside risk. Thank you, Mr. Chairman. " CHRG-111shrg51395--261 PREPARED STATEMENT OF LYNN E. TURNER Former Chief Accountant, Securities and Exchange Commission March 10, 2009 Thank you Chairman Dodd and Ranking Member Shelby for holding this hearing on an issue important to not only investors in America's capital markets, but to all who are being impacted by the current economic devastation. Before I start with my personal perspective on the issues surrounding the current economic crisis and securities regulation, it might be worthwhile to provide some background on my experience. I serve as a trustee of a mutual fund and a public pension fund. I have served as an executive of an international semiconductor manufacturer as well as on the board of directors of both Fortune 500 and small cap public companies. In the past, I served as chief accountant of the U.S. Securities and Exchange Commission (SEC) and as a partner in one of the major international auditing firms, where I was involved with audits and restructurings of troubled or failed institutions. I also was the managing director of research at a financial and proxy advisory firm. In addition, I have also been a professor of accounting at a major U.S. public university and an investor representative on the Public Companies Accounting Oversight Board (PCAOB) Standards Advisory Group and the Financial Accounting Standards Board's (FASB) Investor Technical Advisory Committee (ITAC).The Crisis--Bad Loans, Bad Gatekeepers, and Bad Regulation The economic crisis of 2007-2009 has three root causes; the making of bad loans with other peoples money, gatekeepers who sold out, and a lack of regulation. In order to prevent a repeat of this debacle it is of paramount importance that policy makers understand what will cure the ``disease'' before they remedy the cause. To that end, I would urge the committee to take the same approach it did some seven decades ago when the Senate Banking Committee, with experienced investigators using its subpoena powers, investigated the banking and security markets, stock exchanges, and conduct of their participants. A similar approach in the midst of the current crisis would give Americans and investors hope and confidence that their interests will be served, and adequate protections restored. Unfortunately, if the public perceives the remedy is off target, as it has with other recent legislation, I fear the markets will continue their downward spiral resulting in a lengthening of the recession, or potentially worse outcome. From my perspective, those most responsible for the current crisis are the banks, mortgage bankers, and finance companies who took money from depositors and investors and loaned it out to people who simply could not, or did not repay it. In some instances predatory practices occurred. In other instances, people borrowed more than they should have as Americans in general ``leveraged'' their personal and corporate balance sheets to the max. Speculators also took out loans expecting that real estate values would continue to rise, allowing them to profit from flipping their investments. But who can dispute that when ``liar,'' ``no doc,'' and ``Ninja loans'' are being made while banking regulators are watching, there is something seriously wrong. In addition to the financiers, a second problem was the gatekeepers--the credit rating agencies and underwriters--who are suppose to protect investors. They did anything but that. Instead they became the facilitators of this fraud on the American public, rather than holding up a stop sign and putting the brakes on what was occurring. They became blinded by the dollars they were billing rather than providing insight to the public into the perfect storm that was forming. Recent testimony before the House of Representatives that the rating agencies knew their models did not work, but did not fix them was stunning. But perhaps not as stunning as the report of the SEC in which employees of an agency stated they would rate a product even if it had been created by a cow. And while lenders were making bad loans in exchange for up-front fees, and gatekeepers were falling down on the job, Federal Government agencies were failing to supervise or regulate those under their oversight, as well as failing to enforce laws. It is a huge public concern that a systemic failure of financial and securities market regulation in this country occurred. Some of this was due to the lack of regulation of new products and institutions, such as credit default swaps and hedge funds, but more importantly, the fundamental problem was the lack of Federal Government regulators doing their jobs, or lacking the resources to do so. For example, for 13 years, as abuses of subprime lending occurred, the Federal Reserve refused to issue regulations as mandated by the Homeownership Equity Protection Act of 1994 (HOPEA). That legislation specifically stated: PROHIBITIONS--The Board, by regulation or order, shall prohibit acts or practices in connection with-- ``(A) mortgage loans that the Board finds to be unfair, deceptive, or designed to evade the provisions of this section; and (B) refinancing of mortgage loans that the Board finds to be associated with abusive lending practices, or that are otherwise not in the interest of the borrower.''. Not less than once during the 3-year period beginning on the date of enactment of this Act , and regularly thereafter, the Board of Governors of the Federal Reserve System, in consultation with the Consumer Advisory Council of the Board, shall conduct a public hearing to examine the home equity loan market and the adequacy of existing regulatory and legislative provisions and the provisions of this subtitle in protecting the interests of consumers, and low-income consumers in particular . . . Yet the Federal Reserve Board (Federal Reserve or Fed), which had examiners in the very banks who were making mortgage loans, did nothing. Had the Federal Reserve acted, much of the subprime disaster might have been averted. Instead, ignoring the clarion calls of one of its own Governors for action, the late Edward Gramlich, it was not until 2007 that the Federal Reserve acted. But by then, much of the damage to the American economy and capital markets had been done. Indeed, even the Comptroller of the Currency spoke in 2006 of 3 years of lowering of lending standards. In a press release in 2006, the Comptroller stated: ``What the Underwriting Survey says this year should give us pause,'' Mr. Dugan said. ``Loan standards have now eased for three consecutive years.'' The Comptroller reported ``slippage'' in commercial lending involving leverage lending and large corporate loans as well as in retail lending with significant easing in residential mortgage lending standards including home equity loans. [Emphasis supplied] Unfortunately, armed with this information and legislative authority to fix the problem, the Comptroller of the Currency (OCC) failed to act in earlier years. Rather than reining in these abusive practices, the OCC permitted them to continue, with the most toxic of the subprime loans being originated in 2006 or 2007. And today, we have Inspector General reports that have cited the lack of action by the OCC and Office of Thrift Supervision, leaving taxpayers and investors exposed to losses totaling trillions of dollars. What is equally troubling about this lack of action by the banking regulators, is that it comes after similar problems occurred with the crisis in the savings and loan and banking industries in the 1980s and early 1990s. I was at the SEC at that time and watched as the Federal Reserve who had oversight over an undercapitalized CitiBank, worked to keep it afloat. It seems that we are seeing a repeat performance of this situation and rather than having learned from history, we are again repeating it. After having two swings at the bat, I wonder why some want to make the same regulators the risk regulator for the entire financial system in the United States. These are regulators who all too often have been captured by the regulated. Once again, as with Enron, a lack of transparency has also been a contributing factor to the current crisis. Investors have time and time again--from Bear Stearns to Lehman to Wachovia to Citigroup and Bank of America--questioned the validity of the financial numbers they are being provided. The prices of their stocks have reflected this lack of credibility driven by transactions hidden off the balance sheets and values of investments and loans that fail to reflect their real values. Unfortunately, millions of bad loans were made that are not going to be repaid. While financial institutions argue they will hold the loans to maturity and be repaid, that just isn't true for loans subject to foreclosures or short sales. And for many mortgages, they prepay and once again are not held to maturity. At the same time, collateral values of the underlying assets securing the loans have taken a tremendous tumble in values. Almost 5 million Americans have lost their jobs since this recession began impacting their ability to make their mortgage payments. There is a years worth of inventory of unsold homes on the market even further depressing home prices. Asset backed securities are being sold in actual transactions at pennies on the dollar. Yet the financial institutions continue to act like an ostrich with their head in the sand and ignore these facts when valuing their assets. At the same time however, the markets are looking through these numbers and revaluing the stocks in what is an inefficient approach, driving stocks of some of the largest financial institutions in this country to a price that is lower than what you can buy a Happy Meal for at McDonalds. In 1991 the General Accounting Office (GAO) published a report titled ``Failed Banks--Accounting and Auditing Reforms Urgently Needed.'' In their report, the GAO noted how during the savings and loan crisis, the failure of banks and savings and loans to promptly reflect their loans and assets at their market values drove up the cost to the taxpayer. I hope Congress will not allow this mistake to be repeated by allowing banks to avoid marking their assets to market. Managing the assets held by a financial institution and the positions taken has also been lacking. One large institution that was failing and required a bailout through a buyer did not even have a chief risk officer in place as the risks that caused their demise were entered into. This could have been avoided in if the recommendations of the 2001 Shipley Working Group on Public Disclosure had been adopted by the banking and securities regulators that had convened the group. Instead, consistent with a deregulatory approach, the type of risk disclosures the group called remained nonexistent, hiding the buildup of risks in the financial system. There has also been a lack of regulation of new products and institutions. Credit rating agencies were not subject to regulation by the SEC until after many of the subprime loans had been made. Credit default swaps and derivatives were specifically exempted by Congress from regulation, despite a plea for regulation from the CFTC chairman, creating grave systemic risks for the financial system. These markets grew to over $60 trillion, a multiple of many times the actual debt subject to these swaps. In essence, a betting system had been established whereby people were wagering on whether others would pay their debt. But while we regulate betting in Las Vegas, congress chose to specifically not regulate such weapons of mass destruction in the capital markets. This has directly led to the more than $160 billion bailout of the bets AIG placed, and those to whom it is indebted on those on those bets. Likewise, there has been a rise in a shadow banking system that includes hedge funds and private equity firms. These funds have under management money from many public sources, such as public pension funds and their members and the endowments of colleges and universities. Yet they remain largely opaque and these unregulated entities have been allowed to co-exist alongside the regulated firms as a push was made for less regulation. That push was advanced by an argument the markets can regulate themselves, a perspective that has been proven to totally lack any credibility during this decade of one scandal after another. Others said that without regulation, these unregulated entities could innovate and create great wealth. Unfortunately, their innovation has not always created wealth and in other instances has been quite destructive. The subprime crisis, and our economic free fall, is the showcase for what can happen without adequate regulation and enforcement. Those who made the loans including mortgage bankers, the credit rating agencies who put their stamp of approval on the Ninja, no doc and liar loans, and the investment bankers who packaged them up and sold them to an unsuspecting public were all unregulated or regulated only in a token fashion. Unfortunately, the deregulation of the U.S. capital markets that many not so long ago called for, has not resulted in increased competitiveness of the markets. Rather it has left the preeminence and credibility of our capital markets shattered. Instead of making the allocation of capital more efficient, it has resulted in a lack of transparency and mispricing and misallocation of capital. Investors have watched as over ten trillion in wealth has disappeared. And instead of fueling a growth in our economy, we have seen it fall into a decline the likes that haven't been seen since the great depression. Indeed, some have now called our situation the ``Not So Great Depression'' and one commentator, Stephen Roach of Morgan Stanley has warned of a Japanese style economy that continues to this day to sputter along.Reforms--The Long Road Back On a bipartisan basis, we have dug the hole we find ourselves in over an extended period of time. During much of that time we have enjoyed economic prosperity that in recent years contributed to the ``suspended disbelief'' that the good times would never end. All too often people spoke of the ``New Economy'' and those who doubted it or warned of dangers were treated as outcasts. But as with many a bubble in the past, this one too has burst. The capital markets have always been the crown jewel of our economy--the engine that powered it. And it can once again achieve that status, firing on all cylinders, but only if care is taken in structuring reforms that protect the investing public.Basic Principles In creating regulator reform, I believe there are some critical fundamental principles that should be established. They include: 1. Independence 2. Transparency 3. Accountability 4. Enforcement of the law 5. Adequate ResourcesIndependence Those responsible for oversight, including regulators and gatekeepers, must be independent and free of conflicts and bias when doing their jobs. And it is not just enough that they are independent on paper, they must be perceived by investors to be free of conflicts avoiding arrangements that cause investors to question their independence. They need to be free of political pressures that unduly influence their ability to carry out their mandates to protect the American consumer and investor. They must avoid capture by the regulated. And their ability to get resources should not be contingent on whether they reach a favorable decision for one special interest group or political affiliation. This is especially true of regulators such as the SEC and CFTC. These agencies must avoid becoming political footballs thrown between opposing benches. Unfortunately, that has not always been the case as we saw recently at the SEC or with the CFTC when it asked for regulation of credit derivatives. Similarly, the credit rating agencies have suffered from some of the same lack of independence the auditors did before Enron, WorldCom, and the enactment of the Sarbanes-Oxley Act of 2002 (SOX). They became captured by the desire to increase revenues at just about any cost, while ignoring their gatekeeper role. Independence also means there is a lack of conflicts that can impact one's independent thinking. For example, when a bank originates a subprime loan it may will ask its investment banking arm to securitize it. But if it is a no doc, liar loan or Ninja loan, will the investment banker perform sufficient due diligence and ensure full and fair disclosure is made to the investors clearly delineating in plain English what they are being sold? I doubt that has really occurred. Unfortunately, when the Gramm-Leach-Bliley Act was passed, allowing the creation of giant financial supermarkets, it failed to legislate and adequately address such conflicts. In fact, it did not address them at all leaving us with huge conflicts that have now given rise to investments that are not suitable for the vast majority of investors. Given this Act gave an implicit blessing to the creation of institutions that are ``Too Big To Fail'' and knowing that after the failure of Long Term Capital management the creation of such institutions brings with it the backing of taxpayers money, this serious deficiency in the laws governing regulation of conflicts of interests in these institutions needs to be addressed in a robust fashion.Transparency Transparency is the life blood of the markets. Investors allocate their capital to those markets where they get higher returns. Investors need the best possible financial information on which to base their decisions as to which capital markets they will invest in, and which companies, in order to generate the maximum possible returns. Maximizing those returns is critical to investors, and institutions who manage their investments, as it determines how much they will have for retirement, or spending. Investors will allocate their capital to those markets where returns are maximized. While economic growth in a particular country has a significant impact on returns for a capital market, the quality of the information provided to those who allocate capital also significant impacts it. In general, the better the information, the better the decisions made, and the more efficiently capital is allocated and returns maximized. The U.S. capital markets have maintained their lead in transparency, albeit our pride in that respect has been tarnished by off balance sheeting financings, a lack of disclosures regarding the quality of securities being sold, and credit ratings that were at best poorly done, if not outright misleading. Nonetheless, even in today's markets, the U.S. markets have continued to outperform foreign markets.Accountability Accountability clearly places the responsibility for decisions made and actions taken. People act differently when they know they will be held accountable. When people know there is a state trooper ahead on the highway, they typically drive accordingly. When they know there is no trooper, a portion of the population will hit the accelerator and speed ahead. There needs to be greater accountability built into the system. The executives and boards of directors of the financial institutions that have made the bad loans bringing our economy to its knees, causing Americans to lose their jobs, students to have to forgo their education, all at a great cost to the taxpayer should be held accountable. The American public will demand nothing less. The banking, insurance, commodities and securities regulators all need to have greater accountability. We need to know that we have a real cop on the beat, not just one in uniform standing on a corner. Likewise, gatekeepers must be held accountable for the product they provide the capital markets. Their product is critical to ensuring the credibility of financial information needed for capital allocation.Enforcement We are a Nation of laws. The laws governing the capital markets and banking in this country have been developed to provide protections for investors and consumers alike. They provide confidence that the money they have worked hard for, when invested, is safe from abusive, misleading and fraudulent practices. Without such laws, people would be much more reluctant to provide capital to banks and public companies that can be put to work creating new plants and products and jobs. But laws aren't worth the paper they are written on if they are not properly enforced. An unleveled playing field in the markets brought on by a lack of enforcement of laws providing consumer and investor protections can have the devastating effect we are now seeing. For example, the Financial Accounting Standards Board Chairman has written members of this committee citing how some institutions were not properly following the standards hiding transactions off balance sheet. Yet to date, enforcement agencies have not brought any cases in that regard. And laws are not just enforced by the law enforcement agencies, but also through private rights of actions of investors and consumers. This is critically important as law enforcement agencies have lacked the adequate resources to get the job done alone. Unfortunately, in recent years we have seen an erosion of investor and consumer rights to enforce the laws. Court cases setting up huge hurdles to these attempts to enforce the laws have made it much more costly taking significant time and resources to get justice. For example, one such court decision has now made it in essence legal for someone to knowingly aid another party in the commission of a fraud on investors, yet be protected by the courts from legal liability. It is akin to saying that if one drives a getaway car for a bank robber, they can go to jail. But if one wears a white collar and provides assistance to such a fraud in the securities market, they get a pass. Something is just simply wrong when that is allowed to occur in our Nation. Congress needs to remedy this promptly with legislation Senator Shelby introduced 7 years ago in 2002. Likewise we have seen passage of laws such as the Commodities Modernization Act of 2000 which also put handcuffs on our enforcement and regulatory agencies. This Act passed in the waning moments of that Congress at the requests of special interests. Supported by government officials, the Act specifically prevented the SEC and CFTC from regulating the derivatives market now totaling hundreds of trillions of dollars. These handcuffs need to be promptly removed. The securities and commodities laws need to be clarified to give the CFTC the authority to regulate commodities and any derivative thereof such as carbon trading, and the SEC the authority to regulate securities and any derivative thereof such as credit derivatives.Adequate Resources No one can do their job if they are not provided the proper tools, sufficient staffing and other resources necessary for the job. This includes being provided the necessary authority through legislation to do the job. It means Congress has to provide a budget to these agencies to hire sufficient number of staff. But it is not just the numbers that count, the agencies must also be given enough money to hire staff with sufficient experience. For example, while I was at the SEC, the budget you provided to the agency did not give the Office of Compliance Inspections and Examination a sufficient number of staff. And it certainly did not provide the office with enough money to hire senior experienced examiners who had the type of depth and breadth of expertise in the industry that was necessary to do the job right. Whose fault is it then when that agency fails to detects frauds through their examinations? I would say a good part of the blame lies at the feet of Congress. I would urge you to take a look at how these agencies that are so critical to the proper functioning of our markets are funded. In the case of the SEC, it collects sufficient fees to pay for an adequate budget. Yet each year it must go hat in hand to ask for a portion of those fees in an amount that has not met its needs. Instead, the SEC should be removed from the annual budget process and established as an independently funded agency; free to keep the fees it collects to fund its budgets.Necessary Reforms Once again, before legislating reforms, I would urge this committee to undertake ``Pecora'' hearings to ensure it gets the job done right. Some of the reforms that I believe are necessary, and which could be examined in such hearings include the following; Regulatory Structure: Arbitrage among banking regulators should be eliminated, and accountability for examination and regulation of banks centralized in one agency. To accomplish that, Congress should once again consider the legislation offered in 1994 by the former Chairman of this Committee, Donald Reigle. That legislation would combine the examination function into one new agency, while having the FDIC remain in its role as an insurer and the Federal Reserve as the central banker. Careful consideration needs to be given to the conflicts that arise when the central banker both sets monetary policy, such as when it created low interest rates earlier this decade, and then regulates the very banks such as Citigroup and Country Wide that exploit that policy, and at the same time fails to put in place safeguards as the Fed had been asked to do by Congress in 1994. And the mission of the new agency, as well as the missions of the FDIC and Fed with respect to consumer and investor protection needs to be made much more explicit. All too often these regulators have been captured by industry, much to the detriment of consumers and investors and in the name of safety and soundness. Yet we have learned that what is good for consumers and investors alike, is also good for safety and soundness, but not necessarily the reverse. I believe the roles of the CFTC and SEC should be clarified. I do not support the merger of the two agencies as I don't believe the synergies some believe exist will be achieved. I also believe commodities and securities are fundamentally two different markets, with significantly differing risks, and the regulator needs significantly differing skill sets to regulate them. Accordingly, as I have previously mentioned, I would clarify the roles of these two agencies by giving all commodities and derivatives thereof to the CFTC to regulate, and all securities and derivatives thereof to the SEC. Some have argued for the creation of new agencies. To date; I have yet to see the need for that. For example, some have argued that a separate investor and consumer protection agency should be created. However, when it comes to the securities markets, I believe the SEC should continue in that role, and given the resources to do so. Over the years, the SEC has shown it can be a strong investor protection agency. It has only been in recent years, when quite frankly people who did not believe in regulation were appointed to the Commission, that it fell down on the job. By appointing investor minded individuals to the Commission, who have a demonstrated track record of serving and protecting the public, this problem can be fixed. Likewise however, if a separate agency is created, but the wrong people put in place to run it, we will see a repeat performance of what has occurred at the SEC. Gaps in Regulation: There are certain gaps in regulation that are in need of fixing. Credit derivatives should become subject to regulation by the SEC as former SEC Chairman Cox urged this committee to do some time ago. While the establishment of a clearing house is a positive development, in and of itself it is insufficient. I understand the securities laws generally exclude over-the-counter swaps from SEC regulation. This improperly limits the SEC's ability to provide for appropriate investor protection and market quality. The OTC derivatives market is enormous, and proper regulation is in the public interest. The SEC would be in a better position to provide that regulation if the following changes were made: Repeal the exclusion of security-based swap agreements from the definition of ``security'' under the Securities Act of 1933 and Securities Exchange Act of 1934. Include within the definition of ``security'' financial products that are economic derivatives for securities. It is important to consolidate the regulatory authority at the SEC because of its investor protection and capital markets mandate. While the SEC has a mandate to protect investors and consumers, other regulators may lose sight of that mission. Based on my business and agricultural background, I have found derivatives in agriculture and other physical commodities have a different purpose than financial derivatives as they permit risk management and secure supplies for users and producers of goods. Require all transactions in securities to be executed on a registered securities exchange and cleared through a registered clearing agency. There needs to be much greater transparency for this market. The recent reluctance of the FED to disclose the counter parties receiving the bailout in connection with AIG is alarming but not surprising. Even the current Fed Chairman has stated this is an agency that has been all too opaque in the past. There needs to be greater disclosure to the public of the trading, pricing and positions of these arrangements. There also needs to be disclosure identifying the counterparties when the impact of the contracts could have a material effect on their operations, performance or liquidity. Given the deficiencies that have existed in some contracts, there also needs to be more transparency provided around the nature, terms, and amounts of such contracts when they are material. There is also a legitimate question as to whether one party should be able to bet on whether another party will pay their debt, when the bettor has no underlying direct interest in the debt. Certainly as we have seen at AIG and elsewhere, these contracts can have devastating effect. Quite frankly, they do not serve a useful purpose for investors as a whole in the capital markets. As such, I would like to see them prohibited. There is also a gap in regulation of the municipal securities market as a result of what is known as the Tower Amendment. Recent SEC enforcement actions such as with the City of San Diego, the problems in the auction rate securities, and the lurking problems with pension obligation bonds, all cry out for greater regulation and transparency in these markets. These token regulated municipal market now amount to trillions of dollars and poses very real and significant risks. Accordingly, as former Chairman Cox recommended, I believe Section 15B(d)--Issuance of Municipal Securities--of the Securities Act of 1934 should be deleted. The SEC should be given authority to regulate hedge and private equity funds that directly or indirectly take public capital including from retail investors. They should be subject to the same type of regulation as their counter parts in the mutual fund market. This regulation should give the SEC the (i) authority to require the funds to register with the SEC, (ii) give the SEC the authority to inspect these firms, (iii) require greater transparency through public quarterly filings of their positions and their financial statements and (iv) give the SEC appropriate enforcement capabilities when their conduct causes damage to investors or the financial markets and system. As testimony before this committee in the past has demonstrated, the SEC has insufficient authority over the credit ratings agencies despite the roles those firms played in Enron and now the subprime crisis. This deficiency needs to be remedied by giving the SEC the authority to inspect credit ratings, just as Congress gave the PCAOB the ability to inspect independent audits. In addition, the SEC should be given the authority to fine the agencies or their employees who fail to adequately protect investors. Greater transparency should be provided to credit ratings themselves. And disclosure should be required, similar to that for independent auditors of potential conflicts of interests. The SEC, CFTC and Banking Regulators should also be given powers to regulate new financial products issued by those whom they regulate. This should be accomplished through disclosure. The agencies should have to make a determination that adequate disclosures have been made to consumers and investors regarding the risks, terms conditions of new products before they can be marketed. If a new product is determined by an agency to present great risk to the financial system or investors, the regulating agency should be empowered to prevent it from coming to market, just as is done with new drugs. In addition, there needs to be greater regulation of mortgage brokers. Some States have already made progress in this regards. However, the Federal banking regulators should be given power to provide consumers necessary protections, if they find that state regulators have failed to do so. Greater Accountability Through Improved Governance and Investor Rights: Legislation equivalent to an investor's Bill of Rights should be adopted. Investors own the company and should have some basic fundamental rights with respect to their ownership and investments. It is well known that investors in the U.S. lack some of the fundamental rights they have in foreign countries such as the United Kingdom, the Netherlands and Australia. Yet while some argue for regulation and regulators similar to those in foreign countries, these very same people often oppose importing investor rights from those same countries into our system of governance. The excesses of executive compensation have been well documented and need no further discussion. Some have argued investors have an ability to directly address this by voting for or against directors on the compensation committee of corporate boards. But that is a fallacy. First of all, investors can only vote for, not against a director in the system we have today. Second, some institutional investors have direct conflicts when voting as a result of receiving fees for managing corporate pension funds of the management they are voting on. At times this seems to unduly and improperly influence their votes. To remedy these shortcomings, Congress should move to adopt legislation that would: Require majority voting for directors and those who can't get a majority of the votes of investors they are to represent should be required to step down. Require public issuers to annually submit their compensation arrangements to a vote of their investors-- commonly referred to as ``say on pay.'' Give investors who own 3 to 4 percent of the company, the same equal access to the proxy as management currently has. While some argue this will give special interests an ability to railroad corporate elections, that simply has proven not to be the case. When special interests have tried to mobilize votes based on their interests and not those of investors, they have ALWAYS failed miserably. Investors who own 5 percent or more of the stock of a company should be permitted, as they are in other countries, to call for a special meeting of all investors. They should also be given the right to do so to call for a vote on reincorporation when management and corporate boards unduly use state laws detrimental to shareholder interests to entrench themselves further. Strengthen the fiduciary requirements of institutional investors when voting on behalf of those whose money they manage. This should extend to all such institutional investors including mutual funds, hedge funds, public and corporate pension funds as well as the labor pension funds. Since voting is an integral part of and critically important to governance, greater oversight should be put in place with respect to those entities who advise institutions on how they should vote. Recently a paper from the Milstein Center for Governance and Performance at Yale has made recommendations in this regard as well. As a former managing director of one such entity, I would support legislation that would: Require these entities to register with the SEC as investment advisors, subject to inspection by the SEC. While some have registered, others have chosen not to. Require these entities to improve their transparency by disclosing their voting recommendations within a reasonable time period after the vote. Require all institutional investors, including public, corporate, hedge and labor pension funds to disclose their votes, just as mutual funds are currently required to disclose their votes. Require that only the legal owner of a share of stock can vote it, prohibiting those who borrow stock to unduly influence an election by voting borrowed stock they don't even own, and eliminating broker votes. It should also be made explicit that the SEC has authority to set governance standards for the mutual funds. For example, the SEC should have the authority, and act on that authority, to require a majority of independent directors for mutual funds, as well as an independent chair. Investor's rights of private actions have also been seriously eroded in the past decade. Certainly we should not return to the abuses of the court system that existed before the Private Securities Law Reform Act (PSLRA) was passed. But at the same time, investors should not have to suffer the type of conduct that contributed to Enron and other scandals. And the SEC does not, and will not have the resources to enforce the securities laws in all instances. The SEC should continue to be supportive of investors' private right of action. The SEC should also continue to support court rulings that permit private investors to bring suits in the event of aiding and abetting and scheme liability. In 2004, the SEC filed an amicus brief in Simpson v. Homestore.com, Inc., upholding liability against an individual regardless of whether or not the person made false or misleading statements. In 2007, a request from SEC Commissioners to the Solicitor General to submit a brief in favor of upholding scheme liability in the case of Stoneridge v. Scientific-Atlanta was denied by the White House, despite the urging of Senate Banking Committee Chairman Christopher Dodd (D-CT) and House Financial Services Committee Chairman Barney Frank (D-MA). The SEC needs to reclaim the SEC's role of providing strong support for the right of investors to seek a private remedy. Investors in securities fraud cases have always had the burden of proving that defendants' fraud caused the investors' losses. Congress continued this policy in PSLRA. However, recent lower-court interpretations of a 2005 Supreme Court case have improperly transformed loss causation into an almost impossible barrier for investors in serious cases of fraud. Congress, with the support of the SEC, should act to fix the law in this area. Taking advantage of the loophole in the law the courts have now created, public companies have begun gaming the system. Specifically, corporations may now simultaneously disclose other information--positive and negative--in order to make their adverse disclosures ``noisy,'' so that attorneys representing shareholders will find it more difficult, if not impossible, to satisfy loss causation requirements. Other corporations may leak information related to the fraud, so that the share price declines at an early date, before they formally reveal the adverse news. In sum, narrow lower-court standards of loss causation are allowing dishonest conduct to avoid liability for fraudulent statements by disclosing that the corporation's financial results have deteriorated without specifically disclosing the truth about their prior misrepresentations that caused the disappointing results. Insisting on a ``fact-for-fact'' ``corrective disclosure'' allows fraudsters to escape liability simply by not confessing. Transparency: The lack of credible financial information has done great damage to the capital markets. This has ranged from a lack of information on off balance sheet transactions as was the case with Enron, to a lack of information on the quality of assets on the balance sheets of financial institutions, to a lack of information on risk management at public entities, to a lack of transparency at regulators. The lack of transparency begins with accounting standards that yet again have failed to provide the markets and investors with timely, comparable and relevant information. The off balance sheet transactions that expose great risk to the markets, have once again been permitted to be hid from view by the accounting standard setters. What is more disturbing about this is that the standard setters were aware of these risks and failed to act. To remedy this serious shortcoming, and ensure the standard setters provide a quality product to investors and the markets, I believe Section 108 of SOX should be amended. It should require that before the SEC recognizes an accounting standard setter for the capital markets, either from the U.S. or internationally, that its board of trustees and voting board members must have preferably a majority of representatives from the investor community and certainly no less than 40 percent of their membership should be investors with adequate skills and a demonstrated ability to serve the public. In addition, any standard setter should be required to have an independent funding source before their standards are used. And finally, each standard setter should be required to periodically reevaluate the standards they have issued, and publicly report on the quality of their implementation. For too long accounting standard setters have disavowed any responsibility for their standards once they have been issued, a practice that should come to an immediate halt. The SEC also needs to closely monitor the current efforts of the FASB and International Accounting Standards Board (IASB) to ensure appropriate transactions are brought on balance sheet when a sponsoring company controls, or effectively controls the economics of the transaction. I fear based on developments to date, these efforts may yet once again fail investors. Transparency of the regulators needs to be enhanced as well so as to establish greater accountability. For example, the regulators should be required in their annual reports to Congress to: Identify key risks that could affect the financial markets and participants they regulate, and discuss the actions they are taking to mitigate those risks. For example, the OCC and SEC have had risk management offices for some time, yet their reports have failed to adequately alert Congress to the impending disaster that has now occurred. Unfortunately the SEC risk management office was reduced to a staff of one. They should have to provide greater detail as to their enforcement actions including the aggregate number and nature of the actions initiated, the number of actions in the pipeline and average age of those cases, the number and nature of the cases resolved and how those cases were resolved (e.g., litigation, settlement, case dismissed). Banking and securities regulators should be required to make public their examination reports. The public should be able to see in a transparent fashion what the regulator has found. Regulators who have found problems have all too often failed to disclose their findings of problems to the unsuspecting public or Congress. In some instances, the problems identified have not been promptly addressed by the regulator and have resulted in the need for taxpayer bailouts amounting to hundreds of billions of dollars. That simply should not be allowed to occur. And while some in the industry and banking regulators have indicated such disclosure could harm a financial institution, I believe any such harm is questionable and certainly of much less significance than the damage now being wrought on our economy and society. The securities and banking regulators should also be required to adopt greater disclosures of risks that can impact the liquidity and capital of financial institutions. The Shipley Working Group encouraged such disclosures. These disclosures should include greater information regarding the internal ratings, risks and delinquencies with respect to loans held by financial institutions. In addition, greater disclosures should be required regarding how a company identifies and manages risk, and changing trends in those risks, with an eye to the future. Improve Independence and Oversight of Self Regulatory Organizations: FINRA has been a useful participant in the capital markets. It has provided resources that otherwise would not have been available to regulate and police the markets. Yet serious questions have arisen that need to be considered when improving the effectiveness and efficiency of self regulation. Currently the Board of FINRA includes representatives from those who are being regulated. This is an inherent conflict and raises the question of whose interest the Board of FINRA serves. To address this concern, consideration should be given to establishing an independent board, much like what Congress did when it established the PCAOB. In addition, the arbitration system at FINRA has been shown to favor the industry, much to the detriment of investors. While arbitration in some instances can be a benefit, in other situations it has been shown to be costly, time consuming, and biased towards those who are constantly involved with it. Accordingly, FINRA's system of arbitration should be made optional, and investors given the opportunity to pursue their case in a court of law if they so desire to do so. Finally careful consideration should be given to whether or not FINRA should be given expanded powers over investment advisors as well as broker dealers. FINRA's drop in fines and penalties in recent years, and lack of transparency in their annual report to the public, raises questions about its effectiveness as an enforcement agency and regulator. And with broker dealers involved in providing investment advice, it is important that all who do so are governed by the same set of regulations, ensuring adequate protection for the investing public. Enforcement: With respect to enforcement of the securities laws, there are a number of steps Congress should take. After all, if laws are not adequately enforced, then in effect there is no law. Enforcement by the SEC would be enhanced if it were granted the power to bring civil and administrative proceedings for violations of 18 U.S.C. 1001, and seek civil money penalties therein. 18 U.S.C. 1001 is a criminal statute that provides, in pertinent part: in any matter within the jurisdiction of the executive, legislative, or judicial branch of the Government of the United States, knowingly and willfully--(1) falsifies, conceals, or covers up by any trick, scheme, or device a material fact; (2) makes any materially false, fictitious, or fraudulent statement or representation; or (3) makes or uses any false writing or document knowing the same to contain any materially false, fictitious, or fraudulent statement or entry; shall be fined under this title, imprisoned not more than 5 years or, if the offense involves international or domestic terrorism (as defined in section 2331), imprisoned not more than 8 years, or both. The SEC should be authorized to prosecute criminal violations of the Federal securities laws where the Department of Justice declines to bring an action. When I was at the Commission, it made a number of criminal referrals, including such cases as the Sunbeam matter, which DOJ declined to advance because of resource constraints. Finally the SEC should be provided an ability to take actions for aiding and abetting liability under the Securities Act of 1933. The Commission can bring actions for aiding and abetting violations under the Securities Exchange Act of 1934. The SEC has been chronically underfunded. A dedicated, independent financing arrangement, such as that enjoyed by the Federal Reserve, would be useful, and is long overdue. Finally, we have seen serious problems arise for those who have blown the whistle on corporate fraud. Despite the provisions of SOX designed to protect such individuals, regulatory interpretations of that law have rendered it meaningless all too often. Congress should fix these shortcomings, in part by giving jurisdiction over the law as it is applicable to the securities markets, to the SEC rather than the Department of Labor.Conclusion Improvements to the securities laws and regulations that will once again ensure investors can have confidence they are playing on a level playing field are critical to recovery of our capital markets and economy. Such legislative changes are necessary if a recovery is to occur, but it is equally important that when they are made, they are changes and improvements investors perceive as being credible and worthwhile. Thank you and I would be happy to answer any questions. FOMC20060920meeting--157 155,MR. REINHART.,"3 Thank you, Mr. Chairman and some participants. [Laughter] Over the intermeeting period, tumbling oil prices, better-behaved inflation, and the minutes of the August meeting, which conveyed a more widespread disinclination to tighten than investors suspected, pulled nominal interest rates lower. As can be seen by the solid line in the upper left panel of your first exhibit, the rate on three-month Eurodollar futures expiring this December declined a touch, on net, and is now consistent with the federal funds rate remaining at 5¼ percent for the remainder of the year. Investors seem to expect policy easing thereafter, in that the contract expiring one year later has a rate about ½ percentage point lower. This can be seen most clearly by the black line in the upper right panel, which shows that the path expected for the federal funds rate over the next two years has a decidedly negative slope. As indicated by the shift from the black dotted to the black solid line in the lower left panel, this revision to policy expectations was associated with a roughly parallel step downward in the term structure of nominal Treasury yields over the intermeeting period. The yield curve for indexed securities moved up closer to its nominal counterpart—the shift from the dotted to the solid red line—implying that the difference, inflation compensation, declined. These relative movements can be made more precise by putting them in terms of changes in implied forward rates, as at the right. Nominal forward rates (the top panel) declined in a relatively uniform fashion, from 8 to 15 basis points. The rotation up in the real yield curve, however, was associated with sizable increases in short-term real forward rates and declines at longer horizons. The arithmetic difference between the two is plotted in the bottom right panel: Inflation compensation fell noticeably at short horizons, but the decline tapered off as the maturity lengthened. 3 Materials used by Mr. Reinhart are appended to this transcript (appendix 3). One way to tie these disparate movements into a neat package is to argue that the substantial decline in oil prices in recent weeks represents a disinflationary impetus that is anticipated to be only partly offset by you. That is, nominal rates will move lower but by less than the drop in inflation so as to keep real interest rates higher for a time. In this story, the decline in oil prices represents an opportunity to disinflate—an opportunity that investors expect you to take by being slow to lower nominal interest rates. The same story, however, can take on a darker hue if it is argued that the fall in the prices of oil and other commodities evidenced a slowing in global activity brought on at least in part by your previous 17 policy firmings—that is, this opportunity for disinflation could be one of your own making. Either explanation—one of omission or one of commission—produces a moderation in spending and a drift down in inflation that would seem to be consistent with holding the funds rate at 5¼ percent for now, a possibility examined in more detail in exhibit 2. At its August meeting, the Committee assessed the risks to be such that it could hold policy unchanged given its expectation that growth would moderate and inflation decline. The information received since then would seem to strengthen that determination. As shown in the top left panel, inflation compensation measured in the Treasury market is about unchanged at the longer horizon (the red line) and distinctly lower in the near term (the black line). How much of this decline represents a drop in inflation expectations as opposed to a decline in inflation risk premiums is hard to say, but the evidence at the right may be suggestive. Merrill Lynch conducts a monthly survey of global fund managers about their views of macroeconomic risks and portfolio inclinations. More than 200 of them typically reply, and last month an increased share of them were of the view that inflation would be lower, rather than higher, than in recent months. This view seems to be underpinned by the expectation that economic growth will moderate so that resource slack will open up, perhaps as in the staff forecast in the middle left panel. Indeed, when asked about global economic growth, the fund managers surveyed by Merrill Lynch mostly expected it to slow, as at the middle right, with more of them of that view than earlier in the year. As can be seen directly below, the slowing is not anticipated by investors to be so precipitous as to tip the world economy into recession. More than 90 percent of the managers view such an outcome as unlikely. Thus, they wouldn’t seem to be putting much weight on the flatness of the yield curve, plotted at the bottom left, as a leading indication of recession—nor would you if you’re inclined to keep policy on hold. In that regard, as the chart makes clear, the yield curve has had some predictive power for recession over the past forty years. For instance, the inversion of the term structure in 2000 was sending a signal that, in retrospect, might have warranted a response. This indicator may seem less compelling now for two reasons. First, a flattening yield curve has sent false signals as well over the years, including of recessions that didn’t occur in the mid-1990s. Second, much of the downward tilting of the term structure seems due to a decline in term premiums, which might be a sign of reduced uncertainty rather than a sign of increased economic vulnerabilities. Indeed, some Committee members may be far from seeing the economy as vulnerable—perhaps to the point of inclining them toward firming policy 25 basis points, as in exhibit 3. In particular, financial market participants do not seem to have heard the message of the August statement that the risks were tilted toward higher policy rates. Rather, as shown in the top left panel by the spread of the December 2007 Eurodollar futures contract below the December 2006 one, about 50 basis points of easing is expected next year. This expectation of ease may be contributing to low credit spreads (the top center panel) and the recent rise in equity prices (the top right panel). This financial impetus might be seen as a reason that spending will not moderate sufficiently to make a noticeable dent in inflation. Even if those expectations are wrung out of financial market prices over time—as in the staff forecast—the resulting path of inflation may not be acceptable to the Committee. As shown in the middle panel, core PCE inflation is projected by the staff to remain above 2 percent through the end of 2008, which would mark the fifth consecutive year of such an outcome. The survey expectations of CPI inflation— plotted at the bottom left—similarly remain well above 2 percent. While survey responses came down over the intermeeting period, you might discern a slight uptrend in the past few years that could be taken as an erosion of the public’s confidence. In such a circumstance, members may believe that more-acceptable progress toward price stability will likely involve a firmer stance of policy, a judgment that would be strengthened if you thought the spike in the growth of compensation per hour plotted at the right was not as likely to roll back as the staff projects. The Bluebook lived up to its title, “Monetary Policy Alternatives,” by offering the five different options given in exhibit 4—three formal ones and two variants (which are shaded) that were discussed in the text. If your intent is to solidify current market expectations of easing, switching to balanced risks, as in A, probably has some appeal. The words of alternative B were designed to leave market rates about unchanged, whereas B+ emphasizes that tightening is more likely than easing. It doesn’t really say anything new, but we thought the force of repetition might get the attention of market participants. The alternative labeled C- couples tightening with a removal of the rate bias, signaling that the Committee may be done, whereas C imposes considerable additional restraint by retaining an assessment of upside risks even after firming. Your last exhibit repeats table 1 from the Bluebook with a minor change noted in red in the second row." FOMC20060808meeting--116 114,MR. FISHER.," Mr. Chairman, I think it was in March that I referred to Pascal’s famous wager about the existence of God. Pascal’s view was basically that if you look far out in the future from a risk-management standpoint, the answer was in the affirmative. [Laughter] I happen to accept the existence of inflation, and I admire President Lacker, President Minehan, and others who have made very strong arguments. I take note of one thing that is very different at this meeting from what I have heard in my year-plus at this table. This is the first time that many people have said—and I certainly have heard this from the people I have talked to in the field—that they are moving on prices instead of being tamped down in terms of their desire. In other words, they have pricing power, and it is being realized. This is the first time we’ve heard that in the discussion, and it worries me. It’s very, very important that we signal our anti-inflationary resolve. I generally always agree with President Poole. I happen to be a minimalist as far as the statement is concerned. But if we pause here, it is very important that we use the kind of language that Governor Kohn suggested and that we make it very clear that this may not be the end of the process. Even more important, Mr. Chairman, is that we agree at this table that we’ll be fearless in moving if we have to. As to the market, I think President Minehan made a very good comment. Having been a market operator for thirty years of my career, I have found that markets are usually wrong. Our job is not to satisfy the markets. Our job is to get the economy right—that’s our mission. So I would accept a pause, Mr. Chairman, under the conditions I just mentioned. I like Governor Kohn’s suggestion on language although, like a broken record, I would put the word “global” in front of “resource utilization” because I think that reflects reality. Having said what I just said, I would also say that, if the group decides to raise the rate 25 basis points, I won’t dissent because I don’t have a vote. [Laughter]" FOMC20071211meeting--111 109,MR. KOHN.," Thank you, Mr. Chairman. The outlook for economic activity has weakened over the intermeeting period. The housing bust looks steeper with importantly greater declines in prices, and that will affect future consumption. Weakness in housing and the uncovering of greater losses at key financial intermediaries have contributed to a notable deterioration in financial markets and a tightening of some financial conditions. We are also beginning to see signs that economic weakness has not been confined to the housing-related sectors. With regard to activity outside of housing, like many others who have spoken today, I see the most notable development as the flattening-out of consumption spending in September and October. That could reflect the rise in energy prices, but it seems to me that the very deep dip in consumer sentiment suggests that more is at work—that the actual and expected effects of financial market turmoil, for example, on the cost and availability of credit to households along with lower house and stock prices might also be contributing to less-ebullient consumption spending in the recent past and going forward. Capital spending also seems to be slowing. Although business investment spending hasn’t been revised down in the fourth quarter in the Greenbook, logically slower consumption growth will show through before long, as it does beginning in the first quarter in the Greenbook. In addition, we have some more evidence of greater business caution, which could damp business investment relative to expected activity. The NFIB survey for November, for example, shows that the outlook by small businesses deteriorated decidedly in November. There’s a sharp downturn in almost all the outlook indexes for small businesses in this November survey; and as I listen to the reports from around the table, I think for all except a swath of states from Nebraska through Texas, maybe the lower Midwest, I’m hearing a little more pessimism from other places around the country consistent with this. To be sure, employment continues to expand. Various purchasing manager surveys also suggest that activity continues to increase, albeit slowly. But I agree with the staff that, on balance, the incoming data suggest more near-term weakness than anticipated at our last meeting, including some tentative evidence of spillovers from housing. Financial market conditions have deteriorated substantially, and that will place further restraint on growth next year. I think what we learned in the first few weeks of November was that losses are much larger than had been previously anticipated. Those losses stretched into what had been seen as higher quality mortgage-related assets, as Bill Dudley showed us, and the losses are large enough to call into question the ability of some very essential intermediaries to provide support for markets or to extend much additional credit. Those intermediaries include Fannie and Freddie and the financial guarantors, as well as some investment and commercial banks. As concerns about downgrades and potential fire sales rose, investors and institutions moved to protect themselves, with the rise in term funding spreads symptomatic of the greater level of concern. It is logical and reasonable that the response of intermediaries to this concern would be to tighten terms and conditions for their loans to exert greater control over their balance sheets. Expectations that intermediaries will be tightening credit, along with the incoming spending data, led to a more pessimistic view of the economic outlook, and although Treasury rates fell substantially, concern about the performance of borrowers meant that those declines did not show through very much into the cost of funds to private lenders and borrowers. Indeed, a number of indicators point to a net tightening of credit conditions across a range of borrowing sources over the intermeeting period, and that tightening will persist past the New Year. That tightening will have adverse implications for demand by households and businesses in 2008—that is, I do think there’s going to be some spillover from Wall Street to Main Street. Forward measures of the LIBOR-OIS spread for after the year-end moved substantially higher. In effect, the cost to banks of funding will not reflect the full extent of the easing we’ve done in the federal funds market. The spreads on corporate bonds have widened sufficiently to actually increase borrowing costs for both investment- grade and junk-bond issuers over the intermeeting period. The leveraged-loan market deteriorated in late November, forcing banks to take more loans onto their balance sheets, using up scarce balance sheet room. Secondary markets for nonconforming mortgages remain moribund, with no signs of life, and any loans that will be made in these nonconforming sectors will be placed onto the balance sheets of thrifts and banks, many of which are already facing strains. Perhaps as a consequence, rates on prime jumbo mortgages have actually risen over the intermeeting period; Fannie and Freddie have increased fees and are tightening standards, and they face slightly higher spreads. So the damping effect of lower Treasury rates on the cost of conforming housing credit will be held down. All that said, I do see some encouraging signs that the preconditions for future improvements are coming into place. As others have noted specifically, institutions are recognizing and dealing more directly with the implications of these losses. They are recognizing the losses more aggressively. They’re raising capital, and they’re being more explicit about taking contingent liabilities like SIVs onto their balance sheets. Even so, I think that what we have learned over the intermeeting period is that the process of returning financial markets to more normal functioning is going to take longer and the disruption to the cost and availability of credit will be greater than I had thought just six weeks ago. Prospects for a period of weaker economic growth and reduced resource utilization do work to lower inflation risks. In addition, we’ve seen a downward revision to compensation and unit labor costs, and commodity prices outside food and energy have fallen substantially in recent weeks. At the same time, energy prices have risen, and past inflation data have been revised higher, and the staff has actually revised up its inflation forecast by a tenth or two over the next few years. So on balance, I judge the inflation risk still to be to the upside if the economy follows the modal forecast but by considerably less than I thought at the last meeting. I look forward to a discussion in the next part of the meeting about how we deal with the policy implications of this changing situation." FOMC20070807meeting--57 55,MS. YELLEN.," Thank you, Mr. Chairman. Data on inflation during the intermeeting period have continued to be encouraging, but the prospects for economic activity have become dicier. The results for GDP in the second quarter as a whole actually took on a positive tone, with final sales mainly accounting for the healthy growth rate. But the quarter ended on a weak note, with disappointing data for housing consumption and for orders of core capital goods. Of course, the big developments since our last meeting were in financial markets. I read them as pointing to weaker growth going forward and greater downside risk. The market for mortgage- backed securities is now highly illiquid, and there are indications that credit problems are spilling beyond the subprime sector. It thus seems likely that lending standards will tighten for a broader class of borrowers in the mortgage market. The drop in equity prices and rising rates on most risky corporate debt are further negatives for growth. There are some offsets to these negative factors, including the decline in the dollar and, most important, the steep reduction we have seen in risk-free rates. On balance, however, I expect these offsets to be only partial, providing a cushion against future weakness, because I interpret the decline in Treasury rates during the intermeeting period primarily as a reflection of weaker growth expectations and a correspondingly lower path for the expected future fed funds rate and not a consequence of the fall of the term premium. The jump in oil prices since our last meeting is a further factor weighing on aggregate demand. As a result of these considerations, I have lowered my growth forecast for the second half of this year ½ percentage point, to just over 2 percent. This rate is moderately below my estimate of potential growth, which I now put at about 2½ percent. Going beyond this year, the outlook depends on one’s assumption concerning appropriate monetary policy. I consider it appropriate for policy to aim at holding growth just slightly below potential to produce enough slack in labor and credit markets to help bring about a further gradual reduction in inflation toward a level consistent with price stability. Barring a more serious and prolonged tightening of credit market conditions or a general liquidity squeeze, I would keep the fed funds rate modestly above its equilibrium level to accomplish this goal. However, I now see the fed funds rate as well above the neutral level. So I think it likely that the fed funds rate will need to fall appreciably over the next few years. My assessment of the neutral federal funds rate declined during the intermeeting period for two main reasons—first, because of the tightening in financial conditions associated with the reassessment of risk now taking place and, second, because of the NIPA revisions, which suggest slower structural productivity growth and, in all likelihood, correspondingly slower growth in aggregate demand. I thus think that a larger decline in the fed funds rate will be needed over time than in the Greenbook baseline to achieve a soft landing. A key development during the intermeeting period was the downward revision of real GDP growth over the 2004-06 period. This adjustment reinforces the work of productivity experts at the Board and elsewhere who had previously found evidence of a slowdown in underlying productivity growth. The revision in actual productivity was big enough to lead us to lower our estimate of growth in both structural productivity and potential output, although our estimates remain above those in the Greenbook. In addition to tighter financial conditions, lower structural productivity growth was the reason that we lowered our forecast for real GDP growth to 2¼ percent in 2008. As a result, the unemployment rate edges up in our forecast, reaching nearly 5 percent by the end of next year. The modest amount of slack that this entails should help bring about the desired gradual reduction of inflation in the future. Readings on core PCE prices have been quite tame for some time now, rising only 0.1 percent in each of the past four months. Although a portion of the recent deceleration in core prices likely reflects transitory influences, the underlying trend in core inflation still appears favorable. We anticipate that the core PCE price index will rise 2 percent this year and that core inflation will gradually ebb to around 1.8 percent over the forecast period. This forecast is predicated on continued well-anchored inflation expectations and the eventual appearance of a small amount of labor market slack, as I just mentioned. For some time now, I’ve thought an argument could be made that the NAIRU was a bit lower than assumed in the Greenbook, and the new evidence that structural productivity growth has been lower than we thought for more than three years reinforces this view. It means that the relatively good inflation performance over this period occurred despite the upward pressure that must have been operating because of the deceleration in structural productivity. In any event, I also expect to see modest downward pressure on inflation in the next couple of years from the ebbing of the upward effects of special factors, including the decline in structural productivity, energy and commodity prices, and owners’ equivalent rent. In terms of risk to the outlook for growth, the housing sector obviously remains a serious concern. We seem to be repeatedly surprised with the depth and duration of the deterioration in these markets; and the financial fallout from developments in the subprime markets, which I now perceive to be spreading beyond that sector, is a source of appreciable angst. Of course, financial conditions have deteriorated in markets well beyond those connected with subprime instruments or even residential real estate more generally. It appears that participants are questioning structured credit products in general, the risk assessments of the rating agencies, and the extent of due diligence by originators who package and sell loans but no longer hold a very sizable fraction of these originations on their own balance sheets. The Greenbook has long highlighted, and we have long worried about, the possibility and potential consequences of a broader shift in risk perceptions. With risk premiums having been so low by historical standards, it would hardly be surprising to see them rise, making financial conditions tighter for any given stance of monetary policy. While it remains possible that financial markets will stabilize or even reverse course in the days and weeks ahead, the possibility that the financial markets are now shifting to a historically more typical pattern of risk pricing is very much on my radar screen. Should this pattern persist and possibly intensify, it will have very important implications for policy." CHRG-111shrg52619--192 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM MICHAEL E. FRYZELQ.1. It is clear that our current regulatory structure is in need of reform. At my subcommittee hearing on risk management, March 18, 2009, GAO pointed out that regulators often did not move swiftly enough to address problems they had identified in the risk management systems of large, complex financial institutions. Chair Bair's written testimony for today's hearing put it very well: `` . . . the success of any effort at reform will ultimately rely on the willingness of regulators to use their authorities more effectively and aggressively.'' My questions may be difficult, but please answer the following: If this lack of action is a persistent problem among the regulators, to what extent will changing the structure of our regulatory system really get at the issue?A.1. For the most part, the credit unions have not become large, complex financial institutions. By virtue of their enabling legislation along with regulations established by the NCUA, federal credit unions are more restricted in their operation than other financial institutions. For example, investment options for federal credit unions are largely limited to U.S. debt obligations, federal government agency instruments, and insured deposits. Federal credit unions cannot invest in a diverse range of higher yielding products, including commercial paper and corporate debt securities. Another example of restrictions in the credit union industry includes the affiliation limitations. Federal credit unions are much more limited than other financial institutions in the types of businesses in which they engage and in the kinds of affiliates with which they deal. Federal credit unions cannot invest in the shares of an insurance company or control another financial depository institution. Limitations such as these have helped the credit union industry weather the current economic downturn. These limitations among the other unique characteristics of credit unions make credit unions fundamentally different from other forms of financial institutions and demonstrate the need to ensure their charter is preserved in order to continue to meet their members' financial needs. Restructuring the regulatory system to include a systemic regulator would add a level of checks and balances to the system to address the issue of regulators using their authorities more effectively and aggressively. The systemic regulator should be responsible for establishing general safety and soundness guidelines for financial institutions and then monitoring the financial regulators to ensure these guidelines are implemented. This extra layer of monitoring would help ensure financial regulators effectively and aggressively address problems at hand.Q.2. Along with changing the regulatory structure, how can Congress best ensure that regulators have clear responsibilities and authorities, and that they are accountable for exercising them ``effectively and aggressively''?A.2. If a systemic regulator is established, one of its responsibilities should include monitoring the implementation of the established safety and soundness guidelines. This monitoring will help ensure financial regulators effectively and aggressively enforce the established guidelines. The oversight entity's main functions should be to establish broad safety and soundness principles and then monitor the individual financial regulators to ensure the established principles are implemented. This structure also allows the oversight entity to set objective-based standards in a more proactive manner, and would help alleviate competitive conflict detracting from the resolution of economic downturns. This type of structure would also promote uniformity in the supervision of financial institutions while affording the preservation of the different segments of the financial industry, including the credit union industry. Financial regulators should be encouraged to aggressively address areas of increased risk as they are discovered. Rather than financial institution management alone determining risk limits, financial regulators must take administrative action when the need arises. Early recognition of problems and implementing resolutions will help ensure necessary actions are taken earlier rather than later. In addition, financial regulators should more effectively use off-site monitoring to identify and then increase supervision in areas of greater risk within the financial institutions.Q.3. How do we overcome the problem that in the boom times no one wants to be the one stepping in to tell firms they have to limit their concentrations of risk or not trade certain risky products? What thought has been put into overcoming this problem for regulators overseeing the firms?A.3. There is a need to establish concentration limits on risky products. NCUA already has limitations in place that have helped the credit union industry avoid some of the issues currently faced by other institutions. For example: Federal credit unions' investments are largely limited to United States debt obligations, federal government agency instruments, and insured deposits. \2\ Federal credit unions cannot invest in a diverse range of higher yielding products, including commercial paper and corporate debt securities. Also, federal credit unions have limited authority for broker-dealer relationships. \3\--------------------------------------------------------------------------- \2\ NCUA Rules and Regulations Part 703. \3\ NCUA Rules and Regulations Part 703. Federal credit unions are much more limited than other financial institutions in the types of businesses in which they engage and in the kinds of affiliates with which they deal. Federal credit unions cannot invest in the shares of an insurance company or control another financial depository institution. Also, they cannot be part of a financial services holding company and become affiliates of other depository institutions --------------------------------------------------------------------------- or insurance companies. Unlike other financial institutions, federal credit unions cannot issue stock to raise additional capital. \4\ Also, federal credit unions have borrowing authority limited to 50 percent of paid-in and unimpaired capital and surplus. \5\--------------------------------------------------------------------------- \4\ 12 U.S.C. 1790d(b)(1)(B)(i). \5\ 12 U.S.C. 1757(9). Sound decision making should always take precedence over following the current trend. The addition of a systemic regulator would provide the overall monitoring for systemic risk that should be limited. The systemic regulator would then establish principles-based regulations for the financial regulators to implement. This would provide checks and balances to ensure regulators were addressing the issues identified. The systemic regulator should be charged with monitoring and implementing guidelines for the systemic risks to the industry, while the financial regulators would supervise the financial institutions and implement the guidelines established by the systemic regulator. Since the systemic regulator only has oversight over the financial regulators, they would not have direct supervision of the financial institutions. This buffer would help overcome the issue of when limits should be ---------------------------------------------------------------------------implemented.Q.4. Is this an issue that can be addressed through regulatory restructure efforts?A.4. As stated above, the addition of a systemic regulator would help address these issues by providing a buffer between the systemic regulator establishing principles-based regulations and the financial regulators implementing the regulations. The addition of the systemic regulator could change the approach of when and how regulators address areas of risk. The monitoring performed by the systemic regulator would help ensure the financial regulators were taking a more proactive approach to supervising the institutions for which they are responsible.Q.5. As Mr. Tarullo and Mrs. Bair noted in their testimony, some financial institution failures emanated from institutions that were under federal regulation. While I agree that we need additional oversight over and information on unregulated financial institutions, I think we need to understand why so many regulated firms failed. Why is it the case that so many regulated entities failed, and many still remain struggling, if our regulators in fact stand as a safety net to rein in dangerous amounts of risk-taking?A.5. While regulators are a safety net to guard against dangerous amounts of risk taking, the confluence of events that led to the current level of failures and troubled institutions may have been beyond the control of individual regulators. While many saw the risk in lower mortgage loan standards and the growth of alternative mortgage products, the combination of these and the worst recessionary conditions and job losses in decades ended with devastating results to the financial industry. Exacerbating this combination was the layering of excess leverage that built over time, not only in businesses and the financial industry, but also in individual households. In regards to the credit union industry's record in the current economic environment, 82 federally insured credit unions have failed in the past 5 years (based on the number of credit unions causing a loss to the National Credit Union Share Insurance Fund). Overall, federally insured credit unions maintained reasonable financial performance in 2008. As of December 31, 2008, federally insured credit unions maintained a strong level of capital with an aggregate net worth ratio of 10.92 percent. While earnings decreased from prior levels due to the economic downturn, federally insured credit unions were able to post a 0.30 percent return on average assets in 2008. Delinquency was reported at 1.37 percent, while net charge-offs was 0.84 percent. Shares in federally insured credit unions grew at 7.71 percent, with membership growing at 2.01 percent, and loans growing at 7.08 percent. \6\--------------------------------------------------------------------------- \6\ Based on December 31, 2008, Call Report (NCUA Form 5300) data.Q.6. While we know that certain hedge funds, for example, have ---------------------------------------------------------------------------failed, have any of them contributed to systemic risk?A.6. As the NCUA does not regulate or oversee hedge funds, it is not within our scope to be able to comment on the impact of failed hedge funds and whether or not those failures contributed to systemic risk.Q.7. Given that some of the federal banking regulators have examiners on-site at banks, how did they not identify some of these problems we are facing today?A.7. NCUA does not have on-site examiners in natural person credit unions. However, as a result of the current economy, NCUA has shortened the examination cycle to 12 months versus the prior 18 months schedule. NCUA also performs quarterly reviews of the financial data submitted to the agency by the credit union. NCUA does have on-site examiners in some corporate credit unions. Natural person credit unions serve members of the public, whereas corporate credit unions serve the natural person credit unions. On March 20,2009, NCUA placed two corporate credit unions into conservatorship, due mainly to the decline in value of mortgage backed securities held on their balance sheets. Conventional evaluation techniques did not sufficiently identify the risks of these newer structured securities or the insufficiency of the credit enhancements that supposedly protected the securities from losses. NCUA's evaluation techniques did not fully keep pace with the speed of change in the structure and risk of these securities. Additionally, much of the information obtained by on-site examiners is provided by the regulated institutions. These institutions may become less than forthcoming in providing negative information when trends are declining. NCUA is currently evaluating the structure of the corporate credit union program to determine what changes are necessary. NCUA is also reviewing the corporate credit union regulations and will be making changes to strengthen these entities. ------ CHRG-111hhrg52397--41 Mr. Ferreri," Thank you, Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee for allowing me the opportunity to participate in today's hearing. I am Chris Ferreri, and I work for a company called ICAP. We are the world's largest inter-dealer broker, employing more than 4,000 personnel worldwide, including New York, New Jersey, and the other major financial centers. Using a combination of voice and electronic services, our function is to match buyers and sellers, specifically banks and other large financial institutions, operating in the wholesale financial markets. On their behalf, we execute thousands of trades daily and a broad array of financial products, including U.S. Treasury securities, foreign exchange, commodities, and other financial derivatives. Products and trades in the OTC markets are simply products that do not trade exclusively on registered exchanges. It should be noted that included in these products are U.S. Treasury securities and foreign exchange, by volume of trade, the world's two largest financial products. It should also be emphasized that for the most part institutional participants in these markets are currently subject to regulation by government authorities, specifically in the United States, the Fed, the SEC, and FINRA. During my testimony, I would like to emphasize the following three points: First, ICAP supports greater oversight of major participants in OTC markets, in particular to ensure the integrity of their capital base. We also support additional transparency through the increased use of electronic trading platforms and post-trade reporting facilities already available through companies like ICAP and others. Second, some have suggested that the solution to greater oversight with regard to the over-the-counter market should be to force much of the present activity on to existing exchanges. We do not believe this is necessary or indeed that it would accomplish its intended goal. Rather, we believe that better use of facilities that already exist, such as the electronic trading platforms, direct and immediate access to clearinghouses, and post-trade reporting and processing will lead to greater price transparency, more efficient markets, and additionally facilitate the oversight function of the regulatory authorities. Third, these products have increased in number and size so dramatically because virtually every major financial and corporate institution in the world needs and uses them to raise capital, to protect portfolio positions, and to mitigate risk. Whatever regulatory decisions are made, we must make every effort that they do not impair access to capital or the ability to hedge risk for private and public institutions alike. The subcommittee did give us seven points to touch on. I will address as many as I can in the time allotted. On the view for OTC regulation: ICAP favors changes to the regulatory framework supporting fairness and transparency. Inter-dealer brokers like ICAP are regulated by both the national regulators in each relevant market and by their overall lead regulator. There are many forms of regulation already in place that apply to the OTC cash and derivatives markets, in cases where the markets themselves may not be regulated but participants can be. How clearing will affect the OTC markets: Roughly 60 percent of the OTC markets we operate are cleared. We would expect that increased clearing can lead to increased liquidity in the OTC markets. The pros and cons of exchange trading: We must first underscore the distinctions between exchange trading and clearing. ICAP operates fully electronic marketplaces for many products and none of them are single silos of exchange trading and clearing but are traded electronically and cleared centrally. This one-size-fits-all approach is completely standardized, non-fungible contracts means that corporations, mortgage providers, bond issuers and others are unable to accurately hedge their risk exposures. It is for this reason that the OTC markets are both larger in scale and broader in scope than the exchange markets. The potential benefits of electronic trading: Electronic trading could provide more efficient price discovery; simplify trade capture; materially reduce operational risk; improve trading supervision; increase audit ability; and create processing capacity in the OTC markets. In addition, multiple trading venues increase competition, keep costs down, and provide security from failure of individual platforms. Migrating liquidity is difficult. The turnkey development of a completely new market infrastructure is unnecessary and will require significant implementation time and incur a high level of risk. Rather than rushing to develop new infrastructure, better and more extensive use should be made of the tremendous capabilities of the existing OTC market infrastructure. In summary, it should be clear that the over-the-counter market is not unregulated or even less regulated. Our electronic trading platforms are global, connect to thousands of customers in dozens of countries, as well as the world's largest clearance and settlement systems. ICAP welcomes the coming reform, and we feel our goals of promoting competition, electronic trading, and clearing helps both our customers and ICAP. The OTC market has already invested significantly in developing this infrastructure for price discovery, trade execution and post-trade automated processing which contributes hugely to reducing risks, but it needs to be further developed and better leveraged for the benefit of all. Once again, I think the committee for allowing me to speak on this topic, and I look forward to working with the committee on building a bridge for a better marketplace. Thank you. [The prepared statement of Mr. Ferreri can be found on page 147 of the appendix.] " CHRG-111shrg51395--30 Mr. Pickel," Thank you, Mr. Chairman and Ranking Member Shelby and Members of the Committee. Thank you for inviting ISDA to testify here today. We are grateful for the opportunity to discuss the privately negotiated derivatives business, and more specifically, the credit default swaps market. I have submitted written testimony, and as you noted, Mr. Chairman, it is a lengthy submission and so I would like to summarize some of the key remarks that I included in that testimony. I think first and foremost, we need to understand that the benefits of the OTC derivatives business are significant for the American economy and American companies. They manage a broad range of risk using these instruments that are not central to their businesses, allowing them to manage these financial risks typically so that they can focus on the business that they run. So a borrower borrowing on a floating basis can use an interest rate swap to manage its exposure to exchange fixed for floating obligations. Currency exposure--many companies have significant operations around the world and have significant currency exposure and use currency swaps, OTC currency swaps, to manage that risk. ISDA itself uses currency swaps to manage its overseas exposure. Commodity exposure--airlines have significant exposure to fuel costs and they typically look to utilize OTC derivatives to manage that exposure. And finally, credit exposure--using credit derivatives, credit default swaps, exposure to suppliers or to customers where credit is a significant concern, companies can use these products to help manage that risk. These products also create efficiencies in pricing and wider availability of credit, particularly credit default swaps. They facilitate lending at lower rates, and they are critical to have available, and have them widely available, as we come out of this recession. I think they will be an important part of the ability of firms to manage credit risk as they look at these important credit issues that we face in this financial crisis. As far as the role of the credit default swaps and OTC derivatives generally in the financial crisis, first of all, I think, and this Committee has certainly heard testimony, the fundamental source of the crisis is imprudent lending, particularly in the U.S. housing sector, but extending to other markets, as well, credit cards and commercial lending as an example. We must distinguish between the credit default swap business and the collateralized debt obligation business. There has been reference to the originate to distribute model. That certainly applies to the securitization process and to the CDO process. In the credit default swap business, a company, a bank that has lent money may use a credit default swap to hedge its exposure on that credit. In that process, it will be maintaining its lending relationship with the borrower and it will also be taking on credit risk and paying a fee to the company that is selling protection. So it is distinctly different from the originate to distribute model. We certainly have heard testimony, and this Committee heard testimony last week on the AIG situation. I think we need to spend some time and this organization needs to spend some time talking about that. AIG obviously was significantly involved in credit default swaps. It was the means by which it took risk. But we must understand the poor choices, the adverse policies, and the misunderstood risk that were involved there, and this Committee heard a lot about that in the testimony last week, particularly from Mr. Polakoff from the Office of Thrift Supervision. These were the source of their problems, these misunderstood risks and poor decisions. They were contrary to the best practices in the industry and to the experiences of swap market participants for the past 20 years. The fundamental decision that AIG made was to take on exposure to the housing market. They did that, yes, via credit default swaps. They also did that, as the Committee heard last week, in other means, as well, through their securities lending business, in which they actually continued to lend and take exposure to those markets into 2006 and 2007, when the worst of these securities were generated through the lending process. They also had a very myopic view of loss. They were only looking at the payout potential, the possibility they would actually have to pay out on these transactions. There was no consideration of the implications of the mark-to-market losses that they could face and to the effects on their capital and their liquidity. They seem to have completely ignored the possible effects of that. They relied on their AAA rating and refused to provide collateral from the start of their trading relationships. It takes away the discipline that collateral provides in that trading relationship. Collateral is extensively used in the OTC derivatives business to help manage risk and also introduce discipline to the trading relationship. They agreed, on the other hand, to provide collateral on the downgrade of their credit rating. That led to a falling off of a cliff, effectively, leading to substantial liquidity problems which eventually led to the decision to intervene. So yes, these decisions and policies are important to understand and we need to take steps to make sure that this does not happen again, but those relate to the decisions they made and not to the products themselves. The products, in fact, have performed as the parties intended. In fact, just yesterday, the Senior Supervisors Group, which is a group of senior supervisors from the G-7 countries, talked about how the CDS product had performed multiple times over the course of last fall and into this year in helping to settle transactions, credit default swaps that parties had engaged in, and they acknowledged that this process has been extremely effective. And then finally, this is a very important week in the credit default swap market. I believe Mr. Ryan referred earlier to the fact that one of the clearinghouses that has been talked about for many, many months has now actually begun to clear transactions, and that is a very significant development. And later this week, ISDA itself will introduce some changes to the standard contract that will facilitate the settlement of these trades in the future and will also facilitate moving more transactions onto a clearinghouse. So that is a very important development. There is much to be done by ISDA, by the industry, in close consultation with this Committee and other committees in Congress as well as the regulators here in the United States and globally and we are committed to be engaged in that process. We look forward to working with you as you analyze the causes of this financial crisis, and based on that analysis, consider changes to our regulatory structure with a goal to obtaining greater transparency, greater disclosure, and greater coordination among regulators. Thank you again for your time, and I look forward to your questions. " FOMC20080430meeting--93 91,MR. FISHER.," Mr. Chairman, I want to focus my comments today on what I have heard from my CEO contacts. With regard to my District, it continues to do well relative to the rest of the country, but it is not immune to the pathology that is afflicting the overall economy. Although still positive, economic growth and employment creation are slowing, and our manufacturers in the survey we just took are experiencing substantial price pressures. Seventy-one percent of our manufacturers in the survey report higher prices, and 65 percent are expecting input prices to be even higher six months from now. Setting aside the 11th District, I spoke in depth to 31 CEOs nationwide. You have that list, Mr. Chairman, and I would like to speak to what I deduced from triangulating those conversations with what I read in the Bluebook and the Greenbook. Let me note that the focus of my conversations with these CEOs and CFOs was not what they have seen or what they are seeing now but how their behavior is likely to be affected going forward and how they are budgeting going forward. Distilling the inputs to their essence, it's clear that activity is likely to weaken further. Those 21 miles of 89-foot flat cars that haul lumber, Mr. Chairman, are now up to 22.6 miles. Inventories of unsold homes are clearly building, and that is important against the background that March is almost always a good month in the housing or home sales business. The CEO of Centex reports that this is the first down March he has seen, and he has been in the business since 1974. It came down hard--20 percent. Consumer confidence is weak. Job insecurity is spreading. Companies are tightening their head counts. Banks are tightening credit standards, as we have discussed. According to the CEO of MasterCard, year-over-year retail sales to date in April--that is, ex-autos and ex-gas--were 2.2 percent, the lowest he has ever seen. Citibank, Chase, Bank of America, and the other credit card purveyors are experiencing high delinquency rates and a significant slowdown in their revenues from credit cards, and Wal-Mart reports the ""cascading"" use of credit as a form of payment, as their CEO for U.S. operations put it. In short, the consumer-driven corrective credit cycle is prolonging the economic slowdown and vice versa. Consistent with this sustained headwind, we have revised downward the Dallas forecast and continued for longer our projection of economic ""anemia"" (we are not among the four that included the word ""recession"") not only for '08 but also for '09, and we have revised upward, to the upper end, our sense of projected unemployment. Thus, from what I am hearing, from what I am reading, and from what we are getting from our analysis, I acknowledge the thesis of the presence of a negative feedback loop among GDP growth, employment growth, and credit market conditions. I find more worrisome the reports I am receiving on expected price developments and behavior, and I see a feedback loop of another kind at work. Page 30 of the Bluebook notes, as I think President Plosser pointed out and President Evans referred to, that core PCE inflation has averaged more than 2 percent in every year since 2004 and is forecasted, as per David's earlier comments, as doing so again in 2008. What concerns me more is the left-hand panel in chart 1 on page 4 of the Bluebook that indicates that the staff's index of inflation expectations and uncertainty is now at the top of its range over the last decade. This is confirmed by my corporate contacts. Something persistent and pernicious, Mr. Chairman, has been occurring on the inflation front and calling into question the credibility of our continued reliance on core measures. Here is what I am hearing from my corporate contacts. I'm going to just mention a few because it is fairly consistent across the board. From the CEO of the largest retailer in the country, not to be named but located in Arkansas, [laughter] I reported last time that they are budgeting price increases on 10,000 items of a little over 5 percent in 2008. Yet his comment to me was, ""Inflation is our number 1 concern, and it's escalating significantly."" He added, ""All the information we have points to an intermediate- and longer-term supply�demand problem, especially for food and any energy-dependent articles."" By the way, that was verified by the CEO of Frito-Lay, who tells me that they are offsetting their input price escalation of 11 percent in 2008 by raising prices 9 percent effective last Sunday. He added that--and this is interesting in terms of the mindset--""We have to--otherwise we'll disappoint the Street, and in these markets no one can afford at this fragile time to do so."" The price pressures are less for clothing and nonfood items, but they are still there. I would like to use the example of JCPenney. JCPenney sells clothing to one-half of all the families in America, and 60 percent of their sales are apparel. The average price point for an apparel sale at that retailer is $15. The leading source of apparel is China. According to Penney's CEO, increases in China's labor costs, changes in their labor rules, and the cost of fuel and of cotton fibers have led to significantly escalating price pressures. He says that they can eat some of those costs and drive them down through other offsets and tighter controls, but they are planning a 4 percent increase in apparel costs in 2009. Here is his punch line, and it is not funny--this is a first-rate CEO, one of the best in the country: ""We think the customer can take a little more price. After all, what's 40 to 60 cents on $15? It won't even be noticed."" This is the essence of the accommodation of inflationary expectations, and you are beginning to see this mentality set in in several industries. For example, the airlines. We talked about the increase in the price of crude. If you take what is called the crack spread and figure out what has happened in terms of jet fuel, year over year through mid-April jet fuel was up 70 percent. That's an industry average, mitigated somewhat by the hedging of Southwest Airlines, which has been successful. According to the CEO of American Airlines, ""This oil is a tsunami. We will have to get some pricing power, or we'll be left with only one airline, Southwest."" Kimberly-Clark, a paper producer, notices that the weaker dollar and oil are driving realized costs increasingly up from, in their case, $250 million in '07 to an estimated $600 million in '08. They have raised prices, as I have previously mentioned, but the CEO feels that--and this is a winner--""We are having to learn how to run a business in an inflationary environment. We got used to productivity as the driver, but we can't drive productivity any harder than we can. We will need more pricing."" It even affects semiconductor producers. Texas Instruments reports that the weakness of the dollar and the prices of energy, gold, and copper offset by their hedges added 2� percent nonannualized to their costs in the first quarter. Asked what he envisions going forward, the CFO said, ""Well, that just means we can't spend it elsewhere. We have to take it out of our employees' backs or out of cap-ex."" One CEO of a company that is expecting soon to lay off between 12,000 and 15,000 people and is, therefore, carefully surveying the attitudes of their employees because they have a morale problem, is finding out that employees are tapping into their 401(k) plans or not funding them. In their surveys they find the leading complaint is that ""the price of gasoline and food is eating into my living standards. I can't afford them."" Last but not least, just to bring this home, the Eagle Scout who mows my lawn in Dallas sent me a very nice, beautiful letter. It is clear that he and his mother had prepared it on a printer and put a fancy title on it, but the rest of the letter was, ""Dear Mr. Fisher, I have to levy a 7 percent fuel surcharge."" [Laughter] We gave into it--he is a nice boy. In summary, Mr. Chairman, while there are many who have voiced concern with the adverse feedback loop that runs from the economy to tighter credit conditions and back to the economy, I am very troubled by a different adverse feedback loop--namely, the inflation dynamic whereby reductions in fed funds rates lead to a weaker dollar and upward pressures on global commodity prices, which feed through to higher U.S. inflation. That higher U.S. inflation not only has a price impact but also leads to cutbacks by consumers and by employers so as to offset the effects of inflation. I am worried that, if we do not respond to higher inflation, the whole cycle will intensify. When economic growth and activity return to normal, inflation is likely to have notched up considerably, according to our sense. I know my respected colleagues say that we are willing to be equally aggressive in raising rates once the outlook for real activity improves, but the practicability of that notion I find in talking to my interlocutors is met with some skepticism and doubt. With that, Mr. Chairman, I see a tail risk on the downside of growth. I acknowledge the argument of President Yellen and others. I think I'm sympathetic, but I see a fatter tail, perhaps an otter's tail, on inflation. I am hearing this loud and clear from my corporate contacts. I believe that the risk posed by inflation is more significant than the extension of further anemia in the economy, especially now that we have put in place innovative liquidity bridging mechanisms, which we are amplifying upon today. Mr. Chairman, the other day Governor Kohn reminded me that reasonable people can disagree, and he quipped that he hoped that we could agree on the following--that we are at least reasonable people. [Laughter] I'm doing my very best, I hope, to provide reasonable alternative perspectives, and I hope you will judge me on that basis. Thank you, Mr. Chairman. " FOMC20061025meeting--211 209,CHAIRMAN BERNANKE., That would break many years of tradition. [Laughter] FOMC20061212meeting--198 196,CHAIRMAN BERNANKE.," I would say we crossed the border. [Laughter] Well, let me try to summarize. [Laughter] First of all, the economy is still on the course that we have been projecting for some time. A soft landing scenario with some slow but, I hope, decided reduction in inflation seems to be a reasonable expectation. However, there still are significant uncertainties in the forecast, and we’re quite aware of that. I note parenthetically that it’s a good thing that the bond markets aren’t simply parroting our statements. They’re providing their own take, and we should use that information and not necessarily consider it a failure if their views are distinct from ours. So since the situation seems to be on trajectory, I would advocate today not changing the federal funds rate. With respect to the statement, we did try in the first iteration to make some changes to the assessment of risk. I have some sympathy with President Poole’s view in that, read literally, our assessment of risk admits no possibility that our next move will be down, which I don’t think could be true under any circumstances. However, we have been using this language for a while. We have been clear in our minutes that we do see some downside risk to output. The market, I think, has understood whose statement we are trying to emphasize, our particular concern about inflation, and our willingness to raise rates if inflation doesn’t moderate significantly. Again, although I’m sympathetic to President Poole and I’m trying to think about how we are going to move away from this language into other forms of language, I think, along with Vice Chairman Geithner, that our changing the risk assessment today would send a very strong signal that our discussion has not suggested. That’s why I propose to leave the risk assessment unchanged for today but to take on board the concerns that President Poole has raised about getting it to a perhaps more accurate description of our risk assessments and expectations. On section 2, the two suggestions that I think have commanded some significant support are, first, President Minehan’s suggestion of using the second section under alternative C and, second, the alternative in the Christmas-tree colors using “although recent indicators have been mixed” in the present perfect tense—“although recent indicators have been mixed, the economy seems likely to expand at a moderate pace on balance over coming quarters.” I think those are the two that people have preferred. I don’t think it makes a great deal of difference, frankly, but I lean personally a bit toward including the reference to indicators only on the grounds of trying to signal to the market again that we are watching the data, that we are aware of developments in the economy, and that we’re not just taking the statement out and putting a new date on it. So that would be my recommendation—that we use the phrase “although recent indicators have been mixed, the economy seems likely to expand,” and so on. I’d be happy to take comments." FOMC20060328meeting--164 162,CHAIRMAN BERNANKE.," Thank you. I would like now to summarize these views and add a few comments of my own. At that point, if there are additional comments or questions, they will be welcome. We have had, I think, a fairly upbeat group here the last couple of days, which is of course good, both in terms of views of economic activity and in terms of keeping inflation well controlled. The economy appears to be quite strong, but my sense is that most people feel that risks on that score are relatively balanced, which I take to imply that, after being strong in this quarter, growth will slow to something closer to a more-sustainable pace in the remainder of the year. Perhaps the leading source of uncertainty on the output side is the housing market, but I was reassured to hear that most participants think that a decline in housing will be cushioned by strong fundamentals in terms of income, jobs, and continuing low interest rates. The labor market is clearly continuing to strengthen, but I heard not too many concerns about increasing wage pressures. There was some discussion about shortages of more highly skilled workers, which presumably might affect wages at some point but apparently has not so far; and there was additional discussion of productivity gains, which are helping to keep unit labor costs down and to support growth. On the inflation side, I have not been in this conversation for a while, but I was impressed at least relative to a year ago that the angst about inflation seems to have declined. Clearly, inflation expectations are well anchored. Margins are high, and the sense of the group was that pass-through to consumer inflation was likely to be limited. Still, I took from the group some sense of at least a slight upside risk to inflation, reflecting the increasing resource utilization; the fact that inflation is somewhat on the high side of what many people describe as their comfort zone; and the fact that, if inflation does rise, there will be costs to bringing it back down and maintaining our credibility. So that is my overall summary of the Committee discussion. My own views, you will probably not be surprised to hear, are not radically different from what we have heard around the table. I would point out, first, that except for housing, the economy continues to be very strong. One might be tempted to average the expected rate of growth of the first quarter at about 4½ percent with the 1½ percent of the fourth quarter and say we’re at a pace of about 3 percent, but then I would remind you that we had 4.1 percent in the third quarter despite Katrina and about 3.7 percent average growth in the first three quarters of ’05. We have a strengthening world economy. We have consumption that looks likely to be well supported by income and jobs. Several people have talked about the strength of investment in nonresidential construction. Job creation at about 200,000 a month is clearly above the long-run sustainable rate. So except for housing—and that is, of course, a critical sector—it looks as though the economy is, if anything, growing more quickly than potential. Housing is the crucial issue. To get a soft landing, we need some cooling in housing. So far there is a good bit of evidence that there has been a peak, but we do not know a great deal more than that. So obviously we are going to have to watch carefully. The range of possible outcomes is quite wide. I agree with most of the commentary that the strong fundamentals support a relatively soft landing in housing. A pessimist might point out that the expectation of future price increases is itself an important part of the user cost of housing. A sea change in people’s views about what is going to happen to house prices in the future might significantly affect their perceived cost of owning a house and lead to lower prices and to weaker activity. On the other side, residential investment is, of course, only about 6 percent of GDP, and so long as consumption is well maintained by incomes, jobs, and other factors, I think it would take a very strong decline in the housing market to substantially derail the strong momentum for growth that we are currently seeing in the economy. What we might see in the next few quarters is some quarter-to-quarter variation. We may not have the stability of growth that we have had the last couple of years. If that happens, we should be willing to accept it. I might offer a very rough analogy to the way we think about energy prices and core inflation. With core inflation, our goal is to accommodate energy prices but to make sure that they do not get into the underlying rate of inflation. Again, this might be a rough analogy, but if the housing market moves significantly, we should perhaps not try to upset that movement but rather just try to ensure that the resources that are released are deployed in the rest of the economy and that the rest of the economy remains on a stable path. Again, I think we are unlikely to see growth being derailed by the housing market, but I do want us to be prepared for some quarter-to- quarter fluctuations. So, broadly speaking, I agree with the Committee that we should see some cooling for the remainder of the year and that we should approach a more-sustainable pace of growth. But I think there is some upside volatility risk, if you will, because of the fluctuations in residential investment. On inflation, like most of you, I am struck by how well behaved core inflation has been. Indeed, in 2005, core inflation was even slightly lower than it was in 2004, and we have all pointed to a number of explanations, including well-anchored inflation expectations, international competition, productivity growth, and since I wasn’t here, I can say good Fed policy. [Laughter] One area of uncertainty in trying to look forward is unit labor costs. Remarkably, unit labor costs in the nonfarm business sector grew only 1.3 percent in 2005, but as was already mentioned in the staff presentation, I think that understates the trend because it is coming off the surge in the fourth quarter of ’04 in bonuses, stock options, and other types of one-time compensation. If you smooth through that bulge, it looks as though the underlying trend of unit labor costs is more like 1.7 percent, and perhaps that may have some upward bias. There is certainly a lot of uncertainty about that, though. We have seen some indicators, such as average hourly earnings, rising. Other indicators, such as the employment cost index, are slowing. I just point this out as a significant source of uncertainty, given how difficult it is to forecast both compensation and productivity going forward. So, again, the stability of inflation in the last couple of years is very reassuring. I would note, however, that over the past three years, since 2003, we have seen a pickup in inflation. That was, of course, by design, but I think it is important for us to think about why that happened. There’s something of an identification problem here. To the extent that the increase in inflation over the last two to three years reflected the pass-through of energy costs and commodity prices, that is actually good news in a sense because, to the extent that those factors soften and flatten in the coming year, we should see some reduction in inflation in ’06 and ’07. To the extent that inflation increases in the last two and a half years reflected increased resource utilization, the strength in the economy, and the return of pricing power, however, there is a bit of concern that we may see some additional updrift of inflation in the next few quarters. Like most of you, I am not at all alarmist about inflation. I think the worst that is likely to happen would be 20 or 30 basis points over the next year. But even that amount is a little disconcerting for me. I think it is very important for us to maintain our credibility on inflation and it would be somewhat expensive to bring that additional inflation back down. So my bottom line on inflation is that there is a very modest upside risk. Again, I think it’s not a large risk but one that we probably should pay attention to. Are there any comments or questions to close our round on the economic outlook? If not, we can move to the policy round. In a moment I’m going to turn to Vincent to introduce the policy options in the statement. Before I do that, I just want to note that we have left unresolved the discussion about the ownership of the statement—in particular, what we are voting on when we vote at the end of the meeting. Currently we vote on the action, on the directive, and on the risk assessment but not on the rationale. The rationale has, however, been largely a consensus paragraph worked out by the Committee. My sense is that this decision is not entirely separable from a wide range of other issues we may want to talk about over the next few quarters concerning the content of the statement, its structure, whether we use forward-looking language, and whether we consider adopting some kind of numerical guidepost for inflation. And so what I would like to do, if it is okay with the Committee, is to maintain the status quo for today in terms of our voting in this statement. By the next meeting, in May, I will come back to the Committee with a proposal for a process by which we can address this whole range of issues over a period of time, and on the top of the agenda for that process will be the ownership of the statement. Is that acceptable? All right. Seeing assent, we will maintain the status quo on the statement just for today. Vincent, whenever you are ready." CHRG-110shrg50409--80 Mr. Bernanke," Two-and-a-half years. Senator Carper. Does it seem that long? [Laughter.] " FOMC20060510meeting--98 96,MR. POOLE.," Thank you, Mr. Chairman. I’m not going to try to help you on that one. [Laughter] I’m going to try to be very brief here because I want to reserve more of my fair share of the time to the policy discussion. One of the problems with the anecdotal reports, of course, is the unsystematic way in which we do them. I’m well aware that some of the answers you get depend on the way you phrase the questions. Some of my contacts say that the economy is doing fine, no real problems. One of my contacts from the trucking industry said that the economy looks pretty stable—“boringly normal” is the way he put it. I don’t have any contacts, though, who say that they see any sign of weakness. They’re not complaining about signs of weakness, and some of the contacts are saying that things are pretty doggone strong. So that’s my attempt to filter the observation. Now, let me just give you a couple of particularly interesting anecdotes. My Wal-Mart contact talked about construction costs. He said even in Indiana, which is not known as one of the great growth states in this country—" FOMC20071031meeting--77 75,MR. KOHN.," Thank you, Mr. Chairman. In broad outline, the situation is evolving as we anticipated in our last meeting. Spending outside of housing has been well maintained. The housing market is very weak. Financial markets have been returning more toward normal functioning, banks have tightened credit terms and standards, and core inflation has remained low. I think it is the nuances around each of these that complicate our decision at this meeting. As Dave Stockton and others pointed out, spending outside housing has been a bit stronger than expected. Paths of consumption and investment, along with employment, seem to be moderating going into the fourth quarter, but gradually. Importantly, the data for September haven’t been especially weak, and these could have potentially been affected by the financial tightening, increased uncertainty, and reduced consumer confidence that followed the events of August. With growth in the third quarter likely to be at or above 3 percent and no material change in the output gap for several quarters now, it does appear that the real funds rate of 3 percent plus that persisted since mid-2006, while quite high relative to historical averages, was not far from the equilibrium real rate at that time, given the low level of long-term rates, the ready availability of credit at historically low spreads, and the high level of wealth relative to income through this period. It seems somewhere between difficult and impossible to calibrate the effects on aggregate demand of the rise in long-term rates last spring, the tightening of credit conditions of the past few months, and the expected decline in housing prices. The staff has judged 50 basis points of easing—we did that at the last meeting—to be enough to keep the economy near its potential in the context of the relatively solid incoming data. That doesn’t seem unreasonable, though it does leave the fed funds rate at the higher end of its historical range. Nonetheless, I see a couple of reasons for important downside risks to such a growth forecast. First, though the housing market was roughly in line with staff forecasts, builders have made only a little progress in reducing inventory overhangs. Moreover, reports suggest that downward price pressures are increasing—for example, the constant quality new home index declined in the past two quarters. Market expectations for the Case-Shiller index revised down, suggesting that the drop in house prices could be steeper than the moderate drop assumed in the staff forecast. Substantial decreases in house prices would at some point revive the demand for housing. At the same time, that decline threatens greater spillovers from wealth effects on consumption and from tighter credit conditions as lenders react to threats to their capital from declining collateral values. Second, although financial markets are improving in many respects, the trajectory is gradual, uneven, and subject to reversal. We saw this just in the past couple of weeks, when adverse housing data, downgrades of highly rated mortgages and senior tranches, and earnings warnings caused some risk spreads to widen out. The secondary markets for nonconforming mortgages are still quite disrupted. Clearly, uncertainty about the pricing of many of the assets in question, about the amount of credit that will get put back to the bank balance sheets, and about the size and location of the losses that have to be taken continue to make lenders very skittish. In this environment, I wouldn’t be at all surprised to see a further tightening of credit availability at banks in the coming months. The developments in housing and financial markets are also likely to weigh on business spending plans, as we saw hinted at in the capital spending revisions that some of the Reserve Banks reported, and for households as evidenced by the low confidence surveys. These downside risks are strong enough that I think they will persist even if we ease slightly tomorrow. Besides the influences I already cited, my judgment in this regard takes account of market expectations. The markets’ implied r* has been below the staff’s and, I think, the Committee’s implied r* for some time now, but the gap seems to have widened considerably. In an environment of increased uncertainty about the outlook, such disparities perhaps aren’t surprising, and we can’t substitute market participants’ judgment for our own, but I did take a little signal from the extent of the pessimism about aggregate demand that I inferred from the interest rate path in the market relative to the staff’s path in the Greenbook. I don’t think r* is quite as low as President Yellen was suggesting—it is perhaps in the 2 to 2½ range since term premiums are still low; and even with house prices declining, the wealth-to-income ratios are still pretty high, and the dollar has been falling. But I did assume a slight easing of monetary policy sometime in the fourth quarter in my projection. I also projected low, stable core and ultimately total inflation, but I do see some upside risks around this outcome if the economy follows its most likely path. It is still producing at a high level of resource utilization, and some measures of compensation and labor costs have been rising. Core CPI inflation on three-month and six-month bases has accelerated even if the acceleration hasn’t shown through to the PCE measures. Increases in energy and commodity prices, along with recent declines of the dollar, are also a risk factor—less from their direct effects on prices, which are likely to be small, but more because they could suggest a potential for a more inflationary psychology that could feed through to expectations. Our decision tomorrow will involve weighing these risks, the extent of the relative risk to our dual objectives, and the potential costs of missing in either direction in the context of the market conditions and expectations built into markets. Thank you, Mr. Chairman." FOMC20050630meeting--172 170,MR. POOLE.," Just for the hell of it, I’d like to offer the hypothesis that property values are too low rather than too high. [Laughter] If you believe that Treasury indexed bonds are a good measure of the real rate of interest—and we were getting into this discussion—the real rate of interest has been cut in half in the past five years. For any asset with a perpetual stream of returns, like land, the capital value has doubled. Now, it may well be that the issue is with the indexed bonds and not with the housing prices. It may be that the right way to state this hypothesis is instead to say that the conundrum is that there’s a disconnect between the prices of some of these assets. In any event, if we are going to be in a world in which the real rate of interest is truly much lower than it was before—if that is going to be the situation for some time to come—then it seems to me that we could expect some long-continuing appreciation of land values in particular. Residential structures have a very long life, so they are almost priced that way. And let me link this analysis to the tear-down phenomenon that Mark Olson was talking about. I’ve been told—I don’t June 29-30, 2005 58 of 234 which is a significant part of new building. Maybe someone knows the data on demolitions and replacements. I don’t." FOMC20070628meeting--390 388,MR. KOHN., We have to put those words in the minutes so that they get out there sooner than five years. [Laughter] CHRG-111shrg52619--206 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM JOSEPH A. SMITH, JR.Q.1. Consumer Protection Regulation--Some have advocated that consumer protection and prudential supervision should be divorced, and that a separate consumer protection regulation regime should be created. They state that one source of the financial crisis emanated from the lack of consumer protection in the underwriting of loans in the originate-to-distribute space. What are the merits of maintaining it in the same agency? Alternatively, what is the best argument each of you can make for a new consumer protection agency?A.1. CSBS believes safety and soundness and consumer protection should be maintained for the benefit of the system. While CSBS recognizes there is a tension between consumer protection and safety and soundness supervision, we believe these two forms of supervision strengthen the other. Consumer protection is integral to the safety and soundness of consumer protections. The health of a financial institution ultimately is connected to the health of its customers. If consumers lack confidence in their institution or are unable to maintain their economic responsibilities, the institution will undoubtedly suffer. Similarly, safety and soundness of our institutions is vital to consumer protection. Consumers are protected if the institutions upon which they rely are operated in a safe and sound manner. Consumer complaints have often spurred investigations or even enforcement actions against institutions or financial service providers operating in an unsafe and unsound manner. States have observed that federal regulators, without the checks and balances of more locally responsive state regulators or state law enforcement, do not always give fair weight to consumer issues or lack the local perspective to understand consumer issues fully. CSBS considers this a weakness of the current system that would be exacerbated by creating a consumer protection agency. Further, federal preemption of state law and state law enforcement by the OCC and the OTS has resulted in less responsive consumer protections and institutions that are much less responsive to the needs of consumers in our states. CSBS is currently reviewing and developing robust policy positions upon the administration's proposed financial regulatory reform plan. Our initial thoughts, however, are pleased the administration has recognized the vital role states play in preserving consumer protection. We agree that federal standards should be applicable to all financial entities, and must be a floor, allowing state authorities to impose more stringent statutes or regulations if necessary to protect the citizens of our states. CSBS is also pleased the administration's plan would allow for state authorities to enforce all applicable law--state and federal--on those financial entities operating within our state, regardless of charter type.Q.2. Regulatory Gaps or Omissions--During a recent hearing, the Committee has heard about massive regulatory gaps in the system. These gaps allowed unscrupulous actors like AIG to exploit the lack of regulatory oversight. Some of the counterparties that AIG did business with were institutions under your supervision. Why didn't your risk management oversight of the AIG counterparties trigger further regulatory scrutiny? Was there a flawed assumption that AIG was adequately regulated, and therefore no further scrutiny was necessary? Was there dialogue between the banking regulators and the state insurance regulators? What about the SEC? If the credit default swap contracts at the heart of this problem had been traded on an exchange or cleared through a clearinghouse, with requirement for collateral and margin payments, what additional information would have been available? How would you have used it?A.2. CSBS believes this is a question best answered by the Federal Reserve and the OCC. However, we believe this provides an example of why consolidated supervision would greatly weaken our system of financial oversight. Institutions have become so complex in size and scope, that no single regulator is capable of supervising their activities. It would be imprudent to lessen the number of supervisors. Instead, Congress should devise a system which draws upon the strength, expertise, and knowledge of all financial regulators.Q.3. Liquidity Management--A problem confronting many financial institutions currently experiencing distress is the need to roll-over short-term sources of funding. Essentially these banks are facing a shortage of liquidity. I believe this difficulty is inherent in any system that funds long-term assets, such as mortgages, with short-term funds. Basically the harm from a decline in liquidity is amplified by a bank's level of ``maturity-mismatch.'' I would like to ask each of the witnesses, should regulators try to minimize the level of a bank's maturity-mismatch? And if so, what tools would a bank regulator use to do so?A.3. While banks tend to have an inherent maturity-mismatch, greater access to diversified funding has mitigated this risk. Beyond traditional retail deposits, banks can access brokered deposits, public entity deposits, and secured borrowings from the FHLB. Since a bank essentially bids or negotiates for these funds, they can structure the term of the funding to meet their asset and liability management objectives. In the current environment, the FDIC's strict interpretation of the brokered deposit rule has unnecessarily led banks to face a liquidity challenge. Under the FDIC's rules, when a bank falls below ``well capitalized'' they must apply for a waiver from the FDIC to continue to accept brokered deposits. The FDIC has been overly conservative in granting these waivers or allowing institutions to reduce their dependency on brokered deposits over time, denying an institution access to this market. Our December 2008 letter to the FDIC on this topic is attached.Q.4. Regulatory Conflict of Interest--Federal Reserve Banks which conduct bank supervision are run by bank presidents that are chosen in part by bankers that they regulate. Mr. Tarullo, do you see the potential for any conflicts of interest in the structural characteristics of the Fed's bank supervisory authorities? Mr. Dugan and Mr. Polakoff does the fact that your agencies' funding stream is affected by how many institutions you are able to keep under your charters affect your ability to conduct supervision?A.4. I believe these questions are best answered by the Federal Reserve, the OCC, and the OTS.Q.5. Too-Big-To-Fail--Chairman Bair stated in her written testimony that ``the most important challenge is to find ways to impose greater market discipline on systemically important institutions. The solution must involve, first and foremost, a legal mechanism for the orderly resolution of those institutions similar to that which exists for FDIC-insured banks. In short we need to end too big to fail.'' I would agree that we need to address the too-big-to-fail issue, both for banks and other financial institutions. Could each of you tell us whether putting a new resolution regime in place would address this issue? How would we be able to convince the market that these systemically important institutions would not be protected by taxpayer resources as they had been in the past?A.5. CSBS strongly agrees with Chairman Bair that we must end ``too big to fail.'' Our current crisis has shown that our regulatory structure was incapable of effectively managing and regulating the nation's largest institutions and their affiliates. Further, CSBS believes a regulatory system should have adequate safeguards that allow financial institution failures to occur while limiting taxpayers' exposure to financial risk. The federal government, perhaps through the FDIC, must have regulatory tools in place to manage the orderly failure of the largest financial institutions regardless of their size and complexity. The FDIC's testimony effectively outlines the checks and balances provided by a regulator with resolution authority and capability. Part of this process must be to prevent institutions from becoming ``too big to fail'' in the first place. Some methods to limit the size of institutions would be to charge institutions additional assessments based on size and complexity, which would be, in practice, a ``too big to fail'' premium. In a February 2009 article published in Financial Times, Nassim Nicholas Taleb, author of The Black Swan, discusses a few options we should avoid. Basically, Taleb argues we should no longer provide incentives without disincentives. The nation's largest institutions were incentivized to take risks and engage in complex financial transactions. But once the economy collapsed, these institutions were not held accountable for their failure. Instead, the U.S. taxpayers have further rewarded these institutions by propping them up and preventing their failure. Accountability must become a fundamental part of the American financial system, regardless of an institution's size.Q.6. Pro-Cyclicality--I have some concerns about the pro-cyclical nature of our present system of accounting and bank capital regulation. Some commentators have endorsed a concept requiring banks to hold more capital when good conditions prevail, and then allow banks to temporarily hold less capital in order not to restrict access to credit during a downturn. Advocates of this system believe that counter-cyclical policies could reduce imbalances within financial markets and smooth the credit cycle itself. What do you see as the costs and benefits of adopting a more counter-cyclical system of regulation? Do you see any circumstances under which your agencies would take a position on the merits of counter-cyclical regulatory policy?A.6. Our legislative and regulatory efforts should be counter-cyclical. In order to have an effective counter-cyclical regulatory regime, we must have the will and political support to demand higher capital standards and reduce risk-taking when the economy is strong and companies are reporting record profits. We must also address accounting rules and their impact on the depository institutions, recognizing that we need these firms to originate and hold longer-term, illiquid assets. We must also permit and encourage these institutions to build reserves for losses over time. Similarly, the FDIC must be given the mandate to build upon their reserves over time and not be subject to a cap. This will allow the FDIC to reduce deposit insurance premiums in times of economic stress. A successful financial system is one that survives market booms and busts without collapsing. The key to ensuring our system can survive these normal market cycles is to maintain and strengthen the diversity of our industry and our system of supervision. Diversity provides strength, stability, and necessary checks-and-balances to regulatory power. Consolidation of the industry or financial supervision could ultimately produce a financial system of only mega-banks, or the behemoth institutions that are now being propped up and sustained by taxpayer bailouts. An industry of only these types of institutions would not be resilient. Therefore, Congress must ensure this consolidation does not take place by strengthening our current system and preventing supervisory consolidation.Q.7. G20 Summit and International Coordination--Many foreign officials and analysts have said that they believe the upcoming G20 summit will endorse a set of principles agreed to by both the Financial Stability Forum and the Basel Committee, in addition to other government entities. There have also been calls from some countries to heavily re-regulate the financial sector, pool national sovereignty in key economic areas, and create powerful supranational regulatory institutions. (Examples are national bank resolution regimes, bank capital levels, and deposit insurance.) Your agencies are active participants in these international efforts. What do you anticipate will be the result of the G20 summit? Do you see any examples or areas where supranational regulation of financial services would be effective? How far do you see your agencies pushing for or against such supranational initiatives?A.7. This question is obviously targeted to the federal financial agencies. However, while our supervisory structure will continue to evolve, CSBS does not believe international influences or the global marketplace should solely determine the design of regulatory initiatives in the United States. CSBS believes it is because of our unique dual banking system, not in spite of it, that the United States boasts some of the most successful institutions in the world. U.S. banks are required to hold high capital standards compared to their international counterparts. U.S. banks maintain the highest tier 1 leverage capital ratios but still generate the highest average return on equity. The capital levels of U.S. institutions have resulted in high safety and soundness standards. In turn, these standards have attracted capital investments worldwide because investors are confident in the strength of the U.S. system. Viability of the global marketplace and the international competitiveness of our financial institutions are important goals. However, our first priority as regulators must be the competitiveness between and among domestic banks operating within the United States. It is vital that regulatory restructuring does not adversely affect the financial system in the U.S. by putting banks at a competitive disadvantage with larger, more complex institutions. The diversity of financial institutions in the U.S. banking system has greatly contributed to our economic success. CSBS believes our supervisory structure should continue to evolve as necessary and prudent to accommodate our institutions that operate globally as well as domestically. ------ CHRG-111shrg54589--137 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM MARY L. SCHAPIROQ.1.a. Do you believe the existence of an actively traded cash market is or should be a necessary condition for the creation of a derivative under law and regulation?A.1.a. The primary function of derivatives is to facilitate the efficient transfer of risk exposure among market participants. Trading of risk exposure through derivatives enables parties who have natural risk exposures as part of their business or investment operations to reduce or eliminate that risk by transferring it to somebody who has a natural offsetting risk, or to somebody else who is more willing to bear that risk. Some sources of fundamental business risk are closely related to the prices of assets that are traded in an active cash market, such as stock or foreign currency. Other risks lack robust cash market pricing sources. Derivatives based on these risks, however, can be important tools for managing these risks. As with any derivative product, the key challenge for policy makers will be determining when and whether the value of these products for risk management purposes outweighs potential concerns about the products' underlying market integrity.Q.1.b. If not, what specific, objective means besides a cash basis market could or should be used as the underlying relationship for a derivative?A.1.b. This issue raises important public policy concerns. Products without an active cash or derivatives market may have less robust price discovery. These products, nevertheless, may be useful to hedge or transfer real economic risks and, therefore can play a beneficial role in facilitating risk management and risk transfer activities. Policy makers should consider whether risk management and distribution purposes outweigh concerns with weak or unreliable pricing sources. Traditionally, the SEC has used disclosure to identify valuation risks associated with securities.Q.2. Why should the models to price OTC derivatives not be published? If there is no visible cash basis for a derivative, and the model is effectively the basis, why should the models not be public?A.2. The best way to improve market understanding and ``value'' determinations for derivatives is to standardize and centrally clear them (to the extent possible) and encourage them to be traded on exchanges. This would provide great transparency. Where standardization or exchange trading is less likely, I believe policy makers should endeavor always to maximize market transparency through reporting or other mechanisms. The argument for making models public when no cash market exists is an interesting way to provide a valuation check, but there are costs to this approach as well. For example, would investors continue to innovate and alter their models if they were public and available to their competitors? Would models become more similar--decreasing market style diversity and increasing the risk that major participants engage in the same trades (increasing volatility and risk)?Q.3. What is the best way to draw the line between legitimate hedges and purely speculative bets? For example, should we require an insurable interest for purchasers of credit protection, require delivery of the reference asset, or something else?A.3. Drawing a line, based on trading positions, between hedgers and speculators will necessarily be arbitrary because we cannot determine the intent of a trader from their portfolio holdings. Some market participants will hold derivative positions as part of a well-defined hedge (e.g., they also have large current or anticipated exposure to the prices of securities or debt instruments). Others have no exposure at all and hold a derivatives position strictly to gain exposure, that is to speculate, on price movements. However, drawing a line between the two motives is difficult and may yield unintended consequences. First, there are a number of entities that do not hold large securities or debt holdings, who may, nonetheless have a legitimate risk management purposes: For example, they may want to hedge their ``exposure'' to a major supplier or customer. Second, even if a reasonable line is drawn, there may be significant market consequences: For example, ``speculators'' can often provide liquidity for hedgers--so eliminating speculators can raise the cost of risk management and make hedges less effective. In developing a regulatory framework for OTC derivatives these and other complexities will need to be addressed in a manner that seeks to prevent the potential for market abuses while also creating a system that facilitates legitimate transactions.Q.4. Is the concern that increased regulation of derivatives contracts in the United States will just move the business overseas a real issue? It seems to me that regulating the contracts written in the U.S. and allowing American firms to only buy or sell such regulated contracts would solve the problem. What else would need to be done?A.4. Clearly we need to move forward with our regulatory framework, even if other jurisdictions do not follow. However, financial markets today are global markets and coordinating with our international counterparts will be critical. Absent a response coordinated with foreign regulators exercising similar authority, the effectiveness of any regulatory limits would be constrained significantly by the international nature of the derivatives market. Because there is the potential for trading business to move to less regulated markets, we are working with our counterparts internationally to ensure that all derivatives dealers and large participants in OTC derivatives market are subject to prudential regulation and supervision.Q.5. Do over-the-counter or custom derivatives have any favorable accounting or tax treatments versus exchange traded derivatives?A.5. There is no difference in the financial statement accounting principles applied to exchange traded versus other types of derivatives. With respect to the financial accounting treatment, contracts or other arrangements that meet the accounting definition of a derivative are ordinarily recognized and measured at fair value with changes recognized in income each period whether the derivative is exchange traded or customized. However, accounting rules allow companies to achieve hedge accounting and defer recognizing the impact of changes in value of derivatives used for hedging purposes when changes in the value of a derivative match and offset changes in the value of the hedged item to a sufficient degree. It is possible, in some cases, that a customized derivative may be more likely to economically offset changes in the value of the exposure a company is trying to hedge. Thus for certain applications, customized derivatives may be more likely to offset the exposure and thus may be more likely to meet the requirements for hedge accounting. In all cases where a derivative serves as a highly effective hedge, accounting standards clearly permit the entity to reflect the reduction in risk in the measurement of income.Q.6. In addition to the Administration's proposed changes to gain on sale accounting for derivatives, what other changes need to be made to accounting and tax rules to reflect the actual risks and benefits of derivatives?A.6. Even before the credit crisis, financial accounting for derivatives had been identified as deserving additional consideration. In this regard, the Financial Accounting Standards Board (FASB) issued new disclosure requirements in 2008 that provide greater transparency about derivative and hedging activities to investors, including a substantial amount of additional information about credit default swaps. Derivatives accounting also represents a component of the FASB's current project to reconsider the accounting principles for all financial instruments, recently undertaken in concert with the International Accounting Standards Board. This project was added to the FASB's agenda, in part, as a response to issues identified by the SEC and others during the credit crisis. Many have argued that the hedge accounting rules are overly complex and could be improved to make hedge accounting easier to apply and more understandable to investors. While we are supportive of such simplification, we would expect that because of their volatile nature, derivatives will continue to be measured at fair value each period on the balance sheet, and significant disclosures will continue to be needed for investors to understand the exposures, strategies, and risks of companies that utilize them. The tax treatment of different types of derivatives is outside of the SEC's area of expertise and may be better addressed by tax professionals and/or the IRS.Q.7. Should parties to derivative contracts be required to post cash collateral, or is other collateral acceptable? And is there any reason not to require segregation of customer collateral?A.7. Provided that positions are marked to market and collateral calls are made daily, cash collateral is one prudent type of collateral. In certain circumstances, though, highly liquid securities that tend to move in price consistent with the underlying reference asset may be as desirable for collateral as cash. Guidelines for acceptable forms of collateral will need to reflect the risks and circumstances associated with each type of acceptable collateral, including, but not limited to, price volatility and liquidity, and be agreed to by both parties to the transaction. Accordingly, under certain circumstances, noncash collateral may be acceptable. A priority of a regulatory framework for OTC derivatives should be ensuring a process that allows for the prompt return of customer collateral. Properly constructed regulations governing the segregation of customer collateral can provide customer protection while still promoting the operation of efficient OTC derivatives markets.Q.8. Is there any reason standardized derivatives should not be traded on an exchange?A.8. In building a framework for the regulation of OTC derivatives, the goal should be to encourage all standardized derivatives to be traded on exchange or equivalent exchange-like venues that provide full regulatory and market transparency. The regulatory scheme for trading OTC derivatives should be designed to achieve vital public policy objectives for such instruments, including transparency, efficiency, and prevention of fraud and manipulation. The regulatory scheme for standardized derivatives should, however, retain sufficient flexibility to allow market mechanisms to develop that meet varying trading needs for products (such as products that may lack sufficient liquidity to be traded on an exchange), while ensuring all dealers and trading markets (including for nonstandardized products) are subject to a unified regulatory scheme that establishes a framework for fair competition among markets, protects the public interest and is sufficiently transparent to allow for regulatory oversight.Q.9. It seems that credit default swaps could be used to manipulate stock prices. In a simple example, an investor could short a stock, and then purchase credit default swaps on the company. If the swaps are not heavily traded, the purchase would likely drive up the price of the swaps, indicating higher risk of default by the company, and lead to a decline in the stock price. Is there any evidence that such manipulation has taken place? And more generally, what about other types of manipulation using derivatives?A.9. The Commission is very concerned about potential manipulation of the equity markets through the use of credit default swaps or other derivative instruments. Because there is no central reporting or audit trail requirement for OTC derivatives, including securities-related OTC derivatives, there is no organized surveillance by any Federal regulatory agency or self-regulatory organization. This regulatory gap substantially inhibits the Commission's examination and enforcement efforts, and the lack of surveillance creates substantial risk to the markets collaterally affected by swap transactions, such as the market for debt and equity securities related to credit default swaps. The antifraud prohibitions in the Federal securities laws currently apply to all securities-related OTC derivatives, including credit default and other swaps related to securities. The Commission, however, needs better tools to enforce existing prohibitions over all securities-related OTC derivatives, including authority to promulgate reporting and record keeping rules and prophylactic antifraud rules. Currently, if Commission enforcement or examination staff suspects illegal conduct in the derivatives market, staff must engage in the time-consuming process of manually recreating activity in this unregulated market, which is challenging in a market without uniform documentation, transparent pricing, and time-stamped records. Under these circumstances, it is difficult to identify violations and prove the intent required to support charges under the Federal securities laws. Uniform record keeping and reporting would provide the type of information needed to identify suspicious trading patterns and to investigate or examine misconduct. With uniform audit trail and record keeping requirements, Commission staff could, for example, better pinpoint where manipulative credit derivative trading occurs in tandem with other trading strategies, such as short selling.Q.10. Credit default swaps look a lot like insurance when there are unbalanced, opportunistic sellers. However, life and property insurance requires an insurable interest for the buyer and reserves for the seller. Why should we not regulate these swaps like traditional insurance?A.10. Although credit default swaps are frequently described as insurance (buying protection against the risk of default) and may have certain elements similar to traditional insurance, we believe that securities-related credit default swaps are more appropriately considered, and regulated, as securities. The value of the payment in the event of default is determined by reference to a debt security, so that the payment is tied directly to a security. As noted in the CDS example in question #9, securities-related credit default swaps are tied directly to the securities markets and issuers of securities. As a result, manipulative activities in the credit default swap market would affect U.S. issuers in the underlying equity market. Congress recognized the impact of these instruments on the primary markets that are regulated by the SEC when it applied the antifraud and antimanipulation provisions of the securities laws to securities-related OTC derivatives, such as securities-related credit default swaps, in 2000. That authority needs to be extended to provide the SEC the regulatory tools to regulate these products. Regulating securities-related credit default swaps as insurance would actually undermine the protections provided by the Federal securities laws by creating the potential for arbitrage between two different types of regulation for economically related products.Q.11. How do we take away the incentive for credit default swap holders to force debtors into bankruptcy to trigger a credit event rather than renegotiate the debt?A.11. Some commenters have identified a phenomenon they characterize as the ``empty creditor'' problem. These commenters have noted that credit default swaps, among other products, allow a creditor holding a debt obligation to reduce or eliminate its economic exposure to the debtor while still retaining the rights as a creditor. As a result, creditors who hold significant credit default swap positions may prefer that the debtor enter into bankruptcy because the creditor will receive payments in connection with its CDSs that exceed any benefit the creditor would get if the debtor restructured its debt. The Federal securities laws do not establish any duties of a creditor to a lender or to other creditors. The motivation of a creditor to take any action with respect to its debt holdings in a particular company may be guided by many different economic and investment factors that are unique to such creditor, with credit default swaps being just one such factor. For example, a creditor that also is a significant equity holder may have different motivations in making credit decisions as compared to a creditor that holds only debt. Focusing only on a creditor's actions as influenced by its holding of credit default swaps does not take into account these other motivating factors.Q.12. How do we reduce the disincentive for creditors to perform strong credit research when they can just buy credit protection instead?A.12. As the financial crisis illustrates, it certainly appears that some major market participants may have used credit protection as an alternative to engaging in more robust traditional credit research and review regarding their credit exposures--leading to hidden/higher credit risk and the risk that the credit protection provider cannot perform. This tension is real. However, this moral hazard that exists in credit protection exists in a number of contexts in the financial arena. For example, this hazard exists when investors rely on a credit rating or an analyst's research report instead of engaging in their own research. Although inherent, this problem is exacerbated by a number of factors in the credit arena--such as when information is limited to a small number of creditors or unavailable to the public; when traditional credit standards are reduced; or when investors and creditors become less vigilant due to perceptions (or misperceptions) of market safety. In the short term, the financial crisis itself has certainly reduced these risks, but it is important that regulators (as well as investors and other market participants) remain vigilant to help avoid the next crisis. To better ensure that vigilance, we believe more accountability and transparency will do a lot to keep investors informed of the flaws of overreliance on credit protection, credit ratings, or a similar third-party validator before making investment or credit decisions.Q.13. Do net sellers of credit protection carry that exposure on their balance sheet as an asset? If not, why shouldn't they?A.13. Sellers of credit protection typically carry a liability on their balance sheets for the obligation to compensate the guaranteed party if a credit event occurs on the referenced asset. Some types of credit protection are considered insurance contracts under the accounting rules and the resulting obligation is measured based on insurance accounting principles. Other types of credit protection, such as credit default swaps, meet the accounting definition of a derivative and the resulting liability is marked to market each period. Unless an insurer or guarantor controls the referenced asset, accounting rules do not permit or require the referenced assets to be recognized on the guarantor's balance sheet. In other words, simply guaranteeing or insuring the value of an asset does not require a guarantor to record the insured asset on its balance sheet under generally accepted accounting principles. On the other hand, guarantors that control the insured or guaranteed assets will generally be required under new off-balance sheet accounting rules to report on their balance sheets the controlled assets effective for 2010 financial reports.Q.14. In your testimony you mentioned synthetic exposure. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.14. Synthetic exposure through derivatives can be a good idea, or a bad idea--depending on the circumstances. While they can be used to increase leverage, they can also be used to reduce transaction costs, achieve tax efficiencies, or manage risk. Synthetic exposure through derivatives is a component of many arbitrage strategies that help align prices of related assets across markets. A key question for policy makers, I believe, will be determining how best to utilize the ``good'' aspects of derivatives use (e.g., as a risk management tool for individual institutions); while minimizing the ``bad'' aspects (unclear pricing, hidden leverage, and increased counterparty and systemic risk). It is also important to keep in mind that when synthetic exposure through securities-related derivatives products is used to replicate the economics of either a purchase or sale of securities without purchasing or selling the securities themselves, the markets for these derivatives directly and powerfully implicate the policy objectives for capital markets that Congress has set forth in the Federal securities laws, including investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation. Given the impact on the regulated securities markets--and the arbitrage available to financial engineers seeking to avoid oversight and regulation--it is vital that the securities laws apply to securities-based swaps.Q.15. Regarding synthetic exposure, if there is greater demand for an asset than there are available assets, why shouldn't the economic benefit of that demand--higher value--flow to the creators or owners of that asset instead of allowing a dealer to create and profit from a synthetic version of that asset?A.15. This is an interesting question. I believe policy makers should consider carefully whether/how the creation of these synthetics affect demand for the underlying securities. Traditionally, the view is that dealers and other financial intermediaries provide liquidity to the market and help make markets more efficient by reducing the extent to which asset prices are subject to excess volatility that may arise from short-term trading imbalances. The ability of liquidity providers to improve market quality is significantly enhanced when they are able to engage in activities that involve synthetic exposure. Constraints on the ability of intermediaries to provide liquidity increase the propensity for asset prices to deviate significantly from fundamental value. These deviations can lead to a misallocation of capital, and can be harmful to the investors. For example, investors are harmed when they buy an asset at a price that is temporarily inflated due to a demand shock.Q.16. One of the arguments for credit default swaps is that they are more liquid than the reference asset. That may well be true, but if there is greater demand for exposure to the asset than there is supply, and synthetic exposure was not allowed, why wouldn't that demand lead to a greater supply and thus more liquidity?A.16. On average, large debt issues tend to be more liquid than small ones because they tend to be held by a greater number of investors and there are more units available for trading. This does not mean, however, that an issuer would have the ability to improve the liquidity of its bond issue by issuing more debt. Market liquidity depends mainly on the ability and willingness of financial intermediaries to take on inventory positions in response to demand shocks.Q.17. Is there any justification for allowing more credit protection to be sold on a reference asset than the value of the asset?A.17. The primary justifications I have seen for permitting the purchase of credit protection beyond an entity's ``exposure'' are (1) these participants provide liquidity to those who are themselves hedging; (2) a participant may use credit protection based on one reference asset to hedge risks on other related assets; and (3) investors may wish to take a position expressing a view that the market is underestimating the probability or severity of default.Q.18. Besides the level of regulation and trading on an exchange, there seems to be little difference in swaps and futures. What is the need for both? In other words, what can swaps do that forward contracts cannot?A.18. The term ``swap'' generally refers to over-the-counter derivative instruments, a category that encompasses a wide range of products, including forward contracts, interest rate swaps, total return swaps, equity swaps, currency swaps, credit default swaps and OTC options, including both traditional and digital (or binary) options. In contrast, futures are a specific kind of standardized, exchange-traded derivative. Swaps may be tailored to address specific risks in ways not available with standardized products such as futures. For example, customized swaps involving foreign currency, interest rates, and hard commodities may play an important risk management role for companies and other end users because standardized contracts, in these circumstances, may not address the needs of a company with respect to the specific risks being hedged.Q.19. One of the arguments for keeping over-the-counter derivatives is the need for customization. What are specific examples of terms that need to be customized because there are no adequate substitutes in the standardized market? Also, what are the actual increased costs of buying those standard contracts?A.19. Commercial businesses will often individually customize OTC derivatives to meet the company's specific risk management needs. Companies may use OTC derivatives to manage fluctuations in materials prices, equity OTC contracts, commodities, fuel, interest rates and foreign currency. For example, a company that borrows money at a variable interest rate might enter into derivatives contracts to turn the borrowing into fixed-rate debt or as protection against swings in currencies or the price of commodities such as food and oil. The company can customize the contract to mature on a specific date or for a nonstandard notional amount, creating a more effective hedge. The inability to create perfect hedges can introduce basis risk. Basis risk can also occur when the asset being hedged is different from underlying asset of the derivative that is being used to hedge the exposure. Allowing firms to continue to bilaterally negotiate customized OTC derivatives contracts can help mitigate these risks. Standardizing OTC derivatives may increase costs in certain instances and decrease costs in others. Standardized derivatives, particularly those that are cleared through central counterparties, require the posting of cash or cash equivalent collateral. This is a cost not faced by financial firms when they enter into OTC derivatives contracts with other large financial firms. Conversely, standardizing OTC derivatives could result in tightening of the bid-ask spread of the instruments due to fewer individual terms that need to be negotiated between counterparties. This could potentially lower costs faced by purchasers and sellers of those contracts. Standardization could also lead to less effective hedges, but would allow a party to trade out of its position as opposed to negotiating a separate termination agreement. These termination agreements can be extremely expensive for the party seeking to exit customized deals.Q.20. On the second panel, Mr. Whalen suggests that Congress should subject all derivatives to the Commodity Exchange Act, at least as an interim step. Is there any reason we should not do so?A.20. To the extent that derivatives are securities-related, the securities laws should continue to apply. Without application of the securities laws, the derivatives market could be used to manipulate the securities market by circumventing securities laws protection against insider trading and improper short selling, among other things. Secretary Geithner recognized that multiple Federal regulatory agencies should play critical roles in implementing the proposed framework, including the SEC and the CFTC. In my testimony, I recommended that primary responsibility for ``securities-related'' OTC derivatives be retained by the SEC, which is also responsible for oversight of markets affected by this subset of OTC derivatives. Primary responsibility for all other OTC derivatives, including derivatives related to interest rates, foreign exchange, commodities, energy, and metals, could rest with the CFTC.Q.21. There seems to be agreement that all derivatives trades need to be reported to someone. Who should the trades be reported to, and what information should be reported? And is there any information that should not be made available to the public?A.21. We agree that all derivatives trades should be reported. Information reported should include the identity of the contract traded, the size of the contract, the price, the parties to the contract (and which party was the buyer and which was the seller), and the time of trade. Additional analysis by appropriate regulators may identify other data elements that should be reported. Where a trade is reported depends on where it is traded. If a product is traded on a regulated exchange or an exchange-like facility (such as an alternative trading system), the details of the trade will be captured by the trading system. If a product is traded elsewhere, trades in that product should be reported to another regulated entity, such as a trade repository or self-regulatory organization. Entities to which trades are reported could disseminate information to the public individually. This approach would likely be the easiest to implement in the near term. However, it would mean that trading and reporting data would be fragmented, and it is unclear how easily or well it could be aggregated by private data vendors. Different entities could adopt different standards for trade reporting and dissemination (such as adopting different identification codes for the same derivatives contracts). Significant regulatory efforts could be necessary to promote uniform standards for these various entities to obtain the full benefits of post-trade reporting and transparency. One way to address these potential problems would be for the appropriate regulator to designate a central information processor to collect trade input from various sources and to disseminate trade information publicly in a uniform manner and subject to regulatory standards that ensure that access to the trade data is on terms that are fair and reasonable, and not unreasonably discriminatory. The SEC relies on and regulates such central information processors in the markets for cash equities, securities options, corporate debt securities, and municipal securities. We believe that these trade reporting and dissemination systems work very well and deliver a robust information stream in a timely and cost-efficient manner. As your question notes, some information that is reported may not be appropriate for public dissemination. One such item may be the names of the counterparties. The systems for cash equities, securities options, corporate debt securities, and municipal debt securities that are regulated by the SEC currently do not disseminate such information.Q.22. Is there anything else you would like to say for the record?A.22. I appreciate the opportunity to testify on this important topic and I look forward to working with the Committee to fill the gaps in regulation of OTC derivatives. These efforts are critical to furthering the integrity of the U.S. capital markets. ------ FOMC20061025meeting--111 109,MR. REINHART.,"2 Thank you, Mr. Chairman. The pulse of the market regarding your policy action today is the flat line in the top panel of your first exhibit. [Laughter] Not weakish data releases early in the period, nor stronger ones later, nor speeches by some of you interpreted as hawkish shook the belief that the intended federal funds rate would remain at 5¼ percent after this meeting. Expectations about the policy rate at the end of next year, proxied by the December 2007 Eurodollar futures rate—the dotted line—showed more life, falling about 20 basis points by the middle of the period but ending up 5 basis points higher, on net. As can be seen in the middle left panel, market participants still anticipate almost ½ percentage point of policy easing next year. Once again, as denoted by the green shaded area, the 70 percent confidence interval derived from options prices is quite narrow. We routinely track the economic forecasts of a subset of nine of the primary dealers, and their average path for the federal funds rate through 2007 is plotted as the dashed line in the middle right panel. Those dealers and the forecast from market quotes—but not the Greenbook assumption plotted as the horizontal line—call for policy easing next year. The primary dealers’ policy call occurs against the backdrop of forecasts for the unemployment rate (the bottom left panel) and core CPI inflation (the bottom middle panel) that about match the Greenbook’s. What is different is plotted at the bottom right: These dealers expect real GDP growth to track about ½ percentage point higher than does the staff. One possibility is that these market participants, compared with the staff, foresee both more drag on domestic spending and faster-expanding potential output. If so, dealers would correspondingly view policy ease as necessary to generate economic growth that will be acceptable to you. 2 Material used by Mr. Reinhart is appended to this transcript (appendix 2). Your own view as to the economy’s potential to produce no doubt influences your views on policy, as do your interpretations of the three factors described in exhibit 2. The top left panel plots existing and new home sales as the solid and dotted lines, respectively. You might see in that chart that house sales have declined sharply and view the resulting weakness as a risk to the outlook, as has been the case at the past few meetings. Alternatively, you might see that home sales appear to be bottoming out amid generally strong fundamentals. As one newsletter put it—and I think that the author meant it to be good news about the prospects for spending—that “the point of maximum deterioration in housing activity has probably passed.” The middle panel plots the real federal funds rate, which some of you may emphasize has risen considerably and take its level now to be restrictive. Others, however, might stress that the real federal funds rate remains below its average of the late 1990s. A third potential source of alternative interpretations might be the measures of inflation compensation plotted in the bottom left panel. For some, the chart shows that inflation compensation remains contained and has declined of late at shorter horizons. Others may find only cold comfort in this because inflation compensation nevertheless remains above the range consistent with their price stability objective. The policy choice today depends on your assessments both of the economy in the near term and of the appropriate path of inflation over a longer time frame—the subject of exhibit 3, which repeats some material from the “Medium-Term Strategies” section of the Bluebook. The solid line in the top left panel plots the setting of the nominal funds rate that, in the FRB/US model, best achieves the objective of minimizing deviations of the unemployment rate from the NAIRU and of core PCE inflation from a goal of 1½ percent, while avoiding jarring adjustments in the nominal funds rate. The forces shaping the outlook are the same as in the extended Greenbook baseline, and investors are assumed to understand the entire path of policy—which they deem credible when determining asset values. Wage and price setters, in contrast, base their expectations on less information and alter their views on long-run inflation only sluggishly in response to actual inflation. As is familiar from such exercises in previous Bluebooks, it thus takes a long time to work down inflation when the goal is below prevailing inflation expectations at the start of the simulation. With the Phillips curve as flat and inflation expectations as inertial as in the FRB/US model and with equal weights placed on the objectives, policymakers find it optimal to trade off a persistent miss of the inflation goal (the bottom left panel) for smaller cumulative labor market slack (the middle left panel). In this simulation, progress may seem especially glacial because the steady dollar depreciation that is required to rein in the deterioration of the current account generates persistent upward pressure on domestic inflation. But even the modest progress that is made on inflation under this scenario requires about ¾ percentage point of firming over the next year. We explored two modifications of the standard framework to help speed disinflation. In the first, and as plotted as the dashed red lines on the left, policymakers are assumed to put much more weight on the inflation goal relative to maximum employment. Indeed, progress in reducing inflation is notable, but the unemployment rate is also notably elevated. The simulation underlying the dotted green lines maintains the assumption of equal weights in the objective function but changes the assumption about the information that wage and price setters use so as to create a more favorable inflation-unemployment rate tradeoff in the short run. This variant assumes that the level of the nominal funds rate conveys a noisy signal to wage and price setters about policymakers’ inflation goal. It is optimal, then, to impose policy restraint early on so as to send inflation expectations down and accomplish a quicker and less costly disinflation. The credibility you attach to such a channel may play some role in your willingness to firm policy in the near term. But you may not see any need to do so if you are drawn to the dashed blue lines in the right-hand column of charts. Those lines summarize macroeconomic outcomes for policymakers with an inflation goal of 2 percent. Because current inflation expectations about comport with that goal, policymakers can keep the nominal funds rate at 5¼ percent for some time and still observe declines in inflation given the other forces of disinflation in the baseline. Exhibit 4 considers some aspects of the wording of your statement to be released after this meeting, starting with the rationale portion in the boxes at the top. As noted at the left, in drafting the Bluebook, we proposed including in row 2 of all the draft statements that “economic growth appears to have slowed further in the third quarter.” This wording seemed to have the advantage of acknowledging the upcoming release of the initial third-quarter estimate of real GDP on Friday, which by the staff’s reckoning is likely to be weak. Some of you may be concerned, however, that this mention might heighten market scrutiny of that data point or potentially set up the Committee for failure if the release proves surprisingly strong. As noted in the top right box, we simplified the language about inflation pressures in row 3 of alternative A, partly in response to earlier criticism that the Committee could be interpreted as having slipped a derivative. The statement has been pointing to the levels of the prices of energy and other commodities as having “the potential to sustain inflation pressures.” Even if you are not drawn to the phrasing of the rest of the alternative, you might see some merit in this simplification for row 3. Or you might not, [laughter] given the focus in markets of changes in the wording of the statement. The Bluebook effectively offered four alternatives this time, the three in the table and a possible middle ground between B and C mentioned in the text. These are laid out in the remainder of the exhibit. In recent statements, the risk assessment has pointed to upside risks to inflation and the possible need to firm policy further. Market participants nevertheless appear to attach greater likelihood to policy easing than tightening. To protest that view and to underscore its commitment to reduce inflation, the Committee might choose to modify its words to note, as in alternative B+, that “although the Committee both seeks and expects a gradual reduction in inflation, it continues to view the risks to that outcome as remaining to the upside.” Some of you, however, may view this as change for the sake of change that unnecessarily risks confusing market participants as to the Committee’s intent. For the sake of reference, the last exhibit repeats, with no change, table 1 from the Bluebook. That concludes my prepared remarks." FOMC20070321meeting--133 131,MR. POOLE.," I had essentially the same question. If you take the two-year rate over the past year, how much of that could be explained by a change in the term premium? You said term premiums are low, but I’m talking about the change." FOMC20060510meeting--127 125,CHAIRMAN BERNANKE., It worries me that we are in the hands of some exuberant 30-year- olds. [Laughter] FOMC20080805meeting--102 100,MR. LOCKHART.," Thank you, Mr. Chairman. The contours and basic outcomes of Atlanta's forecast are similar to the baseline of the Greenbook forecast. So I want to focus my remarks this morning on the underlying assumptions in both forecasts--assumptions that I view as pivotal and if we miscalculate could result in a longer-term policy error. It seems that at every meeting there's great uncertainty around the outlook, and this juncture is no different. I perceive considerable uncertainty and debatable assumptions in the base-case scenario. As I see it, the key assumptions broadly are that housing stabilizes, perhaps as indicated by housing prices, in the second half of '09. Inflation pressures intensify in the near term but then abate because of economic slack and lower commodity prices and, as discussed, core import prices. Recent declines in oil prices stick, and prices remain more or less flat. Certainly since the Greenbook was published, we note the fluctuations just in the past few days that were referred to earlier, and I also can't dismiss geopolitical risks and the potential of a severe shock. Finally, financial market stress will persist for some months but diminish next year. These assumptions, using the respectable term ""assumptions,"" have the feeling to me of ""bets,"" not so respectable a term. The policy assumption integral to both the Greenbook and the Atlanta forecasts could be added to this, and that is that rate rises starting in 2009 won't choke off improving growth and will be enough to blunt remaining inflation pressures. So I'll devote my comments to input from regional and other contacts that either serve to confirm or cast doubt on these assumptions. We oriented this cycle's questions to our Atlanta and Branch directors to, first, evidence of wage pressures and pass-through of higher costs. In interpreting the feedback, we noted some confusion between a business's management of its labor costs versus general wage pressures. We heard that businesses are working to keep their total wage bills in check by raising wages for key talent but letting less critical employees go or cutting their work hours as an offset. The reduction in hours is attributed to some combination of weaker product demand and increased average productivity. Rising unemployment appears to be keeping wage demands in check. There are exceptions, such as the oil field services industry, for which qualified staff are in short supply, and certain skilled industrial and business trades in which local bottlenecks exist. In businesses enjoying strong export demand, some employers are utilizing bonuses rather than commitment to permanent wage increases. So our regional contacts did not indicate the development of broad-based underlying pressures on labor costs reflecting wage demands. As for inflation pass-through, our contacts reported widespread and growing efforts to pass through higher input costs. Pass-through efforts appear to be the rule rather than the exception. As one Branch director put it, people are passing through costs like crazy using high energy costs as cover. The reports of my supervision staff regarding banking conditions indicate a continuing decline in asset quality and a very nervous interbank funding market. Foreclosed properties, both single-family and condo, are making up the majority of house sales and slowing the absorption of the oversupply of new homes. Some contacts are very concerned about the prospect of a second wave of foreclosures as option ARM mortgage borrowers, mostly concentrated in large states like Florida and California--these are borrowers who are currently paying less than the accrued interest--run up against maximum loan-to-value ceilings. New, higher GSE standards are resulting in fewer borrowers being qualified, putting downward pressure on house prices and bringing more foreclosures. Virtually all comparables for Florida residential valuation are based on forced sales and foreclosures, we are told. Beyond the deterioration in real estate portfolios, banks are reporting growing problems in credits to food distributors, restaurants, trucking, and other petroleum fuel or input-intensive industries. Based on my calls with financial market contacts, it seems that--no surprise--much of the attention in financial markets has shifted from private fixed-income markets to Fannie and Freddie. Fixed-income markets for private securities appeared to have improved relative to their lows since the current financial turmoil began. Although significant concerns remain, it appears that leveraged-loan deals are getting done. Volume is down, spreads are up, and the deals are very conservative, but deals are getting done. That said, one of the patterns in my calls over the past year has been that, every time one concern abates, another seems to jump up and take its place. Although the recent legislation appears to have alleviated concerns about the Fannie and Freddie senior debt, my contacts indicate that there is widespread uncertainty about what will happen to junior securities if the Treasury injects funds. Furthermore, more than once I heard the view that foreign holders of GSE debt are concerned that their positions are not as safe as they believed. One contact mentioned that the 18-month term of the guarantee is reportedly affecting some holders' maturity choices. In response to my question about the relative weakness of European banks, one contact suggested that they have booked much of their troubled assets in the ""hold to maturity"" account, suggesting slower recognition of losses and difficulties ahead. We confirmed with one large regional bank CFO significant deterioration of HELOCs in their portfolio and, by implication, broadly among regional banks. The option ARM problem, by contrast, is perceived to be possibly the next shoe to drop but, as I said earlier, not uniformly distributed across the country. Finally, we heard the view that markets perceive banks as facing protracted difficulty raising capital. To conclude, the downside risks to growth have not diminished in my opinion. On the flip side, I agree that the upside risks to inflation are obviously a serious concern. In particular, I put a fair amount of weight on the possibility that inflation will not moderate sufficiently without a more substantial tightening of monetary policy than that projected in the Greenbook baseline. My intermeeting internal and external discussions make it difficult for me to dismiss some of the alternative scenarios in the Greenbook, specifically the ""severe financial stress"" scenario, the ""typical recession"" scenario, and the ""inflationary spiral"" scenario; and in a high-uncertainty environment, I don't view any of these scenarios as exclusive of another. That said, I see the risks to both the inflation and the growth objectives as very roughly in balance at this time. Thank you, Mr. Chairman. " FOMC20070918meeting--149 147,CHAIRMAN BERNANKE., President Evans joins the table with twelve years of experience already. [Laughter] FOMC20060808meeting--7 5,MR. WILCOX.," Thank you, Mr. Chairman. Jack Brickhouse, the voice of the Chicago Cubs for more than thirty years, was more widely known for his knowledge of baseball than for his command of probability. When a Cub would step into the batter’s box after an especially long string of hitless trips to the plate, Brickhouse would invariably declare, “He’s due.” Even we kids knew in our minds that Jack didn’t have it quite right on the probability front, but in our hearts it was enough to keep us going. Some of you may remember that an employment report was released on the Friday after the June meeting, and that time, we pretty much nailed it. So I have to admit to having had a “Brickhouse moment” last Friday and wondering whether we were “due” this time for a real trainwreck. But for a second time in a row, fate smiled, as it so rarely seems to do on macro forecasters. So at the end of today’s meeting, I’ll be happy to pass the baton back to Dave Stockton but with a certain sense of guilt: He’s really due. [Laughter] In fact, as we reported to the Board yesterday, Friday’s labor market report came in very much as expected. Private nonfarm payrolls increased an estimated 113,000 in July, virtually the same as the 100,000 we had been expecting, and the gains in each of the previous two months were revised up by a modest 20,000. The unemployment rate rounded up to 4.8 percent, but unless we receive additional evidence of a more-rapid slackening of conditions in the labor market, we’re inclined to stick with our Greenbook trajectory for the unemployment rate as well. Overall, we made no material adjustments to our macro forecast in light of this news on the labor market. Indeed, I would argue that there was less news in the August Greenbook than met the eye. The quick summary of the August projection is that the pressures on resource utilization look roughly the same to us as they did at the time of the June Greenbook, whereas the outlook for inflation looks just a shade worse. Turning first to the issue of resource utilization, the clearest indication of our thinking in this regard is that the unemployment rate in the August Greenbook never deviates more than 0.1 percentage point from our forecast in the June Greenbook. To put a very fine line on the matter, we nudged the path down ever so slightly over most of the forecast period, and that call still looks about right to us, even in the wake of Friday’s report. Given an unrevised estimate of the NAIRU, the slightly lower level of the unemployment rate implies that the pressures on resource utilization are just a little greater in this Greenbook than they were in the last one. At the same time, we have become a bit more pessimistic about the outlook for the growth of aggregate demand relative to potential over the next six quarters. This slightly greater pessimism derives from several considerations. Most notably, starts and especially permits for the construction of single-family homes came in below our expectations in June, and we responded by taking our projection for residential construction down over the entire projection period. In the June Greenbook, our projection ran above the simulated trajectory from our preferred model for starts, in recognition of the persistent upside errors that model had been making. Now, for what it’s worth, our judgmental forecast happens to be in line with the simulation from that model that jumps off from the last quarter of data. Parenthetically, I might note that the simulations from that model did not revise greatly over the past six weeks. We still see the contraction in residential construction as moderate by historical standards but likely to be a little steeper than we anticipated in June. This time, we forecast that single-family starts will bottom out at an annual rate of 1.43 million units, bringing the overall decline from last summer’s peak to 18 percent, still well shy of the declines that were registered in the early 1980s and early 1990s but starting to be in the same ballpark. We also took on board the growth implications of the further run-up in oil prices since the June meeting, the somewhat lower level of household wealth implied by the downward-revised trajectory for house prices, and the likelihood that greater inventory investment in the second quarter robbed a smidgen of growth from the future. All that said, the adjustments to our forecast of resource utilization are pretty marginal. More eye-catching were our revisions to top-line GDP growth, which averaged 0.5 percentage point over the second half of this year and 0.4 percentage point next year. But here, of course, the changes were driven by the adjustments we made to the supply side of our projection. In its annual revision of the national income and product accounts, the BEA trimmed the average pace of growth of real GDP from 2003 through 2005 about 0.3 percentage point. Because our fundamental views of the pressures on resource utilization and the rate of inflation were unchanged by the NIPA revision, the simplest thing for us to do would have been to take potential GDP down by a like-sized amount, thereby keeping the GDP gap the same as before. As we often do, however, we made a further adjustment to potential in order to bring the output gap into line with the unemployment rate gap at the end of last year thereby eliminating a tension between those two “gap” variables that had become more distracting than informative. As for the forecast, in line with our usual practice, we overlaid the other factors that I discussed earlier with a 0.3 percentage point adjustment for the reduction in the growth of potential, on the theory that households and businesses anchor their spending plans around their longer-term prospects for income. A central issue that we wrestled with in this forecast round was whether the slowdown in growth that we anticipate will materialize to the degree that we expect. The dimensions of that slowdown are significant. Looking ahead six quarters and behind by the same amount helps smooth through some of the quarter-to-quarter wiggles. We estimate that, over the past six quarters, real GDP growth exceeded potential growth, on average, about ¾ percentage point at an annual rate; we expect real GDP growth over the next six quarters to fall short of potential by roughly the same amount. One key factor driving this swing in our forecast is the combination of a waning boost to consumption from household net worth and the higher level of interest rates. The result is reflected in our forecast for the personal saving rate. Again using the same six-quarter window, fore and aft, over the past six quarters, the saving rate declined more than 2 percentage points; we expect that between now and the end of 2007 the smaller gains in wealth and higher interest rates will bring the saving rate back up to 2 percent. Another key factor, especially in the near term, is the slowdown in residential investment. After chipping only about ¼ percentage point from the growth of real GDP during the first half of this year, residential investment is expected to slice about ¾ percentage point from the growth of real GDP over the second half of this year. Next year, the drag from this sector should have diminished but not halted altogether. Finally, we think that the sum of public and private spending related to last year’s hurricanes will top out sometime this year and will begin to drift down, accentuating the downdraft from the other factors weighing on demand. We have assumed that, within the aggregate of total hurricane spending, government spending and the replacement of destroyed equipment have been relatively front-loaded, whereas construction activity, we presume, is still ramping up. Turning to inflation, the news is relatively slight but not of the welcome variety. As you know from the Greenbook, we marked up our projection for core PCE inflation over the second half of this year about ¼ percentage point and nudged the forecast for next year up a tenth. The largest single factor accounting for these upward revisions was the further deterioration during the intermeeting period in the outlook for energy prices; the pass-through of these prices adds about a tenth to our projection of core inflation during the second half of this year and about half a tenth next year. Owners’ equivalent rent surprised us once again to the upside in the most recent CPI release, and we extended forward some of that unfavorable news. Other sources of upward revision, each small but together big enough to generate just a little upward nudge to our projection, included slightly higher near-term core import prices and slightly weaker structural productivity growth. As before, we continue to see core inflation stepping down next year compared with this year, almost entirely because of the flattening out we have projected for energy and other commodity prices: We have the increases in those prices adding about 0.4 percentage point to our forecast of core PCE inflation this year, and we have them adding just 0.1 percentage point next year. Provided that this year’s shocks do not get built into inflation expectations going forward, this removal of upward impetus should be enough to give core inflation a downward tilt. In closing, I might briefly mention that “speed effects” do not play an important role in shaping our outlook for inflation. The slowdown in growth operates first by bringing output down from above potential to right in line with potential by sometime during the first half of next year and then by moving output below potential over the remainder of 2007. For 2007 as a whole, output is so close to potential as to be roughly a neutral factor for inflation. If growth were to proceed at a subpar pace into 2008, the resulting gap in resource utilization could begin to place some downward pressure on inflation. Karen will now continue our presentation." FOMC20060629meeting--113 111,MR. WARSH.," Thank you, Mr. Chairman. In terms of my overall comments, I consider my views really in the center of gravity, as the Vice Chairman described it, of the speakers around the table and probably, again, quite a bit more optimistic in terms of GDP growth and perhaps also more concerned about inflation risks than the Greenbook. When I look at the strength of the fundamentals of the economy, including strong and accelerating profits, low unemployment, highly accessible capital markets, and remarkably strong balance sheets both for consumers and businesses, I find it hard to reconcile those with some of the pessimism coming not just from the Greenbook but also from some economists that the markets follow. The two trends and the two sets of data seem to be going in very different directions. Regarding the data that have come in since our last FOMC meeting, some time has been spent here on a few of the negative surprises, so I want to highlight a few of the positive bits of news. Federal tax receipts in May were up 26 percent from May a year ago. For the past twelve months, as we’ve talked about before, total tax receipts into the government went up 12.9 percent. Core retail sales rose 0.4 percent in May, up about 6.9 percent year over year if we exclude some of the more volatile items. According to surveys and anecdotes, the manufacturing base continues to be remarkably robust, both in terms of growth and in terms of jobs. I’d also note that durable goods orders, though not incredibly robust over the past month, represent growth of about 10 percent over the past three months if we exclude aircraft and look only at nondefense capital goods. So all in all, I think that the data suggest a more positive trend. What I’d like to do is spend a little time talking about how the markets have reacted to this news and build on a couple of the points that Dino made at the outset. First, a lot of pundits have described the “new volatility” in the marketplace, and I think that Dino made a very compelling case that the volatility has really not been nearly as severe as the commentators suggest. Volatility has in some ways been a euphemism for the fact that the markets have been down, and those are obviously quite different things. [Laughter] I think another bit of conventional wisdom is influencing decisionmakers, both in Washington and in business, and it is probably important to correct. That idea is that somehow the Fed has been the cause of this market volatility. I think that is largely incorrect. When I look at what has happened, I think that the markets are focused more and more on core economic fundamentals. We have changed in the perspective of the markets, which used to think some months and quarters ago that bad news meant good news and now they think that bad news is actually bad news. The bad news previously meant that we weren’t going to be moving rates higher. Again, I think the markets, not the commentators, have a better understanding that they really need to be focusing on economic fundamentals. When I look at the economic fundamentals, one of the data points that I look to is the state of corporate profit growth at this point in the cycle. Over the past twelve months, it was 13.6 percent, and if we look at bottom-up analyst forward estimates for the S&P 500 or for the Russell, it appears that those analyst estimates are actually accelerating. As a former banker, I will admit to some bias in these numbers, but they’ve been tracking reasonably well. The forward estimates are that corporate profits should be up something like 16 percent. So one of the things that we can do over the next several meetings is see how actual results track against those expectations, and my bet is that there will not be as much disappointment in those numbers as the top-down macroeconomic views would suggest. Diving down into some of the individual markets, I suggest that they’re telling us different things about the state of the economy and the state of inflation prospects. First, the equity markets have been off on the order of 7 or 8 percent, and many people, myself included, would have thought that that would have significantly affected CEO confidence, that it would have changed some perspectives about where they are in the capital expenditure cycle. I think that probably has happened in the IPO market. The IPO market has gotten slower and more selective, and issues that can come to market now have been at the top end of what’s in the pipeline. If we look more broadly, however, beyond what’s going on in the equity markets, if we look at the cap-ex market, capital expenditures appear to be above plan generally from the discussions I’ve had with folks who are on boards of different companies. One CEO called before coming out with a survey of CEO expectations for growth in capital expenditures, and he exclaimed, “What are you guys seeing that we’re not?” In some way he was checking to try to understand what the reason was for concern when his company surveys continue to be quite positive. The only caution I have is that, if you look across a breadth of CEO surveys on growth, the survey numbers have, in fact, come down from, let’s say, April to June. But, again, my sense of the matter is that CEOs are scratching their own heads at this very moment that we’re having a discussion about the economy in transition. The messages that come from the Fed and from other policymakers over the next month, including in the Chairman’s monetary policy testimony, will be very important to set the tone, because CEOs are not sure whether to continue to hit the accelerator or whether this might be a time in their own businesses for a pause in capital expenditures. I have a few comments on a couple of other markets. Normally in a time like this, when the equity markets are off 7, 8, or 9 percent, the merger and acquisition markets, which I view as a pretty good proxy for CEO confidence, would stop. In fact, that hasn’t happened: M&A pipelines are more robust than ever. The unthinkable deals are being printed and being published. Pipelines are terrifically strong, and CEOs are ready in some ways to “bet the company” on the strength of their convictions—another reason that I have confidence that business growth could well be in excess of the Greenbook estimates. Let me make two or three other comments. First, in terms of inflation, as I look at the commodity markets and at the TIPS markets, I’m most comforted not so much by relative moves, because those TIPS markets are certainly not perfect in describing inflation expectations, but by the responsiveness of those markets to remarks that have come from folks around this table. That is, if we think about what our authority is in influencing inflation expectations, the very real-time changes in the TIPS markets give me comfort that at this point in the cycle we will be able, with proper and appropriate policies that we’ll discuss tomorrow, to change those inflation expectations rather dramatically. So I think that’s a reasonably comforting idea. Finally, the fixed-income markets and high-yield markets certainly have moved higher in terms of spreads but, again, not a lot by historical perspectives. Under normal market conditions or more-pessimistic market conditions than we have now, that move, even a small relative move, would have slowed down those pipelines. Instead, liquidity is plentiful. A couple of anecdotes that we heard before describe the situation: 25 or 30 basis points in the high-yield markets are not changing activity. They’re not changing the interest of investment banks and issuers in coming to market as quickly as they can. So in terms of market functioning, apart from price, those markets are working exceptionally well. What would be a reason for pessimism, and what would be a reason to think that the volatility that has been discussed over the past several weeks might turn into real volatility? One thing that I look to with some degree of concern is the prices that are being paid and the leverage that’s being put on companies that could change the liquidity in those markets very quickly. I wouldn’t be surprised to find—over the forecast period for sure and maybe even over 2006—a “club” deal in which many private equity partners group together in a highly leveraged situation to buy a very large public company and take it private and, after the course of due diligence and of that acquisition, the deal closes and they find that they missed the first coupon. That is, the leverage that is being put on these companies, for all the reasons we have discussed around this table, is relatively remarkable. Those leverage ratios used to sound like purchase prices, and they’re expecting meaningful cost savings that can come out of these businesses six and nine months out. I suppose I’m concerned that, as these deals come together, there might be a negative surprise that affects the company so that the first coupon would be impossible or difficult to meet. In that circumstance, all the optimism that I’ve described in terms of these debt markets could dissipate rather markedly. So I don’t want to suggest a degree of optimism that isn’t borne out by the facts. That’s something we need to continue to stay attuned to. Thank you, Mr. Chairman." FOMC20050322meeting--128 126,MR. KOHN.," Thank you, Mr. Chairman. Activity has come in somewhat stronger in recent months, and price pressures have been a bit more intense than anticipated at the last FOMC meeting. Evidently, continued good growth in income and high profits are keeping household spending rising briskly and eroding any remaining business caution. The fact that surprises have been concentrated in investment in both business equipment and housing may also suggest that the low long-term rates—the conundrum—have been having an effect. If, as seems likely, those rates have been reduced in part by declining term premiums, as President Yellen was discussing, and not just by an expected lack of vigor in demand here or abroad, their depressed real level would represent a net stimulus to demand most especially for business borrowers who are facing very low risk premiums. In fact, business borrowing has strengthened considerably in the fourth and first quarters. And after an extended period in which cash flows have exceeded business investment, low interest rates and ebbing caution have produced a positive business financing gap in the fourth quarter, which is projected to continue for the first quarter. Moreover, the U.S. economy is not the only one in which growth has picked up; the strengthening of demand seems widespread globally after the disappointments in the second half of last year. And I agree with others who have noted that the sharp upward movement in energy and other commodity prices probably reflects in part this global pickup in demand. The surprise in core PCE prices was only for one month and was small relative to our March 22, 2005 66 of 116 prices, and import prices could be passing through to consumer prices more than anticipated. This, coupled with the rise in near-term inflation expectations, does elevate the risk of second-round effects from such relative price movements. And those relative price adjustments have continued in recent weeks. Still, a number of factors seem to be working to restrain tendencies for inflation to move higher, and we can’t ignore those. Importantly, productivity growth was stronger in the fourth quarter, and, apparently, in the first quarter, than anticipated. Whether that suggests faster structural productivity growth than the staff has built in remains to be seen, but revisions to actual productivity growth will help keep pressures off of labor costs and markups. Partly as a consequence, markups in the nonfarm business sector remain at extraordinarily high levels, giving ample scope for future cost increases to be at least partly absorbed in reduced margins. And wage and compensation growth remain essentially flat, indicating to me that slack in labor markets persists, given the upward pressures on compensation that would otherwise be anticipated from rising headline inflation and the rapid productivity growth of recent years. Bond rates have risen noticeably. To be sure, the upward movement seems mostly to reflect higher inflation expectations, but higher nominal rates could have a noticeable effect on housing markets where buyers seem sensitive to the cash flow implications of their monthly obligations. House price increases should slow quite a bit, in any case, holding back the rise in wealth and boosting incentives to save out of current income. In addition, GDP hasn’t been revised up as much as demand. As the trade deficit continues to surprise on the high side, the staff forecast has net exports turning from a drag on activity to a more neutral influence. But until we see the data confirming that shift, I think the possibility of more demand being drained abroad remains a March 22, 2005 67 of 116 The final and most important force that ultimately will constrain inflation is tightening monetary policy. And the narrowing output gap and the possible emergence of greater inflation pressures do raise questions about how we need to adapt our strategy to keep inflation low and the risks in balance. Two possible responses: One would be to count on extending the gradual path of rate increases to go for longer before slowing or stopping. The other approach would be to increase the incline—prepare to raise rates by 50 basis points soon. For the most part, extending the measured path seems preferable to me. At the same time I think we should make it clear to markets that we are prepared to extend that path, should circumstances call for it, and that we have no firm preconceived notion regarding where our tightening should stop. The gradual approach should enable us to better gauge the ongoing effects of our actions in an uncertain world. It will give us more opportunities to assess the effects of past tightening moves when we know that those effects can vary and will occur with a lag. Hence it will give us more opportunities to calibrate our actions better to the needs of the economy. To date, announcing that we expect to remove accommodation at a measured pace hasn’t materially impeded the markets from responding meaningfully and appropriately to incoming data. Over the last intermeeting period, they extended the anticipated series of gradual rate increases— forward rates two and three years out are up by more than 50 basis points over that period, and this seems completely appropriate to me. The structure of interest rates still seems to be consistent with achieving our objectives. The staff forecast has inflation declining with about the policy tightening that is built into the market. Even if we’re not quite as optimistic on price pressures as the staff, gradual increases in the funds rate in line with market expectations should provide some insurance against rising inflation. March 22, 2005 68 of 116 participants expect that the policy actions they now anticipate will be enough to insulate the longer- term trajectory for prices from near-term increases in inflation. As a consequence, “measured” is still my best guess as to how policy rates will evolve, and that’s what I would continue to indicate to the public. Nonetheless, our expectation of a measured pace of firming has always been conditional. And one essential condition that we have articulated and emphasized in the last sentence of the announcement is that inflation and its expectations remain well behaved. In my view, that would be consistent with the rate of growth of core PCE prices stabilizing at levels close to or not very much above the experience of the last year. If doubts about our willingness to maintain price stability emerge, I can see the potential for a very difficult self- reinforcing feedback loop through declining confidence in policymaking in the United States and accelerated dollar depreciation. Incoming information suggesting that core prices will continue to accelerate, or that the output gap is closing rapidly, or that longer-run inflation expectations are deteriorating, could well call for deviating from the measured pace with a larger firming action. If the signs were serious enough, I think we could, and should, do that as soon as the next meeting, even if the “measured pace” language remains in place. After an expression of concern about inflation pressures, as suggested in alternative B, the market should not be entirely surprised by such an action under those circumstances. Thank you, Mr. Chairman." FOMC20050322meeting--61 59,MR. POOLE., Good. Thank you. FOMC20070321meeting--141 139,MR. POOLE., Thank you. FOMC20050630meeting--318 316,MR. POOLE.," You think it’s even as big as minus 1? Over the horizon here, these long- term futures—that’s six years out—you’d probably get a good part of that over a six-year horizon, if June 29-30, 2005 103 of 234" FOMC20050920meeting--45 43,MS. JOHNSON.," Yes, a 17-year high. I volunteer to run the gold price. [Laughter]" CHRG-111hhrg51585--98 Mr. Hullinghorst," It took my wife 3 years to learn how to spell Bob. There are two points that I would like to make in response to your question. There are very few issues rated triple A that are available among the United States corporations, unless you go to governments. And there are very few short-term governments except for Treasurys. And in some markets you don't get anything in investing in Treasurys. Now, the second point I would like to make is that the reason for the State pools in large part is to allow small municipalities to buy anything. You cannot go to Wall Street or to a representative in a brokerage firm and get any sort of a price if you only have $50- to $100,000 to invest at any one time. And so these State pools are there to provide smaller entities, or even entities like myself, who are buying smaller increments to get in at a decent rate in a well-managed pool. If you really want to see a debacle, you will not support the State pools and you will leave investing up to all of these little entities. I came to Washington a little over a year ago to try to talk to some of our congressional delegation and to the SEC about what I call criminalizing the sale of illegal investments to local officials. There was no interest at that time. I think there might be a little more interest now. But what I found was that, in fact, the SEC had the authority through their examination process to make sure that their brokerage firms were not treating us as qualified investors. Most governmental investors in any place in the country need to be treated as investors whose interests need to be protected. Almost every one of us is covered by State legislation that we are not allowed to go beyond. But we could not get a single brokerage firm--in my case, we could not get a single brokerage firm on Wall Street to sign an agreement that they would only sell us investments that qualified under our State law. Thank you. " FOMC20080430meeting--89 87,MR. PLOSSER.," Thank you, Mr. Chairman. In the Third District, there has been little change in economic activity since I reported in March. Business activity remained weak over the intermeeting period but no more or less than anticipated and than we reported in our March meeting. Manufacturing activity, residential construction, and employment remained modestly weak in the District. Retail sales were also sluggish. Our staff's coincident indicators of economic activity, which summarize our regional data, show a decline in activity in Pennsylvania and Delaware but moderate growth in New Jersey in March and, on average, for the last three months. Overall, our firms are not very upbeat about nearterm growth; and like many forecasters, they have revised downward their expectations since the start of the year. For example, in response to a special question in our business outlook survey, the number of manufacturers saying that current demand for their products fell short of what they had expected at the start of the year exceeded those who had underestimated demand. More firms have decreased their capital spending plans, with 10 percent indicating that they either delayed capital spending or postponed it indefinitely. While growth in the District has been weak, price pressures facing our firms and consumers have intensified. Area manufacturers continue to report higher production costs, and the percentage of firms raising prices on finished goods is larger than earlier in the year. The indexes of prices paid and prices received are near 20-year highs for our firms, and firms expect to see prices move higher over the next six months. These firms have a very pessimistic outlook for inflation. Turning to the national outlook, I have revised down my growth forecast from what I submitted in January, as almost all of us have, but that revision occurred largely between January and March. There has been little or no change in my outlook since our March meeting. Compared with my January forecast, I now see real GDP growth coming in around 1.5 percent for 2008 and close to 2.6 to 2.8 percent in 2009�10. Overall, this is about � percentage point weaker for '08 than my January forecast, but there is little difference in my forecast for '09 and '10. The indicators that have come in since our last meeting have generally been in line with my March outlook. Certainly they have pointed to continued weakness, but not worse than I had expected. Although some strains in the interbank markets remain, they do not appear to have intensified, and our alphabet soup of targeted tools seems to be having at least modest beneficial effect, even if only psychologically. I remain concerned, however, about inflation and our calibration of the appropriate level of the fed funds rate consistent with our goals. Inflation readings have abated marginally since our last meeting; but as the Greenbook suggests, there is reason to believe that this is a temporary reprieve and that the levels remained elevated--year-over-year CPI inflation was 4 percent in March, and year-over-year PCE inflation was 3.4 percent--well above their 2007 levels. As we have been noting, oil and other commodity prices continue to move up, and businesses and consumers continue to stress inflation as a concern. Near-term measures of inflation expectations have risen sharply. In the Michigan survey, one-year inflation expectations rose to 4.8 percent in April, up from 4.3 percent in March and 3.4 percent in December. Clearly, the greater media attention on inflation and the discussion among the public are bound to have some effect on expectations as time goes on. I have some concerns and difficulty interpreting the measure in TIPS given the disruptions in financial markets right now. So I take those with a little grain of salt. Nevertheless, five-year, five-year-ahead inflation compensation is 2.8 percent using the Board's measure. This is down a little from early March but is still higher than it was at the end of 2007. In fact, the instability of these measures of inflation expectations itself is a cause of concern for me. It may suggest that markets question our willingness to take actions consistent with sustained and credible price stability. Now, we have often alluded to the idea that near-term weakness will help mitigate some of the inflation pressures. However, I would just like to remind us that this critically depends on inflation expectations remaining well anchored. I hope that going forward we can reinforce that conditionality of the statement about weakness helping us on the inflation side so that we do not perpetuate the notion that a stable Phillips curve is at work here and that a slowing economy will always lower inflation. I believe that the FOMC's commitment to price stability remains credible at this time, but just barely. I worry that we may be resting too much on our laurels, trying to talk a good game, but unwilling to take the actions necessary to support and sustain that credibility. As I have said before in this group, we must not wait until expectations have broken out because by then it will be too late. Inflation has been well above at least our implicit goal for a sustained period. As the Bluebook points out, core PCE inflation has been above 2 percent since 2004 every year, and is projected to be so again this year, and the projections are even worse for headline numbers, either CPI or PCE. If we continue easing or maintaining a real funds rate well below zero for a sustained period despite inflation well above our goal, can we really expect inflation expectations to remain anchored? The Greenbook seems to think that we can. It assumes that the fed funds rate falls to 1.75 percent in June and remains there through the end of 2009. Given the inflation forecast, this means a negative or close to negative real funds rate for almost two years. Despite this, Greenbook baseline inflation expectations remain reasonably contained, and inflation is projected to decline over the forecast period even as growth picks up toward trend. To put it kindly, I have serious reservations about that scenario. The Greenbook discusses an alternative simulation in which there is greater inflationary pressure. The estimated Taylor rule funds path in that is somewhat steeper than in the baseline. Inflation ends up higher at the end of the forecast period--the end of 2011 and 2012--than in the baseline. More progress on inflation will require obviously a steeper path, but even in this alternative simulation, inflation expectations only drift up. They do not become unhinged. If they did, I would expect the policy path to have to be considerably tighter in 2009. Now, I know that talking about money in the context of monetary policy is not very fashionable these days. But I would like to note that the monetary aggregates as measured by M2 and MZM have exploded. Despite the flight to quality and the associated increase in the demand for money associated with that, M2 grew less than 5 percent during the fourth quarter of 2007. Since then, however, its growth rate has nearly tripled. In January it grew 8 percent on an annualized basis. In February after our rate cuts, it grew 18 percent, and in March it grew 13 percent. Growth rates of MZM are even worse over this interval--for the three months the annual rates were 14, 42, and 26 percent. Such rates suggest to me that there is substantial liquidity in the economy. While I don't really like the old P* model and have had a lot of problems with it, at the back of the Greenbook the story it is telling is one of considerable inflation over the next couple of years. Combined, the growth in the aggregates, the substantially negative real interest rates, and the fact that most versions of the Taylor rule call for a higher fed funds rate than we have currently heighten my angst about the outlook for inflation and our credibility. Market participants reacted to the incoming data by appreciably tightening their policy expectations--at least as implied by the futures markets, as Bill Dudley pointed out--and that has had a negligible effect, certainly no negative effect, on markets or the economy more broadly. One interpretation is that the market participants have also become uncomfortable, as I have, with a fed funds rate that remains too low for too long. I take this as a healthy sign actually and one that we shouldn't ignore. Indeed, we may just wish to use it to our advantage. I will stop there, Mr. Chairman. " CHRG-110shrg50420--377 Chairman Dodd," Not Michigan---- Senator Tester. Mexico. What did I say? [Laughter.] Senator Tester. I said Michigan, didn't I? [Laughter.] Senator Tester. Exactly, in Southern Montana. In Mexico, right. By the way, thank you for the correction. [Laughter.] " FOMC20060131meeting--82 80,CHAIRMAN GREENSPAN.," Any further questions for our colleagues? If not, before we go to the general discussion, because of the unusual nature of this particular one-day session with various timing problems, I just calculated that, in the eighteen years I’ve been here, we’ve gone from an average presentation of three minutes to one of six minutes. [Laughter] The drift has been inexorably upward. And I will suggest to you that, unless we are somewhat unusually restrained today, we’re going to run way over what our luncheon plans are, and we will be forced to call them dinner. [Laughter] So may I suggest, if at all possible, that you try to restrain the time that you’re employing on this particular occasion. With those restrictions, who would like to start off? [Laughter]" FOMC20081029meeting--264 262,MR. MADIGAN.," 7 Thank you, Mr. Chairman. I will be referring to the version of table 1 that was distributed to you on Monday. It is reproduced in the package before you labeled ""Material for Briefing on Monetary Policy Alternatives."" Changes in the language relative to the Bluebook version are shown in blue. Starting on the right-hand side of the table, even though members saw the economic and financial information that became available over the intermeeting period as worse than expected, they might be inclined to leave the stance of policy unchanged at today's meeting, as in alternative C. As noted yesterday, your 7 The materials used by Mr. Madigan are appended to this transcript (appendix 7). economic projections reveal that many of you anticipate that inflation pressures will diminish less quickly than the staff anticipates, and several of you noted explicitly that you thought less easing would be appropriate than was assumed in the Greenbook forecast. Also, the Committee already reduced rates in early October, responding to at least some of the adverse economic news. Moreover, the Federal Reserve has put in place additional facilities to support credit intermediation, and the Treasury and the FDIC are moving quickly with the implementation of other programs that should, with time, help stabilize financial institutions and markets and enhance the flow of credit to households and businesses. Finally, you might believe that the Congress is likely to enact a second fiscal stimulus package, possibly reducing the need for additional monetary policy accommodation. The rationale section of the statement suggested for alternative C would acknowledge the intensification of financial turmoil and the weakening of the economic outlook. However, it would also cite the range of policy actions taken in recent weeks as factors that should help over time to improve credit conditions and promote a return to moderate economic growth. The language on inflation would be essentially identical to that used in the Committee's statement earlier this month, noting that the upside risks to inflation have been reduced. The risk assessment would state explicitly that the Committee's primary concern is the downside risks to growth, suggesting a predilection for lowering rates. Nonetheless, with market participants anticipating an easing today--a 50 basis point move is seen as most likely--an announcement along the lines of alternative C would point to a much higher trajectory for the federal funds rate over the next few months than investors had expected. Short- and intermediate-term Treasury yields would likely jump, credit spreads probably would increase further, and equity prices might decline sharply. If the Committee is of the view that further policy accommodation is appropriate at this time but is also quite uncertain about the extent of rate reductions that will ultimately be required, it might be attracted to the 25 basis point easing of alternative B at this meeting. Members might have a less pessimistic outlook for the economy than that presented as the baseline in the Greenbook or might at least be quite uncertain as to the extent of the negative forces at work in the economy. At the same time, you may view the incoming information as suggesting that the 50 basis point easing earlier this month is unlikely to be sufficient to adequately balance the risks to economic activity and inflation. Given these considerations, you might see modest further easing today as appropriate and be prepared to cut rates again in coming months should developments warrant. The statement proposed for alternative B would note that the pace of economic activity appears to have slowed markedly, and it would repeat language from your early October statement indicating that the financial market turmoil is likely to exert additional restraint on spending. The announcement would also indicate that, in light of the decline in the prices of energy and other commodities, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability. As noted in a box in the Bluebook, we think that, in view of your previous policy communications, outside analysts would interpret such a statement on the inflation outlook as indicating that the Committee anticipates that overall inflation will drop to around 1� percent to 1� percent before long, a indication that would be consistent with the central tendency of your inflation projections for 2009. The risk assessment in alternative B, paragraph 4, would cite the same broad range of policy actions that was proposed in alternative C, paragraph 2. It would indicate that the predominant concern of the Committee is the downside risks to economic growth. Market participants see a 25 basis point easing at this meeting as possible, but at this point they seem to place significantly higher odds on a 50 basis point reduction. The explicit citation of downside risks to growth would suggest that further easing could be forthcoming after this meeting, but this announcement still would suggest a higher path for the federal funds rate than they anticipate. Consequently, short- and intermediate-term rates might tend to edge up after such an announcement, credit spreads might widen somewhat further, and equity prices might decline. Under alternative A, the Committee would ease policy 50 basis points at this meeting. An economic outlook along the lines of the Greenbook forecast would provide one rationale for choosing this alternative. The Greenbook forecast for aggregate demand has been slashed dramatically, importantly reflecting a sharp decline in equity prices, a steep rise in credit risk premiums, and a considerable climb in the foreign exchange value of the dollar. One metric for this revision is the Greenbook-consistent measure of the short-run equilibrium real interest rate, r*, which has been cut nearly 3 percentage points since the September meeting to a level of about minus 3 percent. That level is about 2 percentage points below the actual real funds rate defined on a consistent basis. The staff outlook for a protracted period of substantial economic slack, together with the recent plunge in energy prices, points to a considerable diminution of inflation pressures, with overall inflation falling to 1� percent next year in the Greenbook forecast--even with the Greenbook's assumption of 100 basis points of further easing by early next year. But even those who are somewhat less pessimistic about the outlook than the Board staff might view the modal outlook as having deteriorated enough, or the downside risks as having increased enough, to warrant a 50 basis point rate cut today. The rationale language for alternative A in the revised version of table 1 is similar to that for alternative B, but alternative A, paragraph 2, notes additional factors that are restraining growth. The risk assessment, too, is similar to that for alternative B, but it references the rate reduction that would be implemented today under this alternative and notes that downside risks to growth remain, without saying that the downside risks are the Committee's predominant concern. An announcement along these lines seems largely consistent with market participants' expectations, and the market reaction would likely be relatively small. Thank you, Mr. Chairman. " FOMC20080805meeting--136 134,MR. KROSZNER.," Thank you very much. We have now had the first anniversary of all the financial turmoil, and how have the markets celebrated? Well, we have had Freddie and Fannie go down and need one of the largest bailouts. We have had IndyMac go down--the second largest bank failure in U.S. history and perhaps the most costly bank failure in U.S. history. I am talking just in nominal terms; I haven't actually done the real adjustments. Also, we've seen a variety of widening risk spreads. At the last meeting I went on with my standard metaphor of the slow burn and said that things could reignite, and I think we certainly have seen a few things reignite. I very much agree with Governor Warsh with respect to Freddie Mac and Fannie Mae that, although legislation has been passed, the devil will be in the implementation details. Simply because the Treasury has the capacity to do something, it is not quite clear what it will do or be able to do or how the markets will respond to that. Obviously, Freddie and Fannie have been really the only game in town for mortgage securitization. The jumbo markets have not been working. The subprime market is not there right now. So until and unless we can be assured that they will operate properly, they still have a lot of potential for more flames coming out. There are also a number of other reasons that I am still concerned about financial markets being very far from normal. One, reference was made to a study that we have done here at the Board that Nellie Liang is taking the lead on. New York has also done a study; I think they used very different methods but came out with similar numbers. The studies say that large losses are still to come and that total losses associated with the challenges that we have been seeing will be on the order of $900 billion. U.S. and European financial institutions have taken about $400 billion of write-downs. Not all of those losses will be on financial institutions' balance sheets, but there certainly are potentially more losses to come--not only in mortgages, in leveraged loans, and in commercial real estate but also in the consumer parts of the portfolio and potentially other parts of the portfolio. A fragility is there, which has to be taken into account when we look at capital ratios. If you simply look at reported capital ratios, they are off their peaks of a few years ago. However, if you were to do a more-thorough mark-to-market on a lot of different pieces of the portfolio or if you did have to liquidate--even assuming it wasn't a broad fire sale but just one institution that had to liquidate now and it had no further consequences for anyone else's expectations, which I don't think is accurate--you would see those capital ratios be in fact much, much thinner than they appear in an accounting sense. A number of people talked about the OIS spreads and said that things seem to be at 50 basis points rather than at 10 basis points. Well, that is true not only in the U.S. dollar but also in the euro and in sterling. If you look to the forward market, that number is increasing. It is not staying the same. It is going up quite a bit, to about 75 basis points over a year period for the dollar to 130 to 150 basis points in sterling and in euro. That suggests a lot more challenges to come. So even if 50 is the new 10, it is still a major challenge going forward. That puts a lot of pressure on banks to generate earnings to make up for the write-downs and other challenges. In the old days, when you could finance yourself at 10 basis points, the institutions were undertaking a lot of activities that would allow them to generate a lot of revenue, even if they kept taking hits in certain parts of their portfolio. But when funding is at 5 times that, or 10 times that, or 15 times that, a lot of activities that once were profitable are not profitable. The margins are much lower, and their ability to earn their way out of this is much, much more of a challenge. I think that is going to be even truer for the European institutions. That is actually one area in which I see it as more likely that an important shoe might drop, not just in the United States but in a major European institution. European institutions haven't been as active in raising capital, and there are more constraints on their ability to raise capital, given the way rights issues work. I think that greater challenges are going to come in the European economies and that the ECB faces greater challenges in dealing with the increasing inflation threat that they have there and worldwide, while being able to provide some policy accommodation. Third, securitization markets have certainly not recovered. We have talked about that. The infrastructure investment that will be needed for these to come back in terms of data, contract certainty, et cetera is going to take a long, long time. It is not clear exactly how long, but it is clear that recovery will not be right around the corner. That means continuing pressure on banks' balance sheets independent of all the other capital issues. If they just want to continue on, they have to keep a lot of things on their balance sheets. One bright light, just in case you see nothing positive, is that we were able to put off some very significant changes in accounting-- FAS 140 and FIN 46(R). They were on a very fast track to make changes that could have brought literally trillions of dollars of assets back onto balance sheets and would have made it extremely difficult for securitization markets to work. That has been significantly delayed, and I think they will take a more balanced and measured approach. Not only has that been put off, but also the institutions will have more time to deal with it. But this pressure is real. The Senior Loan Officer Opinion Survey couldn't be more crystal clear on the challenges that are there and that are likely to continue to be there. Why is that? Well, as a number of people have mentioned, it is because of challenges on the HELOC portfolios and on the option ARM portfolios and uncertainty about a lot of other pieces of the portfolios. So given my views, I am really glad that the Greenbook baseline has taken on board much more of what was previously a ""delayed recovery"" alternative simulation scenario, much in line with what President Stern mentioned. But I continue to see that the situation is quite brittle and that small pressures potentially can lead to large and rapid responses. The ""severe financial stress"" alternative simulation in the Greenbook is certainly not my central tendency one, but I think that we can't dismiss it too easily because there still could be another--what I have now taken to calling, since I chair the supervision and regulation committee--flare-up with one of my problem children. Many of you know the problems in your Districts, but there are a lot of problems, unfortunately, in all the Districts and around the world. I hope no one will ever hear about the problems that my children are having, but sometimes they do come out. As Governor Warsh said, one way to try to deal with those is through capital. It is becoming increasingly difficult to do that. In the old days the accounting rules were such that you could take over an institution through so-called pooling accounting methods, so you would not face an immediate write-down of everything to current market values. One challenge we have with the institutions that are likely to be failing over time is that these accounting standards are no longer available, so it is very, very difficult to use the kinds of methods that have been used in the past by the FDIC and other regulators to avoid the IndyMac type of problems. It is quite possible that we will be seeing more people queuing up, and more people pulling money out of accounts, even though they are insured accounts. There has certainly not been a generalized drain from the banking system. There has been a recent shuffling, as President Lacker said. But it also makes a lot of institutions much, much more vulnerable than they have been in the past. If you look at the ""severe financial stress"" scenario in the Greenbook, what is interesting about it is that it is relatively benign. For something that is severe stress, the macroeconomic outcomes in terms of GDP and unemployment aren't that severe because of the policy response--taking the federal funds rate down to � percent. I don't think we can possibly do that in the current environment. It is not that I think that inflation expectations have become unanchored or are not contained, but I do think that our policy responses are contained precisely because we can't quite go there. If you look at the ""inflationary spiral"" scenario, it says that by 2009 the fed funds rate would have to go up to 3� percent. I don't think we are in that or anywhere close to that. But if we had to respond as the Greenbook said to bring the fed funds rate down below 1 percent, I think we would get close to that, and we would be in a very, very difficult position. We have to be very careful about inflation expectations. I think we have mixed evidence on inflation expectations and inflation, although I am heartened that things do not seem to have become unanchored. Some of both the market-based measures and the survey-based measures have come down a bit, although I think, as Governor Kohn said, that the situation is much more fragile. I don't want to take on board too much comfort from the change in commodity prices because we have seen temporary movements up and we have seen temporary movements down. It is heartening, but I think we have to still be very, very careful on this issue. Thank you, Mr. Chairman. " FOMC20080430meeting--170 168,MR. PLOSSER.," Thank you, Mr. Chairman. What I would like to do--it will probably come as no surprise--is to make the case for why we should stand pat today and make no change. My case is built on a number of points, and I'd like to articulate those as best I can. First, as we all know, the economic outlook has weakened since the start of the year, but that deterioration occurred largely between January and March. Since the March meeting, there has been little change in the Greenbook forecast or in my own outlook for the economy. Incoming data over the intermeeting period are consistent with a weak first half but not appreciably weaker than we earlier anticipated. I believe that easing policy is appropriate in a weaker economy, but continuing to cut rates for as long as the economy remains weak is not appropriate. Although it is a difficult task, we must try to calibrate the appropriate level of the fed funds rate with the economic prospects and our policy goals. I will just note that, since last September, we have lowered the funds rate 300 basis points. This year alone, in a period of less than 60 days, we have cut 200 basis points. This is a very aggressive policy of easing. Not enough time has passed, in my view, to see the full effect on the economy of those cuts, and a further 25 basis point cut in the funds rate at this point will do nothing to change the near-term outlook of the economy. Second, we are currently running a very accommodative monetary policy, no matter how you look at it. The real funds rate is negative or very negative, depending on which measures of inflation you use to construct it. The nominal funds rate is below the level of most versions of the Taylor rule, even when adjusting for some interest rate and real rate effects, given our objectives. As I noted yesterday, monetary aggregates as measured by M2 and, to some extent, MZM have expanded very rapidly, especially since our rate cuts in late January. Now, although none of these measures of monetary accommodation or monetary ease is perfect--each has its drawbacks--I am concerned that all the measures of monetary accommodation suggest that we are very accommodative at the current time. Third, inflation is high, unacceptably high in my view, and has been that way for a sustained period, as I talked about yesterday. Some would argue that the weakened economy will bring the inflation rate down. But theory and experience both say that such will occur only if expectations of inflation remain anchored. But since the end of last year, most measures of expected inflation have moved up. The instability in the measures of expected inflation is a cause for concern. It suggests to me that markets may be less convinced of our willingness to take the necessary actions that are consistent with sustaining a credible commitment to price stability. I certainly understand the difference between a relative price shock and inflation. Clearly, oil prices and other commodity prices are in part a relative price shock. There is no question about that. But it is also true that in the 1970s one of our mistakes was that we accommodated relative price shocks with very accommodative monetary policy, and in so doing helped convert a relative price shock into sustained inflation. I think we should be careful not to fall into the same trap. Besides, I think that in most monetary models today we worry particularly about stabilizing core inflation because it represents the sticky prices in our stickyprice models. So if relative price shocks begin to seep into the core, or into the sticky-price elements, monetary theory would suggest that we need to respond to those. If we are going to achieve something close to optimal monetary policy, we should be concerned about that seepage because it may affect expectations and it is part of what monetary policy should be doing, at least in that class of models. Although it is true that we have not seen much in the way of wage inflation to date and that is encouraging, I would also reiterate, as some people noted yesterday, that wage inflation tends to be a lagging, not a leading, indicator of overall inflation. Contrary to the Greenbook forecast, which has us maintaining a negative real funds rate for two years and inflation coming down, I think that, if we continue easing or maintain the real funds rate well below zero for a period of time despite inflation well above our goal, it is reasonable to assume that expectations will not remain anchored. The FOMC's stated goal of price stability cannot remain credible independent of our actions. If we want expectations to remain well anchored, we have to act in a way that is consistent with that. Fourth, I believe that we are in the fortunate position today of being able to pause. Market participants have reacted to the incoming data by appreciably tightening their expectations of future funds rate moves--at least as measured by the futures markets, as we have seen. Participants seem to be getting less comfortable with the idea of very easy monetary policy over a sustained period, given the outlook for inflation. I note that the markets' reassessment of their policy expectations over the intermeeting period doesn't appear to have had any significant negative effect on the markets, or the economy more broadly, during this period. I think this reassessment by the markets presents us with an opportunity to reinforce our stated commitment to price stability, not just with words but with action or, in this case, inaction. I think a pause today would send a strong signal of our commitment to price stability, which could further help anchor inflation expectations, which I consider to be very fragile. A pause, it seems to me, balances the risks of the two parts of our mandate. Some might argue that, in the midst of the financial market disruptions that we have seen this year, it is important for the Fed not to add to market turmoil by taking policy actions not anticipated by the markets. The mean expectation for the markets is for 25 basis points of easing today. But market participants are placing odds of somewhere between 25 percent and 30 percent on our pausing, so I don't think a pause would be very disruptive to the markets. The magnitude of the surprise would be about the same as the surprise we had last time when we cut 75 basis points. That surprise, in my view, did not really cause much turmoil in the marketplace. Finally, when I say that cutting 25 basis points won't help the outlook for the economy very much, others might respond that cutting 25 basis points won't hurt it very much either, so why not. I disagree. I think a cut today will not be a disaster but will contribute to a further eroding of our credibility in the eyes of the public. At past meetings this Committee has spoken a lot about the need for rapid reversals of our rate cuts that we took out for insurance. I think we should not be overly confident of our ability to implement such rapid reversals. In fact, the lower the rates go, the further we will need to come back when we start taking the accommodation back. I am dubious of our ability because we will be so much further from what might be a more neutral rate. In summary, to my mind the gain in credibility from pausing today substantially outweighs any negative effects from slightly disappointing the markets. It doesn't preclude us from choosing to resume cuts at a later date should economic conditions warrant them. After all, I think this Committee has demonstrated its ability to act aggressively in response to economic conditions, and we can do so again. But that is the future. For today, I think we should take the opportunity that the economy and the markets have afforded us to pause. As the old Latin expression says, ""Carpe diem."" With regard to language, I am happy with alternative C. Rather than the language in paragraph 4 of alternative C, I would prefer the language of paragraph 4 of alternative B. I would just make that the language for paragraph 4 in alternative C--that is the only change that I think would be necessary. Thank you, Mr. Chairman. " CHRG-109shrg30354--128 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM BEN S. BERNANKEQ.1. China's foreign exchange reserves stand at $941.1 billion, creating excess liquidity in their banking system. In addition, various estimates of China's first and second quarter growth rates suggest that the Chinese economy has grown by upward of 10 percent this year. Do you see any danger that the Chinese economy is overheating? Are the Chinese now willing to take all necessary steps, like a revaluation of their currency, which could rein in problems before they pose systemic risk?A.1. The ratio of investment to GDP was over 40 percent in 2005, which is likely too high a rate for an economy to absorb efficiently. This is leading to overcapacity in some industries and is likely to add to the already large stock of bad loans in the future. However, there is less evidence of widespread overheating. Inflation is still quite low, at about 1\1/2\ percent for consumer prices on a 12-month basis, despite the fact that the money supply has been growing at a rate of almost 19 percent. Chinese authorities have indicated that they would like investment to slow and that they would also like growth to be better balanced between external and domestic demand. They have taken some steps to try to encourage consumption. However, they still have not allowed a substantial appreciation of the reminbi, a step that many analysts argue would be the most effective way to address the imbalances in the economy.Q.2. Has the Federal Reserve been asked or offered to provide guidance to the Chinese Central Bank and are you concerned about any spillover effects that a Chinese economic crisis could have in U.S. markets?A.2. The Federal Reserve has provided technical assistance to the People's Bank of China for a number of years on various aspects of central banking. The Federal Reserve has also been supportive of the U.S. Treasury's initiative to provide technical assistance to China in the economic and financial areas. We believe that the chance of a Chinese economic crisis is very low for the foreseeable future. Although the banking sector is burdened with an enormous and probably growing stock of problematic loans, the government possesses sizable resources and is unlikely to allow the banking system to fail. The large stock of foreign exchange reserves also makes a potential currency crisis a very low probability event. However, we do not entirely discount the possibility of a ``hard landing,'' in the form of significantly slower growth, as the authorities attempt to reduce investment growth from its current rapid pace. We do not think this is the most likely outcome, but it is a possibility. Such an outcome would have significant repercussions for other Asian economies, including Japan, and would also be detrimental for some of the other emerging market economies, notably in Latin America and the Middle East, that have been supplying the enormous Chinese demand for oil and other commodities. The impact on the United States would be less direct, given that China is not a major buyer of our exports, but the overall impact on world GDP would certainly have some negative effect on the United States.Q.3. In recent weeks, several banks have suggested that the current Basel II framework should be revised to provide any bank the option to use either the advanced approach or the standardized approach set forth in the original Basel II framework. Apparently, there is concern that Basel II as set forth in the draft NPR released last March would not be cost effective for banks to implement. Does the Federal Reserve support allowing banks such an option? If not, please explain your rationale. Does the Federal Reserve believe that concerns about the cost effectiveness of Basel II as presently set forth in the draft NPR are valid? Would you please update the Committee on the Federal Reserve's timetable for the implementing Basel II and Basel IA? Please provide specific dates, if possible, by which the Federal Reserve expects to have completed each of steps for implementing Basel II and Basel IA.A.3. The Federal Reserve and the other banking agencies have received several comment letters asking that we provide optionality in the United States. Basel II framework similar to that provided in the Basel Mid-Year text. As with other comments we have received on the draft Basel II NPR, and consistent with out duties under the Administrative Procedure Act, we will seriously consider the merits of the suggestion. As I tried to indicate in my response to a similar question posed by Senator Sarbanes, I am concerned that the Basel II standardized approach would not accommodate the risks that the large, complex, internationally active banks take, both on and off their balance sheets. In my judgment, elements of the Basel II standardized approach, particularly those related to the measurement of credit risk, would be more appropriately applied to smaller, less complex, and primarily domestic U.S. banking organizations. That is how it was designed and that is how it appears it will be implemented in other countries. For example, there is no evidence that any of the largest 50 non-U.S. G-10 banks plans to adopt the standardized approach, even though they have the option to do so. Evaluating the cost effectiveness of Basel II NPR requires measurement of both costs and benefits, both of which are difficult. With respect to the costs of compliance, it should be noted that many of the risk measurement and risk management policies and practices required by the draft Basel II NPR are policies and practices that banking organizations adopted or would have adopted even in the absence of Basel II in order to (i) improve their own understanding of their risk profile; (ii) meet supervisory expectations for good risk measurement and management; or (iii) satisfy Basel II regulatory capital requirements in other jurisdictions. On the benefits side, we expect that Basel II will improve the risk sensitivity of our bank regulatory capital framework, remove opportunities for regulatory capital arbitrage, improve our supervisory ability to evaluate a bank's capital adequacy, improve market discipline of banks, and, ultimately enhance the safety and soundness of our banking system. Given the inherent complexities in measuring costs and benefits, it is difficult to evaluate the question of cost effectiveness in any simple terms. We have sought, and will continue to seek, comment from banks and others to gain a better understanding of the costs of compliance with our Basel II proposals. The timetable for implementation of Basel II and Basel IA is set by the four Federal banking agencies acting in concert. That timetable currently contemplates adoption of final rules for Basel II and Basel IA by mid-2007 so that the parallel run for Basel II can begin in January 2008. Transitional capital floors and other safeguards will be in place at least through January 2012 and perhaps longer for some banks depending on when they complete their parallel run. FOMC20080805meeting--134 132,MR. WARSH.," Thank you, Mr. Chairman. I have no material changes to report in my view on the overall state of financial stability, growth, or inflation; but as I talked about at the last meeting, it still is likely to be a long, hot summer, and we're only about half over with it. I'll talk first about financial institutions--make maybe four or five points--and then turn quickly to the economy and inflation. First, on financial institutions, I think the body blow that the financial markets and the real economy have taken because of the turmoil at the GSEs is not complete. It is easy for those of us in Washington to forget that bill signings don't always solve problems. I'd say, if the last thing that happens on GSEs is that the bill was signed two weeks ago and action isn't taken in the coming weeks and months, then I would be surprised if we could get through this period without more GSE turmoil finding its way onto the front pages. Second, in terms of financial market conditions, the fall in oil prices and the rest of the energy complex is, indeed, good news, but it strikes me that it has camouflaged an even tougher period for financial institutions than would otherwise be the case. That is, financial institutions somehow look a little more resilient, but I think part of that is only because of the negative correlation that's developed in recent times between equity prices of financials and oil prices. The financial institutions themselves strike me as being in worse condition than market prices would suggest. Third, capital raising, as we have long talked about, is essential to the fix among financial institutions. The way I best describe capital raising over maybe the last nine months is that the first round of capital raising, which was in November and December, was really the vanity round. This consisted of very limited due diligence, sovereign wealth funds signing up, issuers relying upon their vaunted global brands, and capital being raised in a matter of days. The second round probably took us to the spring, a round that I'd call the confessional round. [Laughter] In this round, financial institutions said, ""Oh my, look at these real write-downs that I have. Look at the need for this real capital raising, and here I'm telling you, the investors, all that I know."" But the second and third confessions usually have less credibility than the first. The third round is the round that we're in the middle of, which I think of as the liquidation and recap round, likely to be the hardest round to pull off. It is likely to force issuers of new shares or of new forms of preferred stock to be asking of themselves and their investors the toughest choices. They have to assess the strength and durability of their core franchises. I think that this will be happening in very real time. So the circumstance of an investment bank that Bill mentioned at the outset I don't think will be the sole case of this. This liquidation and recap round is later than would be ideal from the perspective of the broader economy, but it is absolutely needed. Until we see how it occurs, it's hard for me to be much more sanguine that the capital markets or the credit markets will be returning to anything like normal anytime soon. Let me make a fourth broad point about financial institutions. Because of these different phases of capital raise, I think management credibility among financial institutions is at least as suspect as it has ever been during this period. Even new management teams that have come in have in some ways used up a lot of their credibility. It would be nice to believe that they have taken all actions necessary to protect their franchises and their businesses, but most stakeholders are skeptical that they've taken significant or sufficient action. At the end of the day, no matter where policy comes out in terms of regulatory policy from the Fed and other bank regulators or accounting policy from the SEC or FASB, it strikes me that those changes in policy are less determinative of how things shake out. That is, management credibility is so in question that the cure is not likely to come from accounting rules or regulators but from the markets' believing that what management says is what management believes and will act on it. As a result, I think that many of these financial institutions are operating in a zero-defect world, which is posing risks to the real economy. Fifth, let me make a final point about financials. We've all talked a lot about the effect of different curves for housing prices on the financial institutions themselves. I don't mean to give short shrift to any of that, but I would say that the level of uncertainty and associated risks of their non-housing-related assets are now very much a focus. According to July 2008 data, of credit currently being extended by banks, only about 20 percent is for residential real estate. Only about 9 percent is for consumer credit. So that leaves the balance in areas where these financial institutions and their management teams have to be asking themselves whether the weaknesses that are emerging in the real economy will place uncertainty over assets that have nothing to do with housing. That's a major downside risk for financial institutions and has not been much of a focus of shareholder and stakeholder concerns. There are two open issues that will guide some of our thinking, at least with respect to these credit markets. First, as we talked about a little last night with the presidents, are the embedded losses so great at such a critical mass of institutions with management credibility so low that many more than currently expected might be unable to survive? This is a question that I'm not sure I know the answer to. Second, despite the concerns about the effect of the credit markets on the broader economy that I talked about, our monetary policy may not be terribly well suited to be fixing those problems, and financial institutions may not be terribly sensitive to the extent we decide that we should change the stance of policy. Taking all that into account, let me say a couple of words about growth and inflation. First, on the economic growth front, given my views of what's happening in the credit markets, it's very hard for me to believe that the economy will get back to potential anytime soon. There are continued financial stresses that could last through year-end, and in there could be an upside surprise. Still, all things considered, my base case has second-half growth still above staff estimates owing in part to the productivity we've seen in recent months and the remarkable resiliency of this economy. If we look beyond that horizon, though, toward the Greenbook forecast in 2009 and beyond, I must say I don't really see the inflection point to take us back to economic growth of 2.2 percent or whatever the Greenbook suggests. I think we're going to be in this period of belowtrend growth for quite some time. My own view is that, when the Congress comes back after its August recess, we will be in the middle of a big debate on ""Son of Stimulus"" and that the stimulus probabilities have moved up quite materially. However, it is not at all obvious to me that it will do much in terms of helping the real economy. Outside the United States, I share the view of Governor Kohn, which is that I'd expect global GDP, particularly GDP among advanced foreign economies, our major trading partners, to continue to disappoint, making the remarkable addition of net export growth to our own GDP likely to dissipate. Turning finally to inflation, my view is that inflation risks are very real, and I believe that these risks are higher than growth risks. I don't take that much comfort from the move in commodity prices since we last met. If that trend continues, then that would certainly be good news; but I must say I don't feel as though inflation risks have moved down noticeably since we last had this discussion. The staff expects food prices to continue to be challenging; that is certainly my view. The staff also expects core import prices to fall rather precipitously. I'm a little skeptical of that view. I think it's possible, but I don't really see the catalyst for that given what we see about changes in input prices overseas and given expectations of the dollar in foreign exchange markets. So with that, I think that the inflation risks are real, and I'll save the balance of my remarks for the next round. Thank you, Mr. Chairman. " FOMC20080430meeting--53 51,MR. STOCKTON.," Nathan and I thought that we would alter slightly the structure of our briefing today so as to focus a bit more closely than usual on the global and domestic outlooks for inflation. I'll start with a brief review of recent economic developments and our outlook for economic activity in the United States. Nathan will then discuss trade and foreign activity before turning to global commodity markets and our forecast for import prices. I will then explain how both foreign and domestic influences are shaping our outlook for U.S. inflation. Brian will conclude by presenting your forecasts. Let me turn first to the domestic economy. From a forecasting perspective, this intermeeting period turned out to be reasonably tranquil, at least by the standards of the past nine months. The incoming data were very close to our expectations and required few adjustments to either top-line GDP or to the individual components of spending. As we noted in the Greenbook, we continue to think it likely that the economy is in recession; and, with the data evolving pretty much as we had expected, we have seen little reason to back away from that call. Readings from the labor market support the view that, at the very least, a pronounced deceleration in aggregate activity is under way. Private payrolls fell about 100,000 in March, the third consecutive month with a drop of that magnitude, and the unemployment rate moved above 5 percent. Moreover, a notable weakening of labor markets is signaled by most of the indicators that we monitor. Surveys of hiring plans have continued to move lower; there are fewer job vacancies; businesses report that jobs are easier to fill; and household attitudes have continued to sour, including their views of the labor market. In the past, such a configuration of readings has been a reasonably reliable indicator of cyclical downturn. The spending data also have been consistent with our forecast of a marked weakening in aggregate demand and activity. After posting modest gains last year, consumer outlays and business equipment spending appear to have been at a near standstill since the turn of the year. Meanwhile, housing continues its steep descent and looks to be on track to subtract about 1� percentage points from the growth of real GDP in the first half of the year--close to our March projection. Moreover, while we had anticipated a sharp deceleration in nonresidential construction in response to more-difficult financing conditions, that sector now appears to be turning down earlier and more sharply than we had projected. Finally, much as we had been expecting, weak domestic demand is receiving some offset from ongoing solid gains in exports. All told, we estimate that real GDP rose at an annual rate of � percent in the first quarter, just a few tenths above our March forecast. As you know, tomorrow morning, the BEA will release its advance GDP estimate for the first quarter. For the second quarter, we are projecting real output to decline at a 1� percent annual rate, a few tenths weaker than our March forecast. On net, the outlook for activity in the first half is basically unchanged from the time of the last meeting. Looking further ahead, our medium-term forecast also hasn't changed much over the past six weeks. The stock market is more than 5 percent higher than we had anticipated. But the favorable effects of that development on activity are nearly offset by the adverse effects of lower house prices and higher oil prices. Consequently, the GDP gap at the end of next year is unchanged from the March forecast. Our basic story remains the same. The contraction in activity that we are projecting over the first half of the year is expected to be relatively mild because of the boost to spending and activity from the tax rebates and because export demand remains solid. In the second half, real GDP turns up, but I wouldn't really term this a recovery. After all, real GDP is projected to grow less than 1 percent at an annual rate, employment continues to decline, and the unemployment rate runs up to 5� percent. But we see a number of factors fostering a more noticeable acceleration of activity to a pace above its potential by 2009. First, the contraction in residential investment abates. Second, the drag on consumption growth from the rise in oil prices wanes. Third, financial conditions stabilize and then begin to improve, gradually reducing restraint on household and business spending. Finally, we assume that monetary policy remains accommodative. With the growth in real GDP running 2� percent next year, about � percentage point above the pace of potential, the unemployment rate drops slowly to 5� percent. Obviously, there are large risks on both sides of our projection. On the upside, we could just be flat-out wrong about an imminent contraction in aggregate activity. Claims were running about 360,000 at the time of the March FOMC and are now averaging about 370,000. While that increase suggests some further softening in the labor market, the level of claims seems lower than would comfortably fit our forecast of payroll employment declines averaging about 160,000 over the next few months. Likewise, industrial production has weakened but hasn't dropped off much. Because we don't expect manufacturing to be at the epicenter of this business cycle, we aren't looking for a plunge, but we are forecasting more noticeable declines than we've seen to date. In addition, although last week's numbers for shipments of nondefense capital goods in March were close to our forecast, the orders figures were firmer than we had expected. In sum, while the data have not pushed us away from our recession forecast, they haven't convincingly confirmed it yet either. More broadly, with bond spreads down, the stock market up, and market expectations for the path of policy revised higher, the situation certainly looks less menacing than at the time of the March meeting. But while we would agree that the risk of a very bad tail event seems to have declined, we are not ready to join others in heaving a sigh of relief just yet about the modal outlook. For one, we still see no signs of a bottom in housing. New homes sales--we received the numbers after the projection was completed--declined more than 8 percent last month to a level that we thought would be the bottom in the second half of this year. A second concern centers on consumption. With oil prices running around $115 per barrel, consumers will be facing sizable further increases in gasoline prices over the next few months from already elevated levels. Also, given the steep declines in employment that we are projecting, incomes and income uncertainty will be taking a hit. We've taken those factors on board as best we can, and we are counting on the tax rebates to provide a powerful offset, but we can't rule out a more adverse reaction to what will be an accumulation of bad news. Furthermore, while there has been improvement in the general tenor of financial markets, I suspect that we've only begun to see the effects of tighter credit conditions on borrowing and spending. That restraint could prove larger and more persistent than is implicit in our baseline forecast. Finally, the mild downturn in activity that we are projecting also suggests some downside risk. Our projected rise in the unemployment rate of 1� percentage points from its low point last year to its high point at the end of this year is small--smaller than occurred in either the 1990�91 recession or the 2001 recession. This time could be different, but as I noted in March, that argument should always give you pause. Nathan will now continue our presentation. " FOMC20070509meeting--90 88,MR. REINHART.,"3 Thank you, Mr. Chairman. I’ll be referring to the materials that were passed around during the coffee break. For the past few years, the Committee has taken a “belt and suspenders” approach to providing guidance to financial markets by characterizing both the likely direction of interest rates and the risks to its dual objectives. In March, you loosened the belt a few notches by replacing the reference to “additional firming” with more-balanced language but retained the macroeconomic assessment that inflation risks were the more serious concern. The top left panel of your first exhibit provides one way to score the immediate market consequences of that change. The black and red bars, respectively, plot the changes in two- and ten- year Treasury yields in the one-and-a-quarter-hour window bracketing the 2:15 p.m. release of statements for the past two years. As some of you predicted, market participants saw particular significance in the March announcement that the Committee was apparently no longer presuming that its next action would be a firming, and two- and ten-year yields fell 10 and 5 basis points, respectively, the biggest moves in the sample shown. After a bit of confusion about what the statement really meant, markets ultimately got the message, aided in part by Chairman Bernanke’s testimony, your speeches, and the minutes. I take from this the sense that the wording of the statement is important [laughter], but that there are also other opportunities to provide a more-nuanced policy message. The message that market participants got both from you and from the incoming data, on net over the intermeeting period, is seen in the top right panel by the shift from the dotted red to the solid black line depicting the path of the 3 Material used by Mr. Reinhart is appended to this transcript (appendix 3). expected federal funds rate. Futures quotes now imply a consensus that policy will be kept on hold today and at the June meeting but then will be eased ¾ percentage point by the end of next year. This modest upward repricing of money market futures yields accompanied a reemergence of remarkably benign financial conditions, the subject of the three middle panels. Corporate bond spreads (at the left) and implied volatilities on equities and money market futures (in the middle) retraced much of the run-up of late February to end the period at relatively low levels by historical standards. Equity prices, at the right, gained 7 percent to reach new highs. As you’ll see a little later, this addition to household wealth pushed up estimates of the equilibrium real federal funds rate and may importantly influence your thinking about near-term economic prospects. In the bottom left panel, I trot out the usual suspects for why stock prices rose. First-quarter earnings reports were solid, so higher share value may just be a bet on rising domestic and foreign profits—the latter seeming especially more secure in light of the apparent vigor of the global economy. Our estimates of the equity premium— one of which is shown at the bottom right as the spread between the forward earnings-price ratio and the long-term real interest rate—narrowed a bit, suggesting that investors were more accepting of risk. Also, investors may see less risk, as in answer C. Potentially bad things that seemed palpable as the subprime market melted down did not go bump in the night—that is, downside risks to the outlook appeared to ease. What is the right answer to this multiple choice test? I think (D), all of the above, in that the world’s growth prospects seem a little more assured and, as a result, investors see fewer risks and are more willing to take them on. That backdrop leads naturally to a discussion of policy choices, which begins by examining the case for alternative B, which is in your next exhibit. The last time that you sat at this table to consider the setting of policy, you chose to keep the federal funds rate at 5¼ percent. The way the staff has filtered the flow of information since March has produced only minor changes to their outlook for real GDP growth, the top left panel, and core PCE inflation, the top right panel. So, if you were content in March, would you not be so in May? Keeping the nominal funds rate at 5¼ percent is consistent, as plotted in the middle panel, with the real federal funds rate, the solid black line, rising to continue to match the Greenbook-consistent measure of its equilibrium value, the dotted green line. If you believe that framework, this stance of policy should return the level of output to its potential within three years. Some of you might argue that such an outcome is not good enough. With core PCE inflation lingering above 2 percent, a more forceful working down of inflation—perhaps even at the cost of creating some slack—may be required for acceptable economic performance. While that may be a relevant consideration, risk-management issues may tug in the opposite direction. In particular, and as shown by the solid line in the bottom panel, the staff forecast puts real GDP growth in the neighborhood of 2 percent for the next six quarters. Times in which economic growth has been at or has dipped below 2 percent—the dashed horizontal line—have often been followed by recession—the shaded regions. Concern that the economy would be flying close to stall speed may stay your hand from dealing more aggressively with inflation. Indeed, concerns about growth may incline you to believe that your next policy action will be an easing—the subject of the left column of charts in exhibit 3. As has been true for some time, the case for alternative A rests importantly on your assessment of the housing market. New-home sales, the solid black line in the middle panel, have taken another step down, further elevating the months’ supply of unsold new homes, the dotted red line. This inventory correction will impose a drag on residential investment for some time—and could get worse if the availability of funds tightens some more in light of the woes in the subprime mortgage market. You also might now harbor doubts that businesses will step up their spending, which would otherwise have cushioned any slowing in the growth of aggregate demand. While the latest readings on orders and on shipments of capital goods, plotted as the solid black and dotted red lines, respectively, in the bottom left panel, were encouraging, you might dismiss those as one month’s noisy signal around a downward-pointing trend. In addition, you might see financial markets as ripe to correct, once investors come to appreciate that earnings prospects are as tepid as in the Greenbook forecast. But risks to economic growth are not the Committee’s sole concerns. In March you identified the failure of inflation to moderate from its current elevated level to be the predominant concern. The case for alternative C, presented in the right panels, probably hinges on the view that inflation is not clearly on a downward trend, seen in the middle panel by inflation as measured by the core PCE price index (the solid black line) and the market-based core PCE index (the dotted red line). In addition, the outlook for inflation may now be seen as less favorable than in March, given the run-up in the prices of oil and other commodities. As shown in the bottom right panel, futures-market participants have revised up their forecasts for the prices of these items well into the future. If the pace of moderation of core inflation turns out to be even slower than previously anticipated, you might be concerned that long-run inflation expectations will drift up, making for difficult policy choices going forward. The prevailing expectations of inaction, shaped in part by official comments, may take alternatives A and C off the table for today. But any inclination to favor the arguments in either the right or the left columns should influence your choice of language in the statement, the subject of your last exhibit. This exhibit is just table 1 repeated from the Bluebook with no emendation. I note that, in the discussion of communications, the Committee thus far has been reluctant to specify an inflation goal consistent with its dual mandate. However, by describing current inflation as “somewhat elevated,” as was the case in March, you are implicitly characterizing the upper limit of your tolerance for inflation, just as you delimited its lower bound in the summer of 2003 with talk of “unwelcome disinflation.” Market participants will read much into your choice of words when the time comes to change that characterization. So, at some point, you will have to come to terms with your preferred specification of your inflation goal, either directly through deliberations on communication policy or indirectly through the wording of the statement. That concludes my prepared remarks." FOMC20070131meeting--415 413,MR. STERN.," Thank you, Mr. Chairman. In the interest of time, I’d like to be able to say that I agree with Governor X or President Y and just let it go at that, but there are some nuances that I feel compelled to cover, so I will. Let me just start out by saying that, while I certainly favor some changes to the production and publication of the forecast, I do think we need to proceed, at least in some areas, cautiously and conservatively. After all, we are the central bank. [Laughter] Beyond that, once we make these changes, we probably won’t be able to retract them; so we’d better make sure that we want to do them before we proceed. In that spirit, let me address the questions. Questions 1 and 2 fall into that category. I think that we ought just to continue what we’re doing now in terms of conducting a survey of individual forecasts and aggregating them. I have reservations about trying to come to common assumptions, for lots of reasons. Practically it would be very difficult, and I’m not sure at the end of the day that there is a big payoff. So I favor the status quo so far as those first two questions are concerned. Question 3 pertains to the narrative description, and there my answer is “yes”—the forecasts should be accompanied by a narrative description. That step is very important, and it feeds into question 4: Should the Committee jointly agree on the minutes-style description or delegate the release? We have a number of options there. As some people suggested, you could tie this in with the minutes in one way or another. That runs the risk of the forecast’s becoming stale by the time the public sees it. I’m perhaps a little less concerned about that than some others because the public will know when the meeting occurred. They know what information we didn’t have, and they presumably know we’re not clairvoyant. [Laughter] Let me put it this way: I am not clairvoyant. Some of you perhaps are, but if so, it escaped my notice. [Laughter] Another way of handling this would be to submit the forecasts with brief narratives in advance; then, of course, we’d have a pretty good jump on preparing the material at the end of the meeting. So if we’re concerned about timing and about forecasts becoming stale, we would have the advantage of having materials before the discussion at the meeting. We can find ways to get out the forecast and the commentary associated with it in a more timely way to the extent that we think doing so is important. Now, here a dry run or two might be very helpful, and I think it will turn out to be essential to changes that we might make. Question 5 is how frequently the forecast should be made. Here again, I’m not sure the current schedule is too bad. Adding a third forecast each year to fill in the hole in the fall and maybe to address a bit the issue that Bill Poole articulated about providing more information about how our views are evolving—that might work out. But this is another place in which I would be relatively cautious about being very ambitious right off the bat. Similarly, with how many years the forecast should cover: I think there are arguments for extending it beyond the current period, but again, I would want to do some dry runs and look very carefully at what we gain before we committed ourselves to going out three years or five years or whatever the period might be. As for the number of variables forecast, I think we need an inflation variable, a growth variable, and some sort of labor market variable, and I’d let it go at that. Putting out more things would only add to the confusion. We could always decide at some future time to put out a federal funds rate number, a year-end number or something like that, but I wouldn’t start with adding it right up front. Finally, should there be some attempt to convey formally the uncertainty surrounding the forecast? There my answer is “yes.” Whether we do it with fan charts or with some other approach is something that we can work out, but I think it is very important to do. I don’t think right now that market participants or the public more generally think that there is little uncertainty associated with our forecast, but it’s important to underscore the high degree of uncertainty associated with policymaking. Those are my views." FOMC20061025meeting--257 255,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20080130meeting--306 304,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20080130meeting--285 283,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20060131meeting--103 101,CHAIRMAN GREENSPAN., Thank you. President Poole. FOMC20060920meeting--68 66,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20070807meeting--111 109,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20070131meeting--278 276,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20070628meeting--358 356,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20070628meeting--328 326,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20071211meeting--85 83,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20060808meeting--67 65,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20060808meeting--170 168,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20060808meeting--105 103,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20060629meeting--99 97,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20071206confcall--21 19,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20080121confcall--20 18,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20071031meeting--69 67,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20061212meeting--74 72,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20060629meeting--173 171,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20070628meeting--123 121,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20070321meeting--160 158,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20061212meeting--36 34,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20060629meeting--123 121,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20070509meeting--54 52,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20071031meeting--160 158,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20070321meeting--108 106,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20061212meeting--148 146,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20060510meeting--136 134,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20061025meeting--73 71,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20070131meeting--432 430,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20070918meeting--154 152,CHAIRMAN BERNANKE., Thank you. President Poole. FOMC20060328meeting--226 224,CHAIRMAN BERNANKE., Thank you. President Poole. CHRG-111shrg55739--89 Mr. Froeba," Senator Reed, Senator Shelby, and Members of the Committee, my name is Mark Froeba. Thank you for giving me this opportunity to talk about rating agency reform. Let me give you a brief summary of my background. I am a 1990 graduate of the Harvard Law School. Barack Obama was 1 year behind me. What a difference a year makes. [Laughter.] " FOMC20081029meeting--246 244,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. We expect a recession at least as bad as the 1990�91 recession, with a significant risk of a deeper, more protracted downturn worse than the '80s, and a very substantial rise in the unemployment rate. Inflation is decelerating quickly, and deflationary forces are ascendant around the globe. The huge decline in energy and commodity prices will add to a very substantial downward pressure on core inflation from increased economic slack around the world. We could see an abrupt change in inflation expectations into deflationary territory. We've seen a lot of policy action over the past few weeks. One question is whether policymakers should wait to measure the effects of these measures before going further, and I want to talk a little about that question. My view is that I don't think so. The outlook has been deteriorating ahead of the policy response. This is true both here and around the world. The magnitude and speed of the tightening financial conditions, the erosion in business and consumer confidence, the fall in actual spending, and the shift in inflation risk together present very grave risks to growth and to the financial system. Mitigating these risks is going to require more monetary policy here but even more so in the other major economies. But in addition to the very substantial easing in the global stance of monetary policy ahead, the substantial damage that has already happened to financial intermediation globally suggests that a broad-based and quite large fiscal stimulus will be critical to prevent an excessive fall in aggregate demand. How quickly and how far should we reduce the federal funds rate in the United States? The Greenbook and the Bluebook present a very strong case for moving down another 100 basis points quickly. In fact, if I read the pictures in the Bluebook correctly, they might imply a need to get real rates to the negative 3 to negative 5 percent territory relatively quickly, if we could do that. If we don't move another 50 today, we'll be behind again. Monetary policy has effectively tightened substantially since the summer, of course, because of the intensification of financial pressures and because of the rise in forward real interest rates that have come with the rapid deceleration in expected future inflation. Beyond this meeting and this choice, our choices are harder. I think we need to get real rates lower and, to make sure we get them there, we need to keep them low enough long enough. This requires that we get the nominal fed funds rate as low as possible as soon as possible. I don't see a good case for monetary policy gradualism in the current context. The risks are too great. If we're too tentative, the damage to the financial system and to the real economy could be much greater and much harder to correct. If we end up doing too much, we can always adjust. That's an easier problem to solve. It just requires will. With global financial markets placing progressively more weight on a very severe global recession, the ""keep our powder dry"" and ""reserve our remaining ammunition"" arguments don't seem that compelling to me. We don't have much ammunition left in the fed funds rate anyway. If we hold that back, it will likely be less effective when we ultimately use it. The more powerful escalation options we have left will probably involve communications, such as continued commitments to keep rates low enough long enough that we avert creeping expectations of deflation and can be confident that inflation will come in around our target level over the forecast period. I don't have a strong view now about how low we can go with the nominal fed funds rate without causing too much risk of damage to the functioning of financial systems. We need to look at all possible options, though. I think the principal focus of our staff's work in the coming weeks will be to put together a set of alternative policy options going forward along with the analysis of their benefits and risks so that we're in a position to act quickly enough to be effective. Just a few final points. I think this basic risk-management choice really involves three dimensions of judgment. One is about the relative probability of alternative outcomes. The second is about the relative consequences of or the damage caused by those alternative scenarios. Importantly, it also involves a judgment about the ease of correcting, adjusting, or mitigating the consequences of being wrong. This is just a stylized presentation, but in the staff notes yesterday, there was a nice way to think about those choices. I just wanted to point out one thing about this stylized framework of those choices, which is the consequence. If you look at exhibit 5, the bottom left panel, which shows the inflation outcome associated with the ""more rapid recovery"" scenario, in this presentation you don't have much risk of a very bad inflation outcome in the event that we end up doing too much with too much policy and have to take that back. Again, it's important to recognize that it's not just about the probability that we attach to the alternative scenarios. It's not just about the relative impact of the consequences of those scenarios. It's about the ease with which we can correct for a judgment that was wrong--in this case, a judgment that we did too much. This may understate the complications in correcting for that error and may make it look easier than it may ultimately be, but I think it's a nice framework. Finally, I just want to point out, just to underscore the basic point: This is not going to be principally about monetary policy going forward. If you look at the broad framework of policies that are now in place, both here and globally, and the instruments we have to play with, along with the fiscal authorities: we have monetary policy; we have the liquidity arrangements and what we do with our balance sheet over time; we, the collectively integrated government, have the broad fiscal policy questions and the scope for either a broad-based substantial fiscal package or more-targeted fiscal measures, as the Chairman suggested, to focus on the credit markets; and we have the capacity to alter the framework of capital and guarantees that is now in place. Beyond that, the government here also has the ability to change what the GSEs, the FHA, and the FHLB can do. So when we think about escalating going forward, to go to President Fisher's question from yesterday, we have the ability on all these fronts to do more if that's necessary and prudent. But I think the mix has already changed substantially. It was probably mostly fiscal nine months ago. It is certainly mostly fiscal now in a broader sense, except that many of the major economies going forward will have to move monetary policy very substantially. Thank you. " CHRG-111shrg57322--930 Mr. Blankfein," A CDO is a pool of assets, in this case, mortgage assets, so mortgages that are pooled together and then can be sliced in a way that will yield a particular credit exposure. The reason why one would want to pool mortgages is it gives diversification so that you can pool mortgages not just from one community, but distribute it over the whole country. The reason why one would want to slice it is so you could pick your place on the credit spectrum and say, I would like the more senior mortgages. I would like the more junior risks. In a synthetic, you don't pool the actual mortgages per se. You pool reference securities that are indexed to specific pools of mortgages. Senator McCain. In other words, in a synthetic CDO, you don't really have any ownership. You are just betting on the fortunes of that CDO, is that correct? " FOMC20071211meeting--138 136,MR. POOLE.," Not quite after that meeting. It is still a little cold. [Laughter] But my instinct is that we have demonstrated a willingness to act decisively when there is a very good case in the data. So if data come in with very bad employment reports, additional financial distress, and all of that, I don’t think there is any question that the market will then anticipate decisive action. That wasn’t so true back in August, by the way, but the fact that there was a 50 basis point move in September has conditioned the market to respond differently. I would be in favor of a strategy that says at this point, if we indeed go down another 25 basis points, we will have cut the target by 100—a strategy that is very open but in a sense follows the market. Now, if it turns out that we have a lot of weak news in the weeks ahead, the market is going to build in further rate cuts. It will do a lot of the work for us without our having to be out front. You will get the benefits brought forward because the market is going to bid those in, and therefore, I think a strategy that tries to follow the data, to demonstrate a clear willingness to respond to the incoming information, gives us the best chance for stability over the coming year. Despite the memo that I distributed, which I think was an option that we should consider, I think that we should not have any balance of risks view because it is highly desirable to leave everything very open. Meeting by meeting, we, or you, will have to decide whether the case is being made from the data. Of course, I think that the speeches and other communication will be very important to try to explain the strategy and the process by which we assess and respond to the data, maintaining always a longer-term view and not getting carried away with the most recent observations. Thank you." CHRG-111shrg54589--64 Mr. Hu," Mr. Chairman and distinguished Members of the Subcommittee, thank you for this opportunity. My name is Henry Hu. I teach at the University of Texas Law School and my testimony reflects my preliminary views as an academic. In the interest of full disclosure, I recently agreed to begin working soon at the Securities and Exchange Commission. I emphasize that I am currently a full-time academic, have been so for over two decades, and after this forthcoming government service will return to my normal academic duties. What I will say today does not reflect the views of the SEC and has not been discussed with, or reviewed by, the SEC. I have submitted written testimony. I ask that it also be included in the record. This is a seminal time for the regulation of over-the-counter derivatives. My understanding is that the Subcommittee wanted me to offer a broad perspective as to undertaking this task instead of analyzing specific elements of the President's proposal. Almost from the beginning of the OTC derivatives markets in the late 1970s, two overarching visions have animated the regulatory debate. The first vision is that of science run amok, of a financial Jurassic Park. In the face of relentless competition and capital market disintermediation, big financial institutions have hired financial scientists to develop new financial products. Often operating in an international wholesale market open only to major corporate and sovereign entities--a loosely regulated paradise hidden from public view--these scientists push the frontier, relying on powerful computers and esoteric models laden with incomprehensible Greek letters. But danger lurks. As these financial creatures are created, evolved, and mutate, exotic risks arise. Not only do the trillions of mutant creatures destroy the creators in the wholesale capital market, they escape to cause havoc in the retail market and economies worldwide. This first vision focuses on the chaos that is presumed to result from the innovation process. The chaos could be at the level of the entire financial system. This motivated, of course, the Federal Reserve's intervention in 1998 of Long-Term Capital Management--perhaps they should have called this hedge fund something else--and the intervention in 2008 as to AIG. There could also be chaos at the level of individual market participants. Witness the bankruptcy of Orange County in 1994, and also in 1994, the huge derivatives losses at Proctor and Gamble--but perhaps that company's name was appropriate. But there is also a second vision, one that is the converse of the first vision. Here, the focus is on the order, the sanctuary from an otherwise chaotic universe made possible by the innovation process. The notion is this. Corporations and others are subject to volatile financial and commodities markets. Derivatives, especially OTC derivatives, can allow corporations to hedge against almost any kind of risk. This allows corporations to operate in a more ordered world. If the first vision is that of a Jurassic Park gone awry, the second vision is that of the soothing, perfect, hedges found in formal English and Oriental gardens. While the first vision focuses on the private and social costs of derivatives, the second vision emphasizes the private and social benefits of OTC derivatives. In fact, there are elements of truth to both visions and the essential task ahead is to try to reduce the costs of such derivatives without losing their benefits. Now, that is easily said. How can we actually accomplish this? Well, in my academic articles on this matter, I stress one theme. We must not just focus on the characteristics of individual OTC derivatives, but also on the underlying process of financial innovation through which products are invented, introduced to the marketplace, and diffused. That is, the financial innovation process itself, not just individual derivatives, has regulatory significance. Because of time limitations, I simply refer to two or three examples, and only very briefly. First, the innovation process can lead to chaos by causing important market participants to make big mistakes. In an article published in 1993 in the Yale Law Journal entitled ``Misunderstood Derivatives,'' I argued that the particular characteristics of the modern financial innovation process will cause even the most sophisticated financial institutions to make big mistakes as to derivatives. Second, the gaps in information as to this innovation process between the regulators and the regulated are extraordinary. Regulators may not even be aware of the existence of certain derivatives, much less how they are modeled or used. And so beginning in 1993, I have urged the creation of a centralized informational clearinghouse as to OTC derivatives. Third, let's focus on one particular example of the innovation process, the so-called ``decoupling'' process. I have--beginning in 2006--been the lead or sole author as to a series of articles suggesting that this decoupling process can affect the core disclosure and substantive mechanisms of our economic system. In the initial 2006 articles, the focus was on the equity side. Those articles showed how you could have an ``empty voter'' phenomenon. For instance, the person holding the highest number of votes in a company could be somebody with no economic interest or a negative economic interest. And similarly, there is a ``hidden morphable ownership'' issue. Those 2006 articles showed how some hedge funds and others have used cash-settled equity swaps in efforts to try to avoid making disclosures under Section 13(d) of the Securities Exchange Act of 1934. In 2007, it suddenly occurred to me that the same kind of decoupling process can work on the debt side. For instance, using credit default swaps, you could have creditors who are ``empty creditors.'' With this empty creditor situation, these creditors might often have weaker incentives than traditionally to make sure that their borrowers stay out of bankruptcy. Indeed, if they hold enough credit default swaps, they might benefit from their borrowers going into bankruptcy. In these times, this is deeply troubling. Let me conclude. Three econometricians went hunting in the wilds of Canada. They were getting hungry and they suddenly see a deer. One econometrician shoots and misses three feet to the right. The second econometrician shoots and misses three feet to the left. The third econometrician doesn't shoot but shouts, ``We got it! We got it!'' It is very difficult to come up with a good model, much less one that would actually put food on the table. The task of coming up with a good model for regulating derivatives is no less difficult, and we now all know that this task is essential to making sure that food is indeed on the table for everyone. Thank you very much. " FOMC20070131meeting--293 291,MR. POOLE.," I have one question here. Do we intend in the minutes to make clear our general—well, “expectation” is too strong—but tilt or bias in the direction of tightening later in the year, which I think matches what you just said." FOMC20080130meeting--159 157,MR. POOLE.," Thank you, Mr. Chairman. I am not sure how I got to be first here, but I guess I was being unusually agreeable when Debbie asked me. [Laughter] The general tenor of comments that I hear from our directors and people around the Eighth Federal Reserve District-- these are the community bankers and smaller firms--is that things are slow but not disastrously slow. The comments that I hear from a series of phone calls to much larger national companies are decidedly more pessimistic, with one exception that I will talk about in a moment. My contact at a large national trucking firm says that they are in a 20-month recession in transportation. They are cutting their capacity, cutting the number of trucks, and I think the numbers on their cap-ex illustrate the situation: for 2006, $410 million; for 2007, $336 million; and their plan for 2008 is $200 million. That is down a little more than 50 percent in two years, so they are really cutting back. I also called friends at UPS and FedEx, and generally things are not a whole lot different but a little weaker than they have been. Neither firm has any particular issues with labor supply. Domestic express business is flat, and customers are switching to the lower-priced services instead of overnight delivery at the end of the afternoon, shifting to ground services, and that sort of thing. On international business, U.S.-outbound volume for FedEx is up 6 percent. That would be consistent with the export increases that we have seen. Reports are that Asia is a bit slower but is still growing very rapidly. Asia to the United States is up 80 percent, 20 percent to Europe and Latin America. The freight market is dead--that is the way my contact put it--down 5 percent year over year. That is consistent with my trucking industry contact--and pretty much the same with UPS. My contact with the fast food industry--the quick-serve restaurant, or QSR, business--says the demand there is definitely weak. They are coming in roughly flat, I guess, or actually down so far this year. Prices are up because of the increase in food costs. The casual dining industry is in worse shape than the fast food industry. My contact also follows retail in general pretty closely and finds that retail business in general is weak. That is consistent with a lot of the reports that we have been receiving. A major exception is in the IT area--software. I have contact with a large software company, and the contact noted that, as announced, Microsoft had a fantastic quarter. The earnings were up sharply. PC hardware sales are growing at a rate of 11 to 13 percent expected in the first half of this year, so we see strong growth in the PC market. Consumer demand is stronger than business demand. Both, however, are pretty strong. The international business is doing better, in part because the industry is having some success in reducing the amount of software piracy. The biggest problem is finding software engineers. This particular company is running 8 percent behind its hiring forecast and cannot find software engineers. Positive for us old guys; some of the retirees are coming back to write code. [Laughter] Thank you. That is all I have. " CHRG-110shrg46629--17 Chairman Bernanke," Thank you. Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. As you know, this occasion marks the 30th year of semiannual testimony on the economy and monetary policy by the Federal Reserve. And in establishing these hearings, the Congress proved prescient in anticipating the worldwide trend toward greater transparency and accountability of central banks in the making of monetary policy. Over the years, these testimonies and the associated reports have proved an invaluable vehicle for the Federal Reserve's communication with the public about monetary policy even as they have served to enhance the Federal Reserve's accountability for achieving that dual objectives of maximum employment and price stability set forth by the Congress. I take this opportunity to reiterate the Federal Reserve's strong support of the dual mandate. In pursuing maximum employment and price stability, monetary policy makes its greatest possible contribution to the general economic welfare. Let me now review the current economic situation and the outlook beginning with developments in the real economy and the situation regarding inflation before turning to monetary policy. I will conclude with comments on issues related to lending to households and to consumer protection, topics not normally addressed in monetary policy testimony but, in light of recent developments, deserving of our attention today. After having run at an above trend rate earlier in the current economic recovery, U.S. economic growth has proceeded during the past year at a pace more consistent with sustainable expansion. Despite the downshift in growth, the demand for labor has remained solid, with more than 850,000 jobs having been added to payrolls thus far in 2007 and the unemployment rate having remained at 4.5 percent. The combination of moderate gains in output and solid advances in employment implies that recent increases in labor productivity have been modest by the standards of the past decade. The cooling of productivity growth in recent quarters is likely the result of cyclical or other temporary factors but the underlying pace of productivity gains may also have slowed somewhat. To a considerable degree, the slower pace of economic growth in recent quarters reflects the ongoing adjustment in the housing sector. Over the past year, home sales and construction have slowed substantially and house prices have decelerated. Although a leveling off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders' inventories to rise further relative to the pace of new home sales. Accordingly, construction of new homes has sunk further, with starts of new single-family houses thus far this year running 10 percent below the pace of the second half of last year. The pace of home sales seems likely to remain sluggish for a time partly as a result of some tightening in lending standards and the recent increase in mortgage interest rates. Sales should ultimately be supported by growth in income and employment as well as by mortgage rates that--despite the recent increase--remain fairly low relative to historical norms. However, even if demand stabilizes as we expect, the pace of construction will probably fall somewhat further as builders work down stocks of unsold new homes. Thus, declines in residential construction will likely continue to weigh on economic growth over coming quarters, although the magnitude of the drag on growth should diminish over time. Real consumption expenditures appear to have slowed last quarter, following two quarters of rapid expansion. Consumption outlays are likely to continue growing at a moderate pace aided by a strong labor market. Employment should continue to expand, though possibly at a somewhat slower pace than in recent years, as a result of the recent moderation in the growth of output and ongoing demographic shifts that are expected to lead to a gradual decline in labor force participation. Real compensation appears to have risen over the past year and, barring further sharp increases in consumer energy costs, it should rise further as labor demand remains strong and productivity increases. In the business sector, investment in equipment and software showed a modest gain in the first quarter. A similar outcome is likely for the second quarter as weakness in the volatile transportation equipment category appears to have been offset by solid gains in other categories. Investment in nonresidential structures, after slowing sharply late last year, seems to have grown fairly vigorously in the first half of 2007. Like consumption spending, business fixed investment overall seems poised to rise at a moderate pace bolstered by gains in sales and generally favorable financial conditions. Late last year and early this year motor vehicle manufacturers and firms in several other industries found themselves with elevated inventories, which led them to reduce production to better align inventories with sales. Excess inventories now appear to have been substantially eliminated and should not prove a further restraint on growth. The global economy continues to be strong. Supported by solid economic growth abroad U.S. exports should expand further in coming quarters. Nonetheless our trade deficit, which was about 5.25 percent of nominal gross domestic product in the first quarter is likely to remain high. For the most part, financial markets have remained supportive of economic growth. However, conditions in the subprime mortgage sector have deteriorated significantly, reflecting mounting delinquency rates on adjustable-rate loans. In recent weeks, we have also seen increased concerns among investors about credit risk on some other types of financial instruments. Credit spreads on lower quality corporate debt have widened somewhat, and terms for some leveraged business loans have tightened. Even after their recent rise, however, credit spreads remain near the low end of their historical ranges and financing activity in the bond and business loan markets has remained fairly brisk. Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy's underlying trend. Such an assessment was made around the time of the June meeting of the Federal Open Market Committee by the members of the Board of Governors and the Presidents of the Reserve Banks, all of whom participate in deliberations on monetary policy. The central tendency of the growth forecasts, which are conditioned on the assumption of appropriate monetary policy, is for real GDP to expand roughly 2.25 to 2.5 percent this year and 2.5 to 2.75 percent in 2008. The forecasted performance for this year is about one-quarter percentage point below that projected in February, the difference being largely the result of weaker than expected residential construction activity this year. The unemployment rate is anticipated to edge up to between 4.5 and 4.75 percent over the balance of this year and about 4.75 percent in 2008, a trajectory about the same as the one expected in February. I turn now to the inflation situation. Sizable increases in food and energy prices have boosted overall inflation and eroded real incomes in recent months, both unwelcome developments. As measured by changes in the price index for personal consumption expenditures, PCE inflation, inflation ran at an annual rate of 4.4 percent over the first 5 months of this year, a rate that if maintained would clearly be inconsistent with the objective of price stability. Because monetary policy works with a lag, however, policymakers must focus on the economic outlook. Food and energy prices tend be quite volatile so that, looking forward, core inflation, which excludes food and energy prices, may be a better gauge than overall inflation of underlying inflation trends. Core inflation has moderated slightly over the past few months with core PCE inflation coming in at an annual rate of about 2 percent so far this year. Although the most recent readings on core inflation have been favorable, month-to-month movements in inflation are subject to considerable noise and some of the recent improvement could also be the result of transitory influences. However, with long-term inflation expectations contained, futures prices suggesting that investors expect energy and other commodity prices to flatten out, and pressures in both labor and product markets likely to ease modestly, core inflation should edge a bit lower on net over the remainder of this year and next year. The central tendency of FOMC participants forecast for core PCE inflation--2 to 2.25 percent for all of 2007 and 1.75 to 2 percent in 2008--is unchanged from February. If energy prices level off as currently anticipated, overall inflation should slow to a pace close to that of core inflation in coming quarters. At each of its four meeting so far this year, the FOMC maintained its target for the Federal funds rate at 5.25 percent, judging that the existing stance of policy was likely to be consistent with growth running near trend and inflation staying on a moderating path. As always, in determining the appropriate stance of policy, we will be alert to the possibility that the economy is not evolving in the way we currently judge to be the most likely. One risk to the outlook is that the ongoing housing correction might prove larger than anticipated, with possible spillovers onto consumer spending. Alternatively consumer spending, which has advanced relatively vigorously on balance in recent quarters, might expand more quickly than expected. In that case, economic growth could rebound to a pace above its trend. With the level of resource utilization already elevated, the resulting pressures in labor and product markets could lead to increased inflation over time. Yet another risk is that energy and commodity prices could continue to rise sharply, leading to further increases in headline inflation and, if those costs pass through to the prices of nonenergy goods and services, to higher core inflation as well. Moreover, if inflation were to move higher for an extended period and increase became embedded in longer-term inflation expectations, the reestablishment of price stability would become more difficult and costly to achieve. With the level of resource utilization relatively high and with a sustained moderation in inflation pressures yet to be convincingly demonstrated, the FOMC has consistently stated that upside risks to inflation are its predominant policy concern. In addition to its dual mandate to promote maximum employment and price stability, the Federal Reserve has an important responsibility to help protect consumers in financial services transactions. For nearly 40 years, the Federal Reserve has been active in implementing, interpreting, and enforcing consumer protection laws. I would like to discuss with you this morning some of our recent initiatives and actions, particularly those related to subprime mortgage lending. Promoting access to credit and to homeownership are important objectives and responsible subprime mortgage can help to advance both goals. In designing regulations, policymakers should seek to preserve those benefits. That said, the recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards, and in some cases by abusive lending practices and outright fraud. In addition, some households took on mortgage obligations they could not meet, perhaps in some cases because they did not fully understand the terms. Financial losses have subsequently induced lenders to tighten their underwriting standards. Nevertheless, rising delinquencies and foreclosures are creating personal, economic, and social distress for many homeowners and communities, problems that will likely get worse before they get better. The Federal Reserve is responding to these difficulties at both the national and the local levels. In coordination with the other Federal supervisory agencies we are encouraging the financial industry to work with borrowers to arrange prudent loan modifications to avoid unnecessary foreclosures. Federal Reserve Banks around the country are cooperating with community and industry groups that work directly with borrowers having trouble meeting their mortgage obligations. We continue to work with organizations that provide counseling about mortgage product to current and potential homeowners. We are also meeting with market participants--including lenders, investors, servicers, and community groups--to discuss their concerns and to gain information about market development. We are conducting a top to bottom review of possible actions we might take to help prevent recurrence of these problems. First, we are committed to providing more effective disclosures to help consumers defend against improper lending. Three years ago, the Board began a comprehensive review of Regulation Z, which implements the Truth in Lending Act, or TILA. The initial focus of our review was on disclosures related to credit cards and other revolving credit accounts. After conducting extensive consumer testing, we issued a proposal in May that would require credit card issuers to provide clearer and easier to understand disclosures to consumers. In particular, the new disclosures would highlight applicable rates and fees, particularly penalties that might be imposed. The proposed rules would also require card issuers to provide 45 days advance notice of a rate increase or any other change in account terms so that consumers will not be surprised by unexpected charges and will have time to explore alternatives. We are now engaged in a similar review of the TILA rules for mortgage loans. We began this review last year by holding four public hearings across the country, during which we gathered information on the adequacy of disclosures for mortgages, particularly for nontraditional, traditional, and adjustable rate products. As we did with credit card lending, we will conduct extensive consumer testing of proposed disclosures. Because the process of designing and testing disclosures involves many trial runs, especially given today's diverse and sometimes complex credit products, it may take some time to complete our review and propose new disclosures. However, some other actions can be implemented more quickly. By the end of the year, we will propose changes to TILA rules to address concerns about mortgage loan advertisements and solicitations they may be incomplete or misleading and to require lenders to provide mortgage disclosures more quickly so that consumers can get the information they need when it is most useful to them. We already have improved a disclosure that creditors must provide to every applicant for an adjustable rate mortgage product to explain that better the features and risks of these products such as ``payment shock'' and rising loan balances. We are certainly aware, however, that disclosure alone may not be sufficient to protect consumers. Accordingly, we plan to exercise our authority under the Home Ownership and Equity Protection Act, HOEPA, to address specific practices that are unfair or deceptive. We held a public hearing on June 14 to discuss industry practices including those pertaining to prepayment penalties, the use of escrow accounts for taxes and insurance, stated income and low documentation lending, and the evaluation of a borrower's ability to repay. The discussion and ideas we heard were extremely useful and we look forward to receiving additional public comments in coming weeks. Based on the information we are gathering, I expect the Board will propose additional rules under HOEPA later this year. In coordination with the other Federal supervisory agencies, last year we issued principles-based guidance for nontraditional mortgages, and in June of this year we issued supervisory guidance on subprime lending. These statements emphasized the fundamental consumer protection principles of sound underwriting and effective disclosures. In addition, we reviewed our policies related to the examination of nonbank subsidiaries of bank and financial holding companies for compliance with consumer protection laws and guidance. As a result of that review and following discussions of the Office of Thrift Supervision, the Federal Trade Commission, and State regulators as represented by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators, we are launching a cooperative pilot aimed at expanding consumer protection compliance reviews at selected nondepository lenders with significant subprime mortgage operations. The reviews will begin in the fourth quarter of this year and will include independent state-licensed mortgage lenders, nondepository mortgage lending subsidies of bank and thrift holding companies, and mortgage brokers doing business with or serving as agents of these entities. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examination of and improved enforcement for nondepository mortgage lenders. Working together to address jurisdictional issues and to improve information sharing among agencies, we will seek to prevent abusive and fraudulent lending while ensuring that consumers retain access to beneficial credit. I believe that the actions I have described today will help address the current problems. The Federal Reserve looks forward to working with Congress on these important issues. Thank you. " FOMC20070321meeting--57 55,CHAIRMAN BERNANKE., Thank you very much. Are there questions? President Poole. FOMC20070321meeting--276 274,CHAIRMAN BERNANKE., Thank you. President Poole has a comment. FOMC20071206confcall--94 92,CHAIRMAN BERNANKE.," Thank you. President Poole, did you have another comment?" FOMC20060131meeting--105 103,CHAIRMAN GREENSPAN.," “How to Be a Joyous Central Banker, Even Though We Don’t Have Hearts.” [Laughter] Can we end the speculation on the title? [Laughter] Thanks very much, Bill. President Stern." FOMC20070131meeting--295 293,MR. POOLE., My question had to do with the coordination between the statement and the minutes—whether we’re going to indicate clearly in the minutes the sense around the table about that tightening. My sense was that we viewed tightening later in the year as more probable than we did certainly in December. That’s all I’m asking about. CHRG-111hhrg51585--86 Mr. Hullinghorst," Yes. Boulder County invested through a State pool. The State pool purchased the Lehman commercial paper, roughly 5 months before the bankruptcy. It was a 6-month paper. It was basically due to mature and pay within the week after bankruptcy. When it was purchased by the pool, it was a 1P1 paper, which is as good as you can get. And the underlying credit of Lehman Brothers at that time was A or AA. So it was an extremely safe investment in a pooled investment. Now, I can tell you from experience that if you don't have pooled investments around the country, and there are a total of 151 of them authorized and regulated in 45 different States and they invest over $200 billion--probably closer to $300 billion before the Lehman Brothers bankruptcy--if you don't provide an avenue for liquidity in these State pools, they will probably cease to exist. At least one of the things that is certain, they will never buy anymore commercial paper, and that will not help. The commercial paper market is so incredibly important to this country because, thanks to people in the Wharton School and whatever, that is the avenue that corporations are using to provide their working capital. And the bankruptcy of Lehman, the reason it is so critical is it cut the heart out of the commercial paper market. So your providing this support to us is one indication that the government understands how important this market is. Mr. Moore of Kansas. Mr. Street? " FOMC20070131meeting--33 31,CHAIRMAN BERNANKE., Thank you. Are there questions for Bill? President Poole. FOMC20060920meeting--10 8,CHAIRMAN BERNANKE., Thank you. Are there any questions for Dino? President Poole. FOMC20080130meeting--16 14,CHAIRMAN BERNANKE.," Thank you, Bill. Are there questions? President Poole. " FOMC20080121confcall--36 34,CHAIRMAN BERNANKE.," Thank you. President Poole, did you want to intervene? " CHRG-111hhrg48868--603 Mr. Lynch," Page 10 of the agreement. It says, ``The effect''--the subheading is, ``The effect of mark-to-market losses on the bonus pool.'' This is again a protection for the bonus pool for the employees. It says: ``The bonus pool of any compensation year beginning with 2008 compensation year will not be effected by the incurrence of any mark-to-market losses or gains or impairment changes arising from the CDO portfolio.'' This is the credit default swaps. This is the underlying--these are the underlying assets. So what you have done here is basically you have reserved the bonus pool for the employees, and not only have you done that in this agreement, but you have basically protected yourself, immunized yourself from the stupidest decisions made by AIG, which earlier in the testimony has been admitted to that it was the credit default swaps that were really--you know, by the Financial Products Division--that really brought this company down to where it is right now. And what you have done here in this agreement is basically you have immunized your own bonuses from that stupid decision. In other words, the bonus pool will not be affected by the CDOs and the credit default swaps that you were all worried about. And this agreement was written in 2007. This is similar--this is like the captain and the crew of the ship reserving the lifeboats saying, ``To hell with the passengers. We're going to take the lifeboats for ourselves.'' That is what happened here. This is a violation of fiduciary duty. When you cordon yourself off and protect yourself, as the managers of this company and as the people running the ship, and you say, well, we're going down, so we're going to make an agreement where we're not affected by the bad decisions we make. We're going to pass that all on to the investor and the shareholder. That amounts to malfeasance. Not just nonfeasance, but that's a complete violation of trust in the people who invested in your company. This should not have happened, and I honestly believe this is reversible. This is so outrageous that you would say we're not going to be victims of our own stupid decisions. We're not going to take the heat for this on the CDOs and the credit default swaps. That is simply unbelievable. It's arrogance. And I think it's probably illegal. And I agree with Chairman Frank that we should probably try to challenge this as shareholders on behalf of the American people as well. Do you have anything to say for yourself? " CHRG-111shrg52619--182 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM JOHN C. DUGANQ.1. It is clear that our current regulatory structure is in need of reform. At my subcommittee hearing on risk management, March 18, 2009, GAO pointed out that regulators often did not move swiftly enough to address problems they had identified in the risk management systems of large, complex financial institutions. My questions may be difficult, but please answer the following: If this lack of action is a persistent problem among the regulators, to what extent will changing the structure of our regulatory system really get at the issue? Along with changing the regulatory structure, how can Congress best ensure that regulators have clear responsibilities and authorities, and that they are accountable for exercising them ``effectively and aggressively''?A.1. As was discussed in Senior Deputy Comptroller Long's March 18th testimony before the Subcommittee on Securities, Insurance, and Investment, looking back on the events of the past two years, there are clearly things we may have done differently or sooner, but I do not believe our supervisory record indicates that there was a ``lack of action'' by the OCC. For example, we began alerting national banks to our concerns about increasingly liberal underwriting practices in certain loan products as early as 2003. Over the next few years, we progressively increased our scrutiny and responses, especially with regard to credit cards, residential mortgages, and commercial real estate loans even though the underlying ``fundamentals'' for these products and market segments were still robust. Throughout this period, our examiners were diligent in identifying risks and directing banks to take corrective action. Nonetheless, we and the industry initially underestimated the magnitude and severity of the disruptions that we have subsequently seen in the market and the rapidity at which these disruptions spilled over into the overall economy. In this regard, we concur with the GAO that regulators and large, complex banking institutions need to develop better stress test mechanisms that evaluate risks across the entire firm and that identify interconnected risks and potential tail events. We also agree that more transparency and capital is needed for certain off-balance sheet conduits and products that can amplify a bank's risk exposure. While changes to our regulatory system are warranted--especially in the area of systemic risk--I do not believe that fundamental changes are required to the structure for conducting banking supervision.Q.2. How do we overcome the problem that in the boom times no one wants to be the one stepping in to tell firms they have to limit their concentrations of risk or not trade certain risky products? What thought has been put into overcoming this problem for regulators overseeing the firms? Is this an issue that can be addressed through regulatory restructure efforts?A.2. A key issue for bankers and supervisors is determining when the accumulation of risks either within an individual firm or across the system has become too high, such that corrective or mitigating actions are needed. Knowing when and how to strike this balance is one of the most difficult jobs that supervisors face. Taking action too quickly can constrain economic growth and impede access to credit by credit-worthy borrowers. Waiting too long can result in an overhang of risk becoming embedded into banks that can lead to failure and, in the marketplace, that can lead to the types of dislocations we have seen over the past year. This need to balance supervisory actions, I believe, is fundamental to bank supervision and is not an issue that can be addressed through regulatory restructure--the same issue will face whatever entity or agency is ultimately charged with supervision. There are, however, actions that I believe we can and should take to help dampen some of the effects of business and economic cycles. First, as previously noted, I believe we need to insist that large institutions establish more rigorous and comprehensive stress tests that can identify risks that may be accumulating across various business and product lines. As we have seen, some senior bank managers thought they had avoided exposure to subprime residential mortgages by deliberately choosing not to originate such loans in the bank, only to find out after the fact that their investment banks affiliates had purchased subprime loans elsewhere. For smaller, community banks, we need to develop better screening mechanisms that we can use to help identify banks that are building up concentrations in a particular product line and where mitigating actions may be necessary. We have been doing just that for our smaller banks that may have significant commercial real estate exposures. We also need to ensure that banks have the ability to strengthen their loan loss reserves at an appropriate time in the credit cycle, as their potential future loans losses are increasing. A more forward-looking ``life of the loan'' or ``expected loss'' concept would allow provisions to incorporate losses expected over a more realistic time horizon, and would not be limited to losses incurred as of the balance sheet date, as under the current regime. Such a revision would help to dampen the decidedly pro-cyclical effect that the current rules are having today. This is an issue that I am actively engaged in through my role as Chairman of the Financial Stability Board's Working Group on Provisioning. Similarly, the Basel Committee on Bank Supervision recently announced an initiative to introduce standards that would promote the build up of capital buffers that can be drawn upon in periods of stress. Such a measure could also potentially serve as a buffer or governor to the build up of risk concentrations. There are additional measures we could consider, such as establishing absolute limits on the concentration a bank could have to a particular industry or market segment, similar to the loan limits we currently have for loans to an individual borrower. The benefits of such actions would need to be carefully weighed against the potential costs this may impose. For example, such a regime could result in a de facto regulatory allocation of credit away from various industries or markets. Such limits could also have a disproportionate affect on smaller, community banks whose portfolios by their very nature, tend to be concentrated in their local communities and, often, particular market segments such as commercial real estate.Q.3. As Mr. Tarullo and Mrs. Bair noted in their testimony, some financial institution failures emanated from institutions that were under federal regulation. While I agree that we need additional oversight over and information on unregulated financial institutions, I think we need to understand why so many regulated firms failed. Why is it the case that so many regulated entities failed, and many still remain struggling, if our regulators in fact stand as a safety net to rein in dangerous amounts of risk-taking?A.3. As alluded to in Governor Tarullo and Chairman Bair's testimonies, most of the prominent failures that have occurred and contributed to the current market disruption primarily involved systemically important firms that were not affiliated with an insured bank and were thus not overseen by the Federal Reserve or subject to the provisions of the Bank Holding Company Act. Although portions of these firms may have been subject to some form of oversight, they generally were not subject to the type or scope of consolidated supervision applied to banks and bank holding companies. Nonetheless, large national banking companies clearly have not been immune to the problems we have seen over the past eighteen months and several have needed active supervisory intervention or the assistance of the capital and funding programs instituted by the U.S. Treasury, Federal Reserve, and FDIC. As I noted in my previous answer, prior to the recent market disruptions our examiners had been identifying risks and risk management practices that needed corrective action and were working with bank management teams to ensure that such actions were being implemented. We were also directing our large banks to shore up their capital levels and during the eight month period from October 2007 through early June 2008, the largest national banking companies increased their capital and debt levels through public and private offerings by over $100 billion. I firmly believe that our actions that resulted in banks strengthening their underwriting standards, increasing their capital and reserves, and shoring up their liquidity were instrumental to the resilience that the national banking system as whole has shown during this period of unprecedented disruption in bank funding markets and significant credit losses. Indeed several of the largest national banks have served as a source of strength to the financial system by acquiring significant problem thrift institutions (i.e., Countrywide and Washington Mutual) and broker-dealer operations (i.e., Bear Stearns and Merrill Lynch). In addition, we worked to successfully resolve via acquisition by other national banks, two large national banks--National City and Wachovia--that faced severe funding pressures in the latter part of 2008. While both of these banks had adequate capital levels, they were unable to roll over their short term liabilities in the marketplace at a time when market perception and sentiment for many banking companies were under siege. Due to these funding pressures, both banks had to be taken over by companies with stronger capital and funding bases. As the breadth and depth of credit problems accelerated in late 2008, two other large banking companies, Citigroup and Bank of America, required additional financial assistance through Treasury's Asset Guarantee and Targeted Investment programs to help stabilize their financial condition. As part of the broader Supervisory Capital Assessment Program that the OCC, Federal Reserve, and FDIC recently conducted on the largest recipients of funds under the Treasury's Troubled Assets Relief Program, we are closely monitoring the adequacy of these firms' capital levels to withstand further adverse economic conditions and will be requiring them to submit capital plans to ensure that they have sufficient capital to weather such conditions. In almost all cases, our large national banking organizations are on track to meet any identified capital needs and have been able to raise private capital through the marketplace, a sign that investor confidence may be returning to these institutions. While the vast majority of national banks remain sound, many national banks will continue to face substantial credit losses as credit problems work through the banking system. In addition, until the capital and securitization markets are more fully restored, larger banks will continue to face potential liquidity pressures and funding constraints. As I have stated in previous testimonies, we do expect that the number of problem banks and bank failures will continue to increase for some time given current economic conditions. In problem bank situations, our efforts focus on developing a specific plan that takes into consideration the ability and willingness of management and the board to correct deficiencies in a timely manner and return the bank to a safe and sound condition. In most instances our efforts, coupled with the commitment of bank management, result in a successful rehabilitation of the bank. There will be cases, however, where the situation is of such significance that we will require the sale, merger, or liquidation of the bank, if possible. Where that is not possible, we will appoint the FDIC as receiver.Q.4. While we know that certain hedge funds, for example, have failed, have any of them contributed to systemic risk?A.4. The failure of certain hedge funds, while not by themselves systemically important (in contrast to the failure of Long Term Capital Management in 1998), led to a reduction in market liquidity as leveraged investors accelerated efforts to reduce exposures by selling assets. Given significant uncertainty over asset values, reflecting sharply reduced market liquidity, this unwinding of leveraged positions has put additional strains on the financial system and contributed to lack of investor confidence in the markets.Q.5. Given that some of the federal banking regulators have examiners on-site at banks, how did they not identify some of these problems we are facing today?A.5. At the outset, it is important to be clear that bank examiners do not have authority over the nonbank companies in a holding company. These nonbank firms were the source of many of the issues confronting large banking firms. With respect to banks, as noted above, we were identifying issues and taking actions to address problems that we were seeing in loan underwriting standards and other areas. At individual banks, we were directing banks to strengthen risk management and corporate governance practices and, at some institutions, were effecting changes in key managerial positions. Nonetheless, in retrospect, it is clear that we should have been more aggressive in addressing some of the practices and risks that were building up across the banking system during this period. For example, it is clear that we and many bank managers put too much reliance on the various credit enhancements used to support certain collateralized debt obligations and not enough emphasis on the quality of, and correlations across, the underlying assets supporting those obligations. Similarly, we were not sufficiently attuned to the systemic risk implications of the significant migration by large banks to an ``originate-to-distribute model'' for commercial and leveraged loan products. Under this model, banks originated a significant volume of loans with the express purpose of packaging and selling them to institutional investors who generally were willing to accept more liberal underwriting standards than the banks themselves would accept, in return for marginally higher yields. In the fall of 2007, when the risk appetite of investors changed dramatically (and at times for reasons not directly related to the exposures they held), banks were left with significant pipelines of loans that they needed to fund, thus exacerbating their funding and capital pressures. As has been well-documented, similar pressures were leading to relaxation of underwriting standards within the residential mortgage loan markets. While the preponderance of the subprime and ``Alt-A'' loans that have been most problematic were originated outside of the national banking system, the subsequent downward spiral in housing prices that these practices triggered have clearly affected all financial institutions, including national banks. ------ CHRG-111hhrg48868--349 The Chairman," I thank you, Mr. Chairman. Given your method of dealing with this, I assume it's a good thing no one was wearing a tee-shirt with a slogan. [laughter] Let me begin by repeating what Mr. Geithner has said and others. Mr. Liddy is in no way responsible for these bonuses having been agreed to. He, as a public service, agreed to come in, and inherited a situation. I disagree with some of the ways in which he has handled it, but there ought to be a clear distinction between people who had a responsibility for creating this situation and those given the responsibility for handling it, who may differ with us. And frankly, on some of those signs talking about jail with regard to imbecility, they were entirely inappropriate and not, it seems to me, seemly for people who believe in civil liberties and fairness to incorrectly suggest that there was any criminality on the part of this witness. Now having said that, I do want to say, as I have said several times, that I think the time has come to make some changes, and indeed I think the time has come for the Federal Government to assert greater ownership rights. That is in part motivated by what I would think was a stronger legal position. If we sued against these bonuses as the owner, charging that there had not been adequate performance to justify the bonuses, as opposed to as a regulator, I think many, myself included, would have more comfort with the Federal Government as a party in interest as the actual owner, saying, ``We are exercising ownership rights not to have paid out bonuses,'' when there was a poor performance, than for the Federal Government to interfere with an existing third-party contract. I also have said that I thought there should be some people removed, and I was not talking about Mr. Liddy, and I may not have been as clear about that. I am very critical of the people who put these contracts in place. As I read earlier from the contract, there is a pool of money to be distributed, and then it says: But losses are to be subtracted from that, but the losses that could be subtracted toward a cap by $65 million. Let me just ask you, Mr. Liddy, is it possible under the way these contracts were written, that you inherited, that the company as a whole could have lost money but there still would have been a bonus pool to distribute to the employees? " CHRG-110hhrg38392--11 Mr. Bernanke," I will do my opening statement. Thank you. Chairman Frank, Ranking Member Bachus, and members of the committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. As you know, this occasion marks the 30th year of semiannual testimony on the economy and monetary policy for the Federal Reserve. In establishing these hearings--Mr. Hawkins and Mr. Humphrey were mentioned--the Congress proved prescient in anticipating the worldwide trend toward greater transparency and accountability of central banks in making monetary policy. Over the years, these testimonies and the associated reports have proved an invaluable vehicle for the Federal Reserve's communication with the public about monetary policy, even as they have served to enhance the Federal Reserve's accountability for achieving the dual objectives of maximum employment and price stability set forth by the Congress. I take this opportunity to reiterate the Federal Reserve's strong support of the dual mandate. In pursuing maximum employment and price stability, monetary policy makes its greatest possible contribution to the general economic welfare. Let me now review the current economic situation and the outlook beginning with developments in the real economy and the situation regarding inflation before turning to monetary policy. I will conclude with comments on issues related to lending to households and consumer protection, topics not normally addressed in monetary policy testimony, but in light of recent developments deserving of our attention today. After having run at an above-trend rate earlier in the current economic recovery, U.S. economic growth has proceeded during the past year at a pace more consistent with sustainable expansion. Despite the downshift in growth, the demand for labor has remained solid with more than 850,000 jobs being added to payrolls thus far in 2007 and the unemployment rate having remained at 4\1/2\ percent. The combination of moderate gains in output and solid advances in employment implies that recent increases in labor productivity have been modest by the standards of the last decade. The cooling of productivity growth in recent quarters is likely the result of cyclical or other temporary factors, but the underlying pace of productivity gains may also have slowed somewhat. To a considerable degree, the slower pace of economic growth in recent quarters reflects the ongoing adjustment in the housing sector. Over the past year, home sales in construction have slowed substantially and house prices have decelerated. Although a leveling off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders' inventories to rise further relative to the pace of new home sales. Accordingly, construction of new homes has sunk further, with starts of new single family houses thus far this year running 10 percent below the pace in the second half of last year. The pace of home sales seems likely to remain sluggish for a time, partly as a result of some tightening and lending standards and the recent increase in mortgage interest rates. Sales should ultimately be supported by growth in income and employment, as well as by mortgage rates that--despite the recent increase--remain fairly low relative to historical norms. However, even if demand stabilizes as we expect, the pace of construction will probably fall somewhat further as builders work down the stocks of unsold new homes. Thus, declines in residential construction will likely continue to weigh on economic growth over coming quarters, although the magnitude of the drag on growth should diminish over time. Real consumption expenditures appear to have slowed last quarter following two quarters of rapid expansion. Consumption outlays are likely to continue growing at a moderate pace, aided by a strong labor market. Employment should continue to expand, though possibly at a somewhat slower pace than in recent years as a result of the recent moderation in the growth of output and ongoing demographic shifts that are expected to lead to a gradual decline in labor force participation. Real compensation appears to have risen over the past year, and barring further sharp increases in consumer energy costs, it should rise further as labor demand remains strong and productivity increases. In the business sector, investment in equipment and software showed a modest gain in the first quarter. A similar outcome is likely for the second quarter, as weakness in the volatile transportation equipment category appears to have been offset by solid gains in other categories. Investment in nonresidential structures, after slowing sharply late last year, seems to have grown fairly vigorously in the first half of 2007. Like consumption spending, business fixed investment overall seems poised to rise at a moderate pace, bolstered by gains in sales and generally favorable financial conditions. Late last year and early this year, motor vehicle manufacturers and firms in several other industries found themselves with elevated inventories, which led them to reduce production to better align inventories with sales. Excess inventories now appear to have been substantially eliminated and should not prove a further restraint on growth. The global economy continues to be strong. Supported by solid economic growth abroad, U.S. exports should expand further in coming quarters. Nonetheless our trade deficit, which was about 5\1/4\ percent of nominal gross domestic product in the first quarter, is likely to remain high. For the most part, financial markets have remained supportive of economic growth. However, conditions in the subprime mortgage sector have deteriorated significantly reflecting mounting delinquency rates on adjustment rate loans. In recent weeks, we have also seen increased concerns among investors about credit risk on some other types of financial instruments. Credit spreads on lower quality corporate debt have widened somewhat and terms for some leveraged business loans have tightened. Even after their recent rise, however, credit spreads remain near the low end of their historical ranges and financing activity in the bond and business loan markets has remained fairly brisk. Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007 with growth then strengthening a bit in 2008 to a rate close to the economy's underlying trend. Such an assessment was made around the time of the June meeting of the Federal Market Committee by the members of the Board of Governors and the presidents of the Reserve Banks, all of whom participate in deliberations on monetary policy. The central tendency of the growth forecast, which are conditioned on the assumption of appropriate monetary policy, is for real GDP to expand roughly 2\1/4\ to 2\1/2\ percent this year and 2\1/2\ to 2\3/4\ percent in 2008. The forecasted performance for this year is about \1/4\ percentage point below that projected in February, the difference being largely a result of weaker than expected residential construction activity this year. The unemployment rate is anticipated to edge up between 4\1/2\ and 4\3/4\ percent over the balance of this year and about 4\3/4\ percent in 2008, a trajectory about the same as the one expected in February. I turn now to the inflation situation. Sizable increases in food and energy prices have boosted overall inflation and eroded real incomes in recent months, both unwelcome developments. As measured by changes in the price index for personal consumption expenditures (PCE inflation), inflation ran at an annual rate of 4.4 percent over the first 5 months of this year, a rate that, if maintained, would clearly be inconsistent with the objective of price stability. Because monetary policy works with a lag, however, policymakers must focus on the economic outlook. Food and energy prices tend to be quite volatile, so that, looking forward, core inflation (which excludes food and energy prices) may be a better gauge than overall inflation of underlying inflation trends. Core inflation has moderated slightly over the past few months, with core PCE inflation coming in at an annual rate of about 2 percent so far this year. Although the most recent readings on core inflation have been favorable, month-to-month movements in inflation are subject to considerable noise, and some of the recent improvement could also be the result of transitory influences. However, with long-term inflation expectations contained, futures prices suggesting that investors expect energy and other commodity prices to flatten out, and pressures in both labor and product markets likely to ease modestly, core inflation should edge a bit lower, on net, over the remainder of this year and next year. The central tendency of FOMC participants' forecast for core PCE inflation--2 to 2\1/4\ percent for 2007 and 1\3/4\ to 2 percent in 2008--is unchanged from February. If energy prices level off as currently anticipated, overall inflation should slow to a pace close to that of core inflation in coming quarters. At each of its four meetings so far this year, the FOMC has maintained its target for the Federal funds rate at 5\1/4\ percent, judging that the existing stance of policy was likely to be consistent with growth running near trend and inflation staying on a moderating path. As always, in determining the appropriate stance of policy, we will be alert to the possibility that the economy is not evolving in the way we currently judge to be the most likely. One risk to the outlook is that the ongoing housing correction might prove larger than anticipated with possible spillovers onto consumer spending. Alternatively, consumer spending, which has advanced relatively vigorously, on balance, in recent quarters, might expand more quickly than expected; in that case, economic growth could rebound to a pace above its trend. With the level of resource utilization already elevated, the resulting pressures in labor and product markets could lead to increased inflation over time. Yet another risk is that energy and commodity prices could continue to rise sharply leading to further increases in headline inflation, and if those costs pass through to the prices of nonenergy goods and services, to higher core inflation as well. Moreover, if inflation were to move higher for an extended period and the increase became embedded in longer-term inflation expectations, the reestablishment of price stability would become more difficult and costly to achieve. With the level of resource utilization relatively high and with the sustained moderation in inflation pressures yet to be convincingly demonstrated, the FOMC has consistently stated that upside risks to inflation are its predominant policy concern. In addition to its dual mandate to promote maximum employment and price stability, the Federal Reserve has an important responsibility to help protect consumers in financial services transactions. For nearly 40 years, the Federal Reserve has been active in implementing, interpreting, and enforcing consumer protection laws. I would like to discuss with you this morning some of our recent initiatives and actions, particularly those related to subprime mortgage lending. Promoting access to credit and to home ownership are important objectives, and responsible subprime mortgage lending can help to advance both goals. In designing regulations, policymakers should seek to preserve those benefits. That said, the recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards, and in some cases, by abusive lending practices and outright fraud. In addition, some households took on mortgage obligations they could not meet, perhaps in some cases because they did not fully understand the terms. Financial losses have subsequently induced lenders to tighten their underwriting standards. Nevertheless, rising delinquencies in foreclosures are creating personal, economic, and social distress for many homeowners and communities, problems that likely will get worse before they get better. The Federal Reserve is responding to these difficulties at both the national and the local levels. In coordination with other Federal supervisory agencies, we are encouraging the financial industry to work with borrowers to arrange prudent loan modifications to avoid unnecessary foreclosures. Federal Reserve banks around the country are cooperating with community and industry groups that work directly with borrowers who are having trouble meeting their mortgage obligations. We continue to work with organizations that provide counseling about mortgage products to current and potential homeowners. We are also meeting with market participants--including lenders, investors, servicers, and community groups--to discuss their concerns and to gain information about market developments. We are conducting a top-to-bottom review of possible actions we might take to help prevent recurrence of these problems. First, we are committed to providing more effective disclosures to help consumers defend against improper lending. Three years ago, the Board began a comprehensive review of Regulation Z, which implements the Truth in Lending Act (TILA). The initial focus of our review was on disclosures related to credit cards and other revolving credit accounts. After conducting extensive consumer testing, we issued a proposal in May that would require credit card issuers to provide clearer and easier-to-understand disclosures to customers. In particular, the new disclosures would highlight applicable rates and fees, particularly penalties that might be imposed. The proposed rules would also require card issuers to provide 45 days' advance notice of a rate increase or any other change in account terms so that consumers will not be surprised by unexpected charges and will have time to explore alternatives. We are now engaged in a similar review of the TILA rules for mortgage loans. We began this review last year by holding four public hearings across the country during which we gathered information on the adequacy of disclosures for mortgages, particularly for nontraditional and adjustable rate products. As we did with credit card lending, we will conduct extensive consumer testing of proposed disclosures. Because the process of designing and testing disclosures involves many trial runs, especially given today's diverse and sometimes complex credit products, it may take some time to complete our review and propose new disclosures. However, some other actions can be implemented more quickly. By the end of this year, we will propose changes to TILA rules to address concerns about mortgage loan advertisements and solicitations that may be incomplete or misleading and to require lenders to provide mortgage disclosures more quickly so that consumers can get the information they need when it is most useful to them. We already have improved a disclosure that creditors must provide to every applicant for an adjustable rate mortgage to explain better the features and risks of these products, such as ``payment shock'' and rising loan balances. We are certainly aware, however, that disclosure alone may not be sufficient to protect consumers. Accordingly, we plan to exercise our authority under the Home Ownership and Equity Protection Act (HOEPA) to address specific practices that are unfair or deceptive. We held a public hearing on June 14th to discuss industry practices, including those pertaining to prepayment penalties, the use of escrow accounts for taxes and insurance, stated income and low documentation lending, and the evaluation of a borrower's ability to repay. The discussion and ideas we heard were extremely useful, and we look forward to receiving additional public comments in coming weeks. Based on the information we are gathering, I expect that the Board will propose additional rules under HOEPA later this year. In coordination with the other Federal supervisory agencies, last year we issued principles-based guidance on nontraditional mortgages, and in June of this year, we issued supervisory guidance on subprime lending. These statements emphasize the fundamental consumer protection principles of sound underwriting and effective disclosures. In addition, we reviewed our policies related to the examination of nonbank subsidiaries of bank and financial holding companies for compliance with consumer protection laws and guidance. As a result of that review, and following discussions with the Office of Thrift Supervision, the Federal Trade Commission, and State regulators, as represented by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators, we are launching a cooperative pilot project aimed at expanding consumer protection compliance reviews at selected nondepository lenders with significant subprime mortgage operation. These reviews will begin in the fourth quarter of this year and will include independent State-licensed mortgage lenders, nondepository mortgage lending subsidiaries of bank and thrift holding companies, and mortgage brokers doing business with or serving as agents of these entities. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations and improved enforcement for nondepository mortgage lenders. Working together to address jurisdictional issues and to improve information sharing among agencies, we will seek to prevent abusive and fraudulent lending while ensuring that consumers retain access to beneficial credit. I believe that the actions I have described today will help address the current problems. The Federal Reserve looks forward to working with the Congress on these important issues. Thank you, Mr. Chairman. [The prepared statement of Chairman Bernanke can be found on page 65 of the appendix.] " FOMC20070321meeting--284 282,MR. MISHKIN., Thank you. [Laughter] FOMC20061212meeting--76 74,MS. YELLEN., Thank you. [Laughter] CHRG-111shrg56376--125 PREPARED STATEMENT OF JOHN E. BOWMAN Acting Director, Office of Thrift Supervision August 4, 2009I. Introduction Good morning, Chairman Dodd, Ranking Member Shelby, and Members of the Committee. Thank you for the opportunity to testify today on the Administration's Proposal for Financial Regulatory Reform. It is my pleasure to address the Committee for the first time in my role as Acting Director of the Office of Thrift Supervision (OTS). We appreciate this Committee's efforts to improve supervision of financial institutions in the United States. We share the Committee's commitment to reforms to prevent any recurrence of our Nation's current financial problems. We have studied the Administration's Proposal for Financial Regulatory Reform and are pleased to address the questions you have asked us about specific aspects of that Proposal. Specifically, you asked for our opinion of the merits of the Administration's Proposal for a National Bank Supervisor and the elimination of the Federal thrift charter. You also requested our opinion on the elimination of the exceptions in the Bank Holding Company Act for thrifts and certain special purpose banks and about the Federal Reserve System's prudential supervision of holding companies.II. Goals of Regulatory Restructuring The recent turmoil in the financial services industry has exposed major regulatory gaps and other significant weaknesses that must be addressed. Our evaluation of the specifics of the Administration's Proposal is predicated on whether or not those elements address the core principles OTS believes arc essential to accomplishing true and lasting reform: 1. Ensure Changes to Financial Regulatory System Address Real Problems--Proposed changes to financial regulatory agencies should be evaluated based on whether they would address the causes of the economic crisis or other true problems. 2. Establish Uniform Regulation--All entities that offer financial products to consumers must be subject to the same consumer protection rules and regulations, so under-regulated entities cannot gain a competitive advantage over their more regulated counterparts. Also, complex derivative products, such as credit default swaps, should be regulated. 3. Create Ability To Supervise and Resolve Systemically Important Firms--No provider of financial products should be too big to fail, achieving through size and complexity an implicit Federal Government backing to prevent its collapse--and thereby gaining an unfair advantage over its more vulnerable competitors. 4. Protect Consumers--One Federal agency should have as its central mission the regulation of financial products and that agency should establish the rules and standards for all consumer financial products rather than the current, multiple number of agencies with fragmented authority and a lack of singular accountability. As a general matter the OTS supports all of the fundamental objectives that are at the heart of the Administration's Proposal. By performing an analysis based on these principles, we offer OTS' views on specific provisions of the Administration's Proposal.III. Administration Proposal To Establish a National Bank Supervisor We do not support the Administration's Proposal to establish a new agency, the National Bank Supervisor (NBS), by eliminating the Office of the Comptroller of the Currency, which charters and regulates national banks, and the OTS, which charters Federal thrifts and regulates thrifts and their holding companies. There is little dispute that the ad hoc framework of financial services regulation cobbled together over the last century-and-a-half is not ideal. The financial services landscape has changed and the economic crisis has revealed gaps in the system that must be addressed to ensure a sustainable recovery and appropriate oversight in the years ahead. We believe other provisions within the Administration's proposal would assist in accomplishing that goal. While different parts of the system were created to respond to the needs of the time, the current system has generally served the Nation well over time, despite economic downturns such as the current one. We must ensure that in the rush to address what went wrong, we do not try to ``fix'' nonexistent problems nor attempt to fix real problems with flawed solutions. I would like to dispel the two rationales that have been alleged to support the proposal to eliminate the OTS: (1) The OTS was the regulator of the purportedly largest insured depository institutions that failed during the current economic turmoil, and, (2) Financial institutions ``shopping'' for the most lenient regulator allegedly flocked to OTS supervision and the thrift charter. Both of those allegations are false. There are four reasons why the first allegation is untrue: First, failures by insured depository institutions have been no more severe among OTS-regulated thrifts than among institutions supervised by other Federal banking regulators. OTS-regulated Washington Mutual, which failed in September 2008 at no cost to the deposit insurance fund, was the largest bank failure in U.S. history because anything larger has been deemed ``too big to fail.'' By law, the Federal Government can provide ``open-bank assistance'' only to prevent a failure. Institutions much larger than Washington Mutual, for example, Citigroup and Bank of America, had collapsed, but the Federal Government prevented their failure by authorizing open bank assistance. The ``too big to fail'' institutions are not regulated by the OTS. The OTS did not regulate the largest banks that failed; the OTS regulated the largest banks that were allowed to fail. Second, in terms of numbers of bank failures during the crisis, most banks that have failed have been State-chartered institutions, whose primary Federal regulator is not the OTS. Third, the OTS regulates financial institutions that historically make mortgages for Americans to buy homes, By law, thrift institutions must keep most of their assets in home mortgages or other retail lending activities, The economic crisis grew out of a sharp downturn in the residential real estate market, including significant and sustained home price depreciation, a protracted decline in home sales and a plunge in rates of real estate investment. To date, this segment of the market has been hardest hit by the crisis and OTS-regulated institutions were particularly affected because their business models focus on this segment. Fourth, the largest failures among OTS-regulated institutions during this crisis concentrated their mortgage lending in California and Florida, two of the States most damaged by the real estate decline, These States have had significant retraction in the real estate market, including double-digit declines in home prices and record rates of foreclosure, \1\ Although today's hindsight is 20/20, no one predicted during the peak of the boom in 2006 that nationwide home prices would plummet by more than 30 percent.--------------------------------------------------------------------------- \1\ See, Office of Thrift Supervision Quarterly Market Monitor, May 7, 2009, (http://files.ots.treas.gov/131020.pdf).--------------------------------------------------------------------------- The argument about regulator shopping, or arbitrage, seems to stem from the conversion of Countrywide, which left the supervision of the OCC and the Board of Governors of the Federal Reserve System (FRB) in March 2007--after the height of the housing and mortgage boom--and came under OTS regulation, Countrywide made most of its high-risk loans through its holding company affiliates before it received a thrift charter. An often-overlooked fact is that a few months earlier, in October 2006, Citibank converted two thrift charters from OTS supervision to the OCC. Those two Citibank charters totaled more than $232 billion--more than twice the asset size of Countrywide ($93 billion)--We strongly believe that Citibank and Countrywide applied to change their charters based on their respective business models and operating strategies. Any suggestion that either company sought to find a more lenient regulatory structure is without merit. In the last 10 years (1999-2008), there were 45 more institutions that converted away from the thrift charter (164) than converted to the thrift charter (119). Of those that converted to the OTS, more than half were State-chartered thrifts (64). In dollar amounts during the same 10-year period, $223 billion in assets converted to the thrift charter from other charter types and $419 billion in assets converted from the thrift charter to other charter types. We disagree with any suggestion that banks converted to the thrift charter because OTS was a more lenient regulator. Institutions chose the charter type that best fits their business model. If regulatory arbitrage is indeed a major issue, it is an issue between a Federal charter and the charters of the 50 States, as well as among the States. Under the Administration's Proposal, the possibility of such arbitrage would continue. The OTS is also concerned that the NBS may tend, particularly in times of stress, to focus most of its attention on the largest institutions, leaving midsize and small institutions in the back seat. It is critical that all regulatory agencies be structured and operated in a manner that ensures the appropriate supervision and regulation of all depository institutions, regardless of size.IV. Administration Proposal To Eliminate the Thrift Charter The OTS does not support the provision in the Administration's Proposal to eliminate the Federal thrift charter and require all Federal thrift institutions to change their charter to the National Bank Charter or State bank. We believe the business models of Federal banks and thrift institutions are fundamentally different enough to warrant two distinct Federal banking charters. It is important to note that elimination of the thrift charter would not have prevented the current mortgage meltdown, nor would it help solve current problems or prevent future crises. Savings associations generally are smaller institutions that have strong ties to their communities. Many thrifts never made subprime or Alt-A mortgages; rather they adhered to traditional, solid underwriting standards. Most thrifts did not participate in the private originate-to-sell model; they prudently underwrote mortgages intending to hold the loans in their own portfolios until the loans matured. Forcing thrifts to convert from thrifts to banks or State chartered savings associations would not only be costly, disruptive, and punitive for thrifts, but could also deprive creditworthy U.S. consumers of the credit they need to become homeowners and the extension of credit this country needs to stimulate the economy. We also strongly support retaining the mutual form of organization for insured institutions. Generally, mutual institutions are weathering the current financial crisis better than their stock competitors. The distress in the housing markets has had a much greater impact on the earnings of stock thrifts than on mutual thrifts over the past year. For the first quarter 2009, mutual thrills reported a return on average assets (ROA) on 0.42 percent, while stock thrifts reported an ROA of 0.04 percent. We see every reason to preserve the mutual institution charter and no compelling rationale to eliminate it. OTS also supports retention of the dual banking system with both Federal and State charters for banks and thrifts. This system has served the financial markets in the United States well. The States have provided a charter option for banks and thrifts that have not wanted to have a Federal charter. Banks and thrifts should be able to choose whether to operate with a Federal charter or a State charter.V. Administration Proposal To Eliminate the Exceptions in the Bank Holding Company Act for Thrifts and Special Purpose BanksA. Elimination of the Exception in the Bank Holding Company Act for Thrifts Because a thrill is not considered a ``bank'' under the Bank Holding Company Act of 1956 (BHCA), \2\ the FRB does not regulate entities that own or control only savings associations. However, the OTS supervises and regulates such entities pursuant to the Home Owners Loan Act (HOLA).--------------------------------------------------------------------------- \2\ 12 U.S.C. 1841(c)(2)(B) and (j).--------------------------------------------------------------------------- As part of the recommendation to eliminate the Federal thrift charter, the Administration Proposal would also eliminate the savings and loan holding company (SLHC). The Administration's draft legislation repeals section 10 of the HOLA, concerning the regulation of SLHCs and also eliminates the thrift exemption from the definition of ``bank'' under the BHCA. A SLHC would become a bank holding company (BHC) by operation of law and would be required to register with the FRB as a BHC within 90 days of enactment of the act. Notably, these provisions also apply to the unitary SLHCs that were explicitly permitted to continue engaging in commercial activities under the Gramm-Leach-Bliley Act of 1999. \3\ Such an entity would either have to divest itself of the thrift or divest itself of other subsidiaries or affiliates to ensure that its activities are ``financial in nature.'' \4\--------------------------------------------------------------------------- \3\ 12 U.S.C. 1467a(c)(9)(C). \4\ 12 U.S.C. 1843(k).--------------------------------------------------------------------------- The Administration justifies the elimination of SLHCs, by arguing that the separate regulation and supervision of bank and savings and loan holding companies has created ``arbitrage opportunities.'' The Administration contends that the intensity of supervision has been greater for BHCs than SLHCs. Our view on this matter is guided by our key principles, one of which is to ensure that changes to the financial regulatory system address real problems. We oppose this provision because it does not address a real problem. As is the case with the regulation of thrift institutions, OTS does not believe that entities became SLHCs because OTS was perceived to be a more lenient regulator. Instead, these choices were guided by the business model of the entity. The suggestion that the OTS does not impose capital requirements on SLHCs is not correct. Although the capital requirements for SLHCs are not contained in OTS regulations, savings and loan holding company capital adequacy is determined on a case-by-case basis for each holding company based on the overall risk profile of the organization. In its review of a SLHCs capital adequacy, the OTS considers the risk inherent in an enterprise's activities and the ability of capital to absorb unanticipated losses, support the level and composition of the parent company's and subsidiaries' debt, and support business plans and strategies. On average SLHCs hold more capital than BHCs. The OTS conducted an internal study comparing SLHC capital levels to BHC capital levels. In this study. OTS staff developed a Tier 1 leverage proxy and conducted an extensive review of industry capital levels to assess the overall condition of holding companies in the thrift industry. We measured capital by both the Equity/Assets ratio and a Tier 1 Leverage proxy ratio. Based on peer group averages, capital levels (as measured by both the Equity/Assets ratio and a Tier 1 Leverage proxy ratio) at SLHCs were higher than BHCs, prior to the infusion of Troubled Asset Relief Program funds, in every peer group category. The consistency in results between both ratios lends credence to the overall conclusion, despite any differences that might result from use of a proxy formula. As this study shows, the facts do not support the claim that the OTS docs not impose adequate capital requirements on SLHCs. The proposal to eliminate the SLHC exception from the BHCA is based on this and other misperceptions. Moreover, in our view the measure penalizes the SLHCs and thrifts that maintained solid underwriting standards and were not responsible for the current financial crisis. The measure is especially punitive to the unitary SLHCs that will be forced to divest themselves of their thrift or other subsidiaries. We believe SLHCs should be maintained and that the OTS should continue to regulate SLHCs, except in the case of a SLHC that would be deemed to be a Tier 1 Financial Holding Company. These entities should be regulated by the systemic risk regulator.B. Elimination of the Exception in the Bank Holding Company Act for Special Purpose Banks The Administration Proposal would also eliminate the BHCA exceptions for a number of special purpose banks, such as industrial loan companies, credit card banks, [rust companies, and the so-called ``nonbank banks'' grandfathered under the Competitive Equality Banking Act of 1987. Neither the FRB nor OTS regulates the entities that own or control these special purpose banks, unless they also own or control a bank or thrill. As is the case with unitary SLHCs, the Administration Proposal would force these entities to divest themselves of either their special purpose bank or other entities. The Administration's rationale for the provision is to close all the so-called ``loopholes'' under the BHCA and to treat all entities that own or control any type of a bank equally. Once again our opinion on this aspect of the Administration Proposal is guided by the key principle of ensuring that changes to the financial regulatory system address real problems that caused the crisis. There are many causes of the financial crisis, but the inability of the FRB to regulate these entities is not one of them. Accordingly, we do not support this provision. Forcing companies that own special purpose banks to divest one or more of their subsidiaries is unnecessary and punitive. Moreover, it does not address a problem that caused the crisis or weakens the financial system.VI. Prudential Supervision of Holding CompaniesA. In General The Administration's Proposal would provide for the consolidated supervision and regulation of any systemically important financial firm (Tier 1 FHC) regardless of whether the firm owns an insured depository institution. The authority to supervise and regulate Tier 1 FHCs would be vested in the FRB. The FRB would be authorized to designate Tier 1 FHCs if it determines that material financial distress at the company could pose a threat, globally or in the United States, to financial stability or the economy during times of economic stress. \5\ The FRB, in consultation with Treasury, would issue rules to guide the identification Tier 1 FHCs. Tier 1 FHCs would be subjected to stricter and more conservative prudential standards than those that apply to other BHCs, including higher standards on capital, liquidity, and risk management. Tier 1 FHCs would also be subject to Prompt Corrective Action.--------------------------------------------------------------------------- \5\ The FRB would be required to base its determination on the following criteria: (i) the amount and nature of the company's financial assets; (ii) the amount and types of the company's liabilities, including the degree of reliance on short-term funding; (iii) the extent of the company's off-balance sheet exposures; (iv) the extent of the company's transactions and relationships with other major financial companies: (v) the company's importance as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the financial system; (vi) the recommendation, if any, of the Financial Services Oversight Council; and (vii) any other factors that the Board deems appropriate. Title II, Section 204. Administration Draft Legislation. http://www.financialstability.gov/docs/regulatoryreform/07222009/titleII.pdf.--------------------------------------------------------------------------- The Proposal also calls for the creation of a Financial Services Oversight Council (Council) made up of the Secretary of the Treasury and all of the Federal financial regulators. Among other responsibilities, the Council would make recommendations to the FRB concerning institutions that should be designated as Tier 1 FHCs. Also, the FRB would consult the Council in setting material prudential standards for Tier 1 FHCs and in setting risk management standards for systemically important systems and activities regarding payment, clearing and settlement. The Administration's Proposal provides a regime to resolve Tier 1 FHCs when the stability of the financial system is threatened. The resolution authority would supplement and be modeled on the existing resolution regime for insured depository institutions under the Federal Deposit Insurance Act. The Secretary of the Treasury could invoke the resolution authority only after consulting with the President and upon the written recommendation of two-thirds of the members of the FRB, and the FDIC or SEC as appropriate. The Secretary would have the ability to appoint a receiver or conservator for the tailing firm. In general, that role would be filled by the FDIC, though the SEC could be appointed in certain cases. In order to fund this resolution regime, the FDIC would be authorized to impose risk-based assessments on Tier 1 FHCs. OTS's views on these aspects of the Administration Proposal is guided by our key principle that any financial reform package should create the ability to supervise and resolve all systemically important financial firms. The U.S. economy operates on the principle of healthy competition. Enterprises that are strong, industrious, well-managed and efficient succeed and prosper. Those that fall short of the mark struggle or fail and other, stronger enterprises take their places. Enterprises that become ``too big to fail'' subvert the system when the Government is forced to prop up failing, systemically important companies in essence, supporting poor performance and creating a ``moral hazard.'' The OTS supports this aspect of the Proposal and agrees that there is a pressing need for a systemic risk regulator with broad authority to monitor and exercise supervision over any company whose actions or failure could pose unacceptable risk to financial stability. The systemic risk regulator should have the ability and the responsibility for monitoring all data about markets and companies, including, but not limited to, companies involved in banking, securities, and insurance. We also support the establishment of a strong and effective Council. Each of the financial regulators would provide valuable insight and experience to the systemic risk regulator. We also strongly support the provision providing a resolution regime for all Tier 1 FHCs. Given the events of recent years, it is essential that the Federal Government have the authority and the resources to act as a conservator or receiver and to provide an orderly resolution of systemically important institutions, whether banks, thrifts, bank holding companies or other financial companies. The authority to resolve a distressed Tier 1 FHC in an orderly manner would ensure that no bank or financial firm is ``too big to fail.'' A lesson learned from recent events is that the failure or unwinding of systemically important companies has a far reaching impact on the economy, not just on financial services. The continued ability of banks, thrifts, and other entities in the United States to compete in today's global financial services marketplace is critical. The systemic risk regulator should be charged with coordinating the supervision of conglomerates that have international operations. Safety and soundness standards, including capital adequacy and other factors, should be as comparable as possible for entities that have multinational businesses,B. Role of the Prudential Supervisor in Relation to the Systemic Risk Regulator You have asked for our views on what we consider to be the appropriate role of the prudential supervisor in relation to the systemic risk regulator. In other words, what is the proper delineation of responsibilities between the agencies? Generally, we believe that for systemically important institutions, the systemic risk regulator should supplement, not supplant, the primary Federal bank supervisor. In most cases the work of the systemic regulator and the prudential regulator will complement one another, with the prudential regulator focused on the safety and soundness of the depository institution and the systemic regulator focused more broadly on financial stability globally or in the United States. One provision in the Proposal provides the systemic risk regulator with authority to establish, examine, and enforce more stringent standards for subsidiaries of Tier 1 FHCs--including depository institution subsidiaries--to mitigate systemic risk posed by those subsidiaries. If the systemic risk regulator issues a regulation, it must consult with the prudential regulator. In the case of an order, the systemic regulator must: (1) have reasonable cause to believe that the functionally regulated subsidiary is engaged in conduct, activities, transactions, or arrangements that could pose a threat to financial stability or the economy globally or in the United States; (2) notify the prudential regulator of its belief, in writing, with supporting documentation included and with a recommendation that the prudential regulator take supervisory action against the subsidiary; and (3) not been notified in writing by the prudential regulator of the commencement of a supervisory action, as recommended, within 30 days of the notification by the systemic regulator. We have some concerns with this provision in that it supplants the prudential regulator's authority over depository institution subsidiaries of systemically significant companies. On balance, however, we believe such a provision is necessary to ensure financial stability. We recommend that the provision include a requirement that before making any determination, the systemic regulator consider the effects of any contemplated action on the Deposit Insurance Fund and the United States taxpayers.C. Regulation of Thrifts and Holding Companies on a Consolidated Basis You have asked for OTS's views on whether a holding company regulator should be distinct from the prudential regulator or whether a consolidated prudential bank supervisor could also regulate holding companies. \6\--------------------------------------------------------------------------- \6\ With respect to this question we express our opinion only concerning thrifts and their holding companies. We express no opinion as to banks and BHCs.--------------------------------------------------------------------------- The OTS supervises both thrifts and their holding companies on a consolidated basis. Indeed, SLHC supervision is an integral part of OTS oversight of the thrift industry. OTS conducts holding company examinations concurrently with the examination of the thrift subsidiary, supplemented by offsite monitoring. For the most complex holding companies, OTS utilizes a continuous supervision approach. We believe the regulation of the thrift and holding company has enabled us to effectively assess the risks of the consolidated entity, while retaining a strong focus on protecting the Deposit Insurance Fund. The OTS has a wealth of expertise regulating thrifts and holding companies. We have a keen understanding of small, medium-sized and mutual thrifts and their holding companies. We are concerned that if the FRB became the regulator of these holding companies, it would focus most of its attention on the largest holding companies to the detriment of small and mutual SLHCs. With regard to holding company regulation, OTS believes thrifts that have nonsystemic holding companies should have strong, consistent supervision by a single regulator. Conversely, a SLHC that would be deemed to be a Tier 1 FHC should be regulated by the systemic regulator. This is consistent with our key principle that any financial reform package should create the ability to supervise and resolve all systemically important financial firms.VII. Consumer Protection The Committee did not specifically request input regarding consumer protection issues and the Administration's Proposal to create a Consumer Financial Protection Agency (CFPA); however, we would like to express our views because adequate protection of consumers is one of the key principles that must be addressed by effective reform. Consumer protection performed consistently and judiciously fosters a thriving banking system to meet the financial services needs of the Nation. The OTS supports the creation of a CFPA that would consolidate rulemaking authority over all consumer protection regulations in one regulator. The CFPA should be responsible for promulgating all consumer protection regulations that would apply uniformly to all entities that offer financial products, whether a federally insured depository institution, a State bank, or a State-licensed mortgage broker or mortgage company. Making all entities subject to the same rules and regulations for consumer protection could go a long way towards accomplishing OTS's often stated goal of plugging the gaps in regulatory oversight that led to a shadow banking system that was a significant cause of the current crisis. Although we support the concept of a single agency to write all consumer rules, we strongly believe that consumer protection-related examinations, supervision authority and enforcement powers for insured depository institutions should be retained by the FBAs and the National Credit Union Administration (NCUA). In addition to rulemaking authority, the CFPA should have regulation, examination and enforcement power over entities engaged in consumer lending that are not insured depository institutions. Regardless of whether a new consumer protection agency is created, it is critical that, for all federally insured depository institutions, the primary Federal safety and soundness regulator retain authority for regulation, examination, and enforcement of consumer protection regulations.VIII. Conclusion In conclusion, we support the goals of the Administration and this Committee to create a reformed system of financial regulation that fills regulatory gaps and prevents the type of financial crisis that we have just endured. Thank you again, Mr. Chairman, Ranking Member Shelby, and Members of the Committee for the opportunity to testify on behalf of the OTS. We look forward to working with the Members of this Committee and others to create a system of financial services regulation that promotes greater economic stability for providers of financial services and the Nation. FOMC20060131meeting--2 0,CHAIRMAN GREENSPAN.," Thank you all very much. I’ll try to say more later, but I’m not sure I can make it. [Laughter] Item 1 on the agenda is just basically for me to turn it over to Roger Ferguson to do as he sees fit. [Laughter]" FOMC20051101meeting--111 109,MR. MOSKOW.," Thank you, Mr. Chairman. The Seventh District economy expanded at a somewhat better pace since the last meeting, though it is still lagging the rest of the country. However, for the Chicago economy, particularly the South Side [laughter], it was the best October in 88 years! President Fisher and I had a side wager, but I’ll let him fill you in on the details of that." FOMC20070807meeting--18 16,CHAIRMAN BERNANKE.," Thank you for a very good report, Bill. Are there questions? President Poole." FOMC20060808meeting--9 7,CHAIRMAN BERNANKE., Thank you very much. Are there questions for David or Karen? President Poole. FOMC20070628meeting--240 238,CHAIRMAN BERNANKE., I think I had President Poole first and then Governor Mishkin. President Poole. FOMC20070509meeting--70 68,CHAIRMAN BERNANKE., Thank you for the arithmetic. [Laughter] FOMC20070131meeting--8 6,CHAIRMAN BERNANKE., Thank you. Objections? [Laughter] CHRG-109shrg21981--204 PREPARED STATEMENT OF ALAN GREENSPAN Chairman, Board of Governors of the Federal Reserve System February 16, 2005 Mr. Chairman and Members of the Committee, I am pleased to be here today to present the Federal Reserve's Monetary Policy Report to the Congress. In the 7 months since I last testified before this Committee, the U.S. economic expansion has firmed, overall inflation has subsided, and core inflation has remained low. Over the first half of 2004, the available information increasingly suggested that the economic expansion was becoming less fragile and that the risk of an undesirable decline in inflation had greatly diminished. Toward mid-year, the Federal Reserve came to the judgment that the extraordinary degree of policy accommodation that had been in place since the middle of 2003 was no longer warranted and, in the announcement released at the conclusion of our May meeting, signaled that a firming of policy was likely. The Federal Open Market Committee began to raise the Federal funds rate at its June meeting, and the announcement following that meeting indicated the need for further, albeit gradual, withdrawal of monetary policy stimulus. Around the same time, incoming data suggested a lull in activity as the economy absorbed the impact of higher energy prices. Much as had been expected, this soft patch proved to be short-lived. Accordingly, the Federal Reserve has followed the June policy move with similar actions at each meeting since then, including our most recent meeting earlier this month. The cumulative removal of policy accommodation to date has significantly raised measures of the real Federal funds rate, but by most measures, it remains fairly low. The evidence broadly supports the view that economic fundamentals have steadied. Consumer spending has been well-maintained over recent months, buoyed by continued growth in disposable personal income, gains in net worth, and accommodative conditions in credit markets. Households have recorded a modest improvement in their financial position over this period, to the betterment of many indicators of credit quality. Low interest rates and rising incomes have contributed to a decline in the aggregate household financial obligation ratio, and delinquency and charge-off rates on various categories of consumer loans have stayed at low levels. The sizable gains in consumer spending of recent years have been accompanied by a drop in the personal saving rate to an average of only 1 percent over 2004--a very low figure relative to the nearly 7 percent rate averaged over the previous three decades. Among the factors contributing to the strength of spending and the decline in saving have been developments in housing markets and home finance that have spurred rising household wealth and allowed greater access to that wealth. The rapid rise in home prices over the past several years has provided households with considerable capital gains. Moreover, a significant increase in the rate of single-family home turnover has meant that many consumers have been able to realize gains from the sale of their homes. To be sure, such capital gains, largely realized through an increase in mortgage debt on the home, do not increase the pool of national savings available to finance new capital investment. But from the perspective of a! n individual household, cash realized from capital gains has the same spending power as cash from any other source. More broadly, rising home prices along with higher equity prices have outpaced the rise in household, largely mortgage, debt and have pushed up household net worth to about 5\1/2\ times disposable income by the end of last year. Although the ratio of net worth to income is well below the peak attained in 1999, it remains above the long-term historical average. These gains in net worth help to explain why households in the aggregate do not appear uncomfortable with their financial position even though their reported personal saving rate is negligible. Of course, household net worth may not continue to rise relative to income, and some reversal in that ratio is not out of the question. If that were to occur, households would probably perceive the need to save more out of current income; the personal saving rate would accordingly rise, and consumer spending would slow. But while household spending may well play a smaller role in the expansion going forward, business executives apparently have become somewhat more optimistic in recent months. Capital spending and corporate borrowing have firmed noticeably, but some of the latter may have been directed to finance the recent backup in inventories. Mergers and acquisitions, though, have clearly perked up. Even in the current much-improved environment, however, some caution among business executives remains. Although capital investment has been advancing at a reasonably good pace, it has nonetheless lagged the exceptional rise in profits and internal cashflow. This is most unusual; it took a deep recession to produce the last such configuration in 1975. The lingering caution evident in capital spending decisions has also been manifest in less-aggressive hiring by businesses. In contrast to the typical pattern early in previous business-cycle recoveries, firms have appeared reluctant to take on new workers and have remained focused on cost containment. As opposed to the lingering hesitancy among business executives, participants in financial markets seem very confident about the future and, judging by the exceptionally low level of risk spreads in credit markets, quite willing to bear risk. This apparent disparity in sentiment between business people and market participants could reflect the heightened additional concerns of business executives about potential legal liabilities rather than a fundamentally different assessment of macroeconomic risks. Turning to the outlook for costs and prices, productivity developments will likely play a key role. The growth of output per hour slowed over the past half year, giving a boost to unit labor costs after 2 years of declines. Going forward, the implications for inflation will be influenced by the extent and persistence of any slowdown in productivity. A lower rate of productivity growth in the context of relatively stable increases in average hourly compensation has led to slightly more rapid growth in unit labor costs. Whether inflation actually rises in the wake of slowing productivity growth, however, will depend on the rate of growth of labor compensation and the ability and willingness of firms to pass on higher costs to their customers. That, in turn, will depend on the degree of utilization of resources and how monetary policymakers respond. To date, with profit margins already high, competitive pressures have tended to limit the extent to which cost pressures have ! been reflected in higher prices. Productivity is notoriously difficult to predict. Neither the large surge in output per hour from the first quarter of 2003 to the second quarter of 2004, nor the more recent moderation was easy to anticipate. It seems likely that these swings reflected delayed efficiency gains from the capital goods boom of the 1990's. Throughout the first half of last year, businesses were able to meet increasing orders with management efficiencies rather than new hires. But conceivably the backlog of untapped total efficiencies has run low, requiring new hires. Indeed, new hires as a percent of employment rose in the fourth quarter of last year to the highest level since the second quarter of 2001. There is little question that the potential remains for large advances in productivity from further applications of existing knowledge, and insights into applications not even now contemplated doubtless will emerge in the years ahead. However, we have scant ability to infer the pace at which such gains will play out and, therefore, their implications for the growth of productivity over the longer-run. It is, of course, the rate of change of productivity over time, and not its level, that influences the persistent changes in unit labor costs and hence the rate of inflation. The inflation outlook will also be shaped by developments affecting the exchange value of the dollar and oil prices. Although the dollar has been declining since early 2002, exporters to the United States apparently have held dollar prices relatively steady to preserve their market share, effectively choosing to absorb the decline in the dollar by accepting a reduction in their profit margins. However, the recent somewhat quickened pace of increases in U.S. import prices suggests that profit margins of exporters to the United States have contracted to the point where the foreign shippers may exhibit only limited tolerance for additional reductions in margins should the dollar decline further. The sharp rise in oil prices over the past year has no doubt boosted firms' costs and may have weighed on production, particularly given the sizable permanent component of oil price increases suggested by distant-horizon oil futures contracts. However, the share of total business expenses attributable to energy costs has declined appreciably over the past 30 years, which has helped to buffer profits and the economy more generally from the adverse effect of high oil and natural gas prices. Still, although the aggregate effect may be modest, we must recognize that some sectors of the economy and regions of the country have been hit hard by the increase in energy costs, especially over the past year. Despite the combination of somewhat slower growth of productivity in recent quarters, higher energy prices, and a decline in the exchange rate for the dollar, core measures of consumer prices have registered only modest increases. The core PCE and CPI measures, for example, climbed about 1\1/4\ and 2 percent, respectively, at an annual rate over the second half of last year. All told, the economy seems to have entered 2005 expanding at a reasonably good pace, with inflation and inflation expectations well anchored. On the whole, financial markets appear to share this view. In particular, a broad array of financial indicators convey a pervasive sense of confidence among investors and an associated greater willingness to bear risk than is yet evident among business managers. Both realized and option-implied measures of uncertainty in equity and fixed-income markets have declined markedly over recent months to quite low levels. Credit spreads, read from corporate bond yields and credit default swap premiums, have continued to narrow amid widespread signs of an improvement in corporate credit quality, including notable drops in corporate bond defaults and debt ratings downgrades. Moreover, recent surveys suggest that bank lending officers have further eased standards and terms on business loans, and anecdotal reports suggest that securities dealers and other market-makers appear quite willing to commit capital in providing market liquidity. In this environment, long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target Federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. The simple mathematics of the yield curve governs the relationship between short- and long-term interest rates. Ten-year yields, for example, can be thought of as an average of 10 consecutive 1 year forward rates. A rise in the first-year forward rate, which correlates closely with the Federal funds rate, would increase the yield on 10-year U.S. Treasury notes even if the more-distant forward rates remain unchanged. Historically, though, even these distant forward rates have tended to rise in association with monetary policy tightening. In the current episode, however, the more-distant forward rates declined at the same time that short-term rates were rising. Indeed, the tenth-year tranche, which yielded 6\1/2\ percent last June, is now at about 5\1/4\ percent. During the same period, comparable real forward rates derived from quotes on Treasury inflation-indexed debt fell significantly as well, suggesting that only a portion of the decline in nominal forward rates in distant tranches is attributable to a drop in long-term inflation expectations. Some analysts have worried that the dip in forward real interest rates since last June may indicate that market participants have marked down their view of economic growth going forward, perhaps because of the rise in oil prices. But this interpretation does not mesh seamlessly with the rise in stock prices and the narrowing of credit spreads observed over the same interval. Others have emphasized the subdued overall business demand for credit in the United States and the apparent eagerness of lenders, including foreign investors, to provide financing. In particular, heavy purchases of longer-term Treasury securities by foreign central banks have often been cited as a factor boosting bond prices and pulling down longer-term yields. Thirty-year, fixed-rate mortgage rates have dropped to a level only a little higher than the record lows touched in 2003 and, as a consequence, the estimated average duration of outstanding mortgage-backed securities has shortened appreciably ! over recent months. Attempts by mortgage investors to offset this decline in duration by purchasing longer-term securities may be yet another contributor to the recent downward pressure on longer-term yields. But we should be careful in endeavoring to account for the decline in long-term interest rates by adverting to technical factors in the United States alone because yields and risk spreads have narrowed globally. The German 10-year Bund rate, for example, has declined from 4\1/4\ percent last June to current levels of 3\1/2\ percent. And spreads of yields on bonds issued by emerging-market nations over U.S. Treasury yields have declined to very low levels. There is little doubt that, with the breakup of the Soviet Union and the integration of China and India into the global trading market, more of the world's productive capacity is being tapped to satisfy global demands for goods and services. Concurrently, greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross-border financing of investment. The favorable inflation performance across a broad range of countries resulting from enlarged global goods, services, and financial capacity has doubtless contributed to expectations of lower inflation in the years ahead and lower inflation risk premiums. But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last 9 months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but ! it will be some time before we are able to better judge the forces underlying recent experience. This is but one of many uncertainties that will confront world policymakers. Over the past two decades, the industrial world has fended off two severe stock market corrections, a major financial crisis in developing nations, corporate scandals, and, of course, the tragedy of September 11, 2001. Yet overall economic activity experienced only modest difficulties. In the United States, only five quarters in the past 20 years exhibited declines in GDP, and those declines were small. Thus, it is not altogether unexpected or irrational that participants in the world marketplace would project more of the same going forward. Yet history cautions that people experiencing long periods of relative stability are prone to excess. We must thus remain vigilant against complacency, especially since several important economic challenges confront policymakers in the years ahead. Prominent among these challenges in the United States is the pressing need to maintain the flexibility of our economic and financial system. This will be essential if we are to address our current account deficit without significant disruption. Besides market pressures, which appear poised to stabilize and over the longer-run possibly to decrease the U.S. current account deficit and its attendant financing requirements, some forces in the domestic U.S. economy seem about to head in the same direction. Central to that adjustment must be an increase in net national saving. This serves to underscore the imperative to restore fiscal discipline. Beyond the near-term, benefits promised to a burgeoning retirement-age population under mandatory entitlement programs, most notably Social Security and Medicare, threaten to strain the resources of the working-age population in the years ahead. Real progress on these issues will unavoidably entail many difficult choices. But the demographics are inexorable, and call for action before the leading edge of baby boomer retirement becomes evident in 2008. This is especially the case because longer-term problems, if not addressed, could begin to affect longer-dated debt issues, the value of which is based partly on expectations of developments many years in the future. Another critical long-run economic challenge facing the United States is the need to ensure that our workforce is equipped with the requisite skills to compete effectively in an environment of rapid technological progress and global competition. Technological advance is continually altering the shape, nature, and complexity of our economic processes. But technology and, more recently, competition from abroad have grown to a point at which demand for the least-skilled workers in the United States and other developed countries is diminishing, placing downward pressure on their wages. These workers will need to acquire the skills required to compete effectively for the new jobs that our economy will create. At the risk of some oversimplification, if the skill composition of our workforce meshed fully with the needs of our increasingly complex capital stock, wage-skill differentials would be stable, and percentage changes in wage rates would be the same for all job grades. But for the past 20 years, the supply of skilled, particularly highly skilled, workers has failed to keep up with a persistent rise in the demand for such skills. Conversely, the demand for lesser-skilled workers has declined, especially in response to growing international competition. The failure of our society to enhance the skills of a significant segment of our workforce has left a disproportionate share with lesser skills. The effect, of course, is to widen the wage gap between the skilled and the lesser skilled. In a democratic society, such a stark bifurcation of wealth and income trends among large segments of the population can fuel resentment and political polarization. These social developments can lead to political clashes and misguided economic policies that work to the detriment of the economy and society as a whole. As I have noted on previous occasions, strengthening elementary and secondary schooling in the United States--especially in the core disciplines of math, science, and written and verbal communications--is one crucial element in avoiding such outcomes. We need to reduce the relative excess of lesser-skilled workers and enhance the number of skilled workers by expediting the acquisition of skills by all students, both through formal education and on-the-job training. Although the long-run challenges confronting the U.S. economy are significant, I fully anticipate that they will ultimately be met and resolved. In recent decades our Nation has demonstrated remarkable resilience and flexibility when tested by events, and we have every reason to be confident that it will weather future challenges as well. For our part, the Federal Reserve will pursue its statutory objectives of price stability and maximum sustainable employment--the latter of which we have learned can best be achieved in the long-run by maintaining price stability. This is the surest contribution that the Federal Reserve can make in fostering the economic prosperity and well-being of our Nation and its people. CHRG-110hhrg46591--44 Mr. Seligman," Mr. Chairman, we have reached a moment of discontinuity in our Federal and State systems of financial regulation that will require a comprehensive reorganization. Not since the 1929-1933 period, has there been a period of such crisis and such need for a fundamentally new approach to financial regulation. Now, this need is only based, in part, on the economic emergency. Quite aside from the current emergency, finance has fundamentally changed in recent decades while financial regulation has moved far more slowly. First, in the New Deal period, most finance was atomized into separate investment banking, commercial banking, or insurance firms. Today, finance is dominated by financial holding companies which operate in each of these and cognate areas such as commodities. Second, in the New Deal period, the challenge of regulation was essentially domestic. Increasingly, our fundamental challenge in financial regulation is international. Third, in 1930, approximately 1.5 percent of the American people directly owned stock on the New York Stock Exchange. Today, a substantial majority of Americans own stock directly or indirectly through pension plans or mutual funds. A dramatic deterioration in stock prices affects the retirement plans and sometimes the livelihoods of millions of Americans. Fourth, in the New Deal period, the choice of financial investments was largely limited to stock, debt, and to bank accounts. Today, we live in an age of increasingly complex derivative instruments, some of which, as recent experience has painfully shown, are not well-understood by investors and, on some occasions, by issuers or counterparties. Fifth, and most significantly, we have learned that our system of finance is more fragile than we earlier had believed. The web of interdependency that is the hallmark of sophisticated trading today means when a major firm such as Lehman Brothers is bankrupt, cascading impacts can have powerful effects on an entire economy. Against this backdrop, what lessons does history suggest for the committee to consider as it begins to address the potential restructuring of our system of financial regulation? First, make a fundamental distinction between emergency rescue legislation, which must be adopted under intense time pressure, and the restructuring of our financial regulatory order, which will be best done after systematic hearings and which will operate best when far more evidence is available. The creation of the Securities and Exchange Commission, for example, and the adoption of six Federal securities laws between 1933 and 1940 was preceded by the Stock Exchange Practices hearings of the Senate Banking Committee and counterpart hearings in the House between 1932 and 1934. Second, I would strongly urge each House of Congress to create a select committee similar to that employed after September 11th to provide a focused and less contentious review of what should be done. The most difficult issues in discussing appropriate reform of our regulatory system become far more difficult when multiple congressional committees with conflicting jurisdictions address overlapping concerns. Third, the scope of any systematic review of financial regulation should be comprehensive. This not only means that obvious areas of omission today such as credit default swaps and hedge funds need to be part of the analysis, but it also means, for example, our historic system of State insurance regulation should be reexamined. In a world in which financial holding companies can move resources internally with breathtaking speed a partial system of Federal oversight runs an unacceptable risk of failure. Fourth, a particularly difficult issue to address will be the appropriate balance between the need for a single agency to address systemic risk and the advantages of expert specialized agencies. There is today an obvious and cogent case for the Federal Reserve System and the Department of the Treasury to serve as a crisis manager to address issues of systemic risk, including those related to firm capital and liquidity. But to create a single clear crisis manager only begins analysis of what appropriate structure for Federal regulation should be. Subsequently, there must be considerable thought as to how best to harmonize the risk management powers with the role of specialized financial regulatory agencies that continue to exist. Existing financial regulatory agencies, for example, often have dramatically different purposes and scopes. Bank regulation, for example, has long been focused on safety insolvency, securities regulation on investor protection. Similarly, these differences and purposes in scope in turn are based on different patterns of investors, retail versus institutional for example, different degrees of internationalization and different risk of intermediation in specific financial industries. The political structure of our existing agencies is also strikingly different. The Department of the Treasury, of course, is part of the Executive Branch. The Federal Reserve System and the SEC, in contrast, are independent regulatory agencies. But, the SEC's independence itself as a practical reality is quite different from the Federal Reserve System with a form of self-funding than for the SEC and most independent regulatory agencies whose budgets are presented as part of the Administration's budget. Underlying any potential financial regulatory reorganization are pivotal questions I urge this committee to consider, such as what should be the fundamental purpose of new legislation, should Congress seek a system that effectively addresses systemic risk, safety insolvency, investor consumer protection, or other overarching objectives. How should Congress address such topics as coordination of inspection examination, conduct or trading rules enforcement of private rules of action? Should new financial regulators be part of the Executive Branch or independent regulatory agencies? Should the emphasis in the new financial regulatory order be on command and control to best avoid economic emergency or on politicization to ensure that all relevant views are considered by financial regulators before decisions are made? How do we analyze the potentialities of new regulatory norms in the increasingly global economy? What role should self-regulatory organizations such as FINRA have in a new system of financial regulations? These and similar questions should inform the most consequential debate over financial regulation that we have experienced since the new deal period. [The prepared statement of Mr. Seligman can be found on page 140 of the appendix.] " CHRG-110shrg46629--144 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System July 19, 2007 Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. As you know, this occasion marks the 30th year of semiannual testimony on the economy and monetary policy by the Federal Reserve. In establishing these hearings, the Congress proved prescient in anticipating the worldwide trend toward greater transparency and accountability of central banks in the making of monetary policy. Over the years, these testimonies and the associated reports have proved an invaluable vehicle for the Federal Reserve's communication with the public about monetary policy, even as they have served to enhance the Federal Reserve's accountability for achieving the dual objectives of maximum employment and price stability set for it by the Congress. I take this opportunity to reiterate the Federal Reserve's strong support of the dual mandate; in pursuing maximum employment and price stability, monetary policy makes its greatest possible contribution to the general economic welfare. Let me now review the current economic situation and the outlook, beginning with developments in the real economy and the situation regarding inflation before turning to monetary policy. I will conclude with comments on issues related to lending to households and consumer protection--topics not normally addressed in monetary policy testimony but, in light of recent developments, deserving of our attention today. After having run at an above-trend rate earlier in the current economic recovery, U.S. economic growth has proceeded during the past year at a pace more consistent with sustainable expansion. Despite the downshift in growth, the demand for labor has remained solid, with more than 850,000 jobs having been added to payrolls thus far in 2007 and the unemployment rate having remained at 4\1/2\ percent. The combination of moderate gains in output and solid advances in employment implies that recent increases in labor productivity have been modest by the standards of the past decade. The cooling of productivity growth in recent quarters is likely the result of cyclical or other temporary factors, but the underlying pace of productivity gains may also have slowed somewhat. To a considerable degree, the slower pace of economic growth in recent quarters reflects the ongoing adjustment in the housing sector. Over the past year, home sales and construction have slowed substantially and house prices have decelerated. Although a leveling-off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders' inventories to rise further relative to the pace of new home sales. Accordingly, construction of new homes has sunk further, with starts of new single-family houses thus far this year running 10 percent below the pace in the second half of last year. The pace of home sales seems likely to remain sluggish for a time, partly as a result of some tightening in lending standards and the recent increase in mortgage interest rates. Sales should ultimately be supported by growth in income and employment as well as by mortgage rates that--despite the recent increase--remain fairly low relative to historical norms. However, even if demand stabilizes as we expect, the pace of construction will probably fall somewhat further as builders work down stocks of unsold new homes. Thus, declines in residential construction will likely continue to weigh on economic growth over coming quarters, although the magnitude of the drag on growth should diminish over time. Real consumption expenditures appear to have slowed last quarter, following two quarters of rapid expansion. Consumption outlays are likely to continue growing at a moderate pace, aided by a strong labor market. Employment should continue to expand, though possibly at a somewhat slower pace than in recent years as a result of the recent moderation in the growth of output and ongoing demographic shifts that are expected to lead to a gradual decline in labor force participation. Real compensation appears to have risen over the past year, and barring further sharp increases in consumer energy costs, it should rise further as labor demand remains strong and productivity increases. In the business sector, investment in equipment and software showed a modest gain in the first quarter. A similar outcome is likely for the second quarter, as weakness in the volatile transportation equipment category appears to have been offset by solid gains in other categories. Investment in nonresidential structures, after slowing sharply late last year, seems to have grown fairly vigorously in the first half of 2007. Like consumption spending, business fixed investment overall seems poised to rise at a moderate pace, bolstered by gains in sales and generally favorable financial conditions. Late last year and early this year, motor vehicle manufacturers and firms in several other industries found themselves with elevated inventories, which led them to reduce production to better align inventories with sales. Excess inventories now appear to have been substantially eliminated and should not prove a further restraint on growth. The global economy continues to be strong. Supported by solid economic growth abroad, U.S. exports should expand further in coming quarters. Nonetheless, our trade deficit--which was about 5\1/4\ percent of nominal gross domestic product (GDP) in the first quarter--is likely to remain high. For the most part, financial markets have remained supportive of economic growth. However, conditions in the subprime mortgage sector have deteriorated significantly, reflecting mounting delinquency rates on adjustable-rate loans. In recent weeks, we have also seen increased concerns among investors about credit risk on some other types of financial instruments. Credit spreads on lower-quality corporate debt have widened somewhat, and terms for some leveraged business loans have tightened. Even after their recent rise, however, credit spreads remain near the low end of their historical ranges, and financing activity in the bond and business loan markets has remained fairly brisk. Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy's underlying trend. Such an assessment was made around the time of the June meeting of the Federal Open Market Committee (FOMC) by the members of the Board of Governors and the presidents of the Reserve Banks, all of whom participate in deliberations on monetary policy. The central tendency of the growth forecasts, which are conditioned on the assumption of appropriate monetary policy, is for real GDP to expand roughly 2\1/4\ to 2\1/2\ percent this year and 2\1/2\ to 2\3/4\ percent in 2008. The forecasted performance for this year is about \1/4\ percentage point below that projected in February, the difference being largely the result of weaker-than-expected residential construction activity this year. The unemployment rate is anticipated to edge up to between 4\1/2\ and 4\3/4\ percent over the balance of this year and about 4\3/4\ percent in 2008, a trajectory about the same as the one expected in February. I turn now to the inflation situation. Sizable increases in food and energy prices have boosted overall inflation and eroded real incomes in recent months--both unwelcome developments. As measured by changes in the price index for personal consumption expenditures (PCE inflation), inflation ran at an annual rate of 4.4 percent over the first 5 months of this year, a rate that, if maintained, would clearly be inconsistent with the objective of price stability.\1\ Because monetary policy works with a lag, however, policymakers must focus on the economic outlook. Food and energy prices tend to be quite volatile, so that, looking forward, core inflation (which excludes food and energy prices) may be a better gauge than overall inflation of underlying inflation trends. Core inflation has moderated slightly over the past few months, with core PCE inflation coming in at an annual rate of about 2 percent so far this year.--------------------------------------------------------------------------- \1\ Despite the recent surge, total PCE inflation is 2.3 percent over the past 12 months.--------------------------------------------------------------------------- Although the most recent readings on core inflation have been favorable, month-to-month movements in inflation are subject to considerable noise, and some of the recent improvement could also be the result of transitory influences. However, with long-term inflation expectations contained, futures prices suggesting that investors expect energy and other commodity prices to flatten out, and pressures in both labor and product markets likely to ease modestly, core inflation should edge a bit lower, on net, over the remainder of this year and next year. The central tendency of FOMC participants' forecasts for core PCE inflation--2 to 2\1/4\ percent for 2007 and 1\3/4\ to 2 percent in 2008--is unchanged from February. If energy prices level off as currently anticipated, overall inflation should slow to a pace close to that of core inflation in coming quarters. At each of its four meetings so far this year, the FOMC maintained its target for the Federal funds rate at 5\1/4\ percent, judging that the existing stance of policy was likely to be consistent with growth running near trend and inflation staying on a moderating path. As always, in determining the appropriate stance of policy, we will be alert to the possibility that the economy is not evolving in the way we currently judge to be the most likely. One risk to the outlook is that the ongoing housing correction might prove larger than anticipated, with possible spillovers onto consumer spending. Alternatively, consumer spending, which has advanced relatively vigorously, on balance, in recent quarters, might expand more quickly than expected; in that case, economic growth could rebound to a pace above its trend. With the level of resource utilization already elevated, the resulting pressures in labor and product markets could lead to increased inflation over time. Yet another risk is that energy and commodity prices could continue to rise sharply, leading to further increases in headline inflation and, if those costs passed through to the prices of nonenergy goods and services, to higher core inflation as well. Moreover, if inflation were to move higher for an extended period and that increase became embedded in longer-term inflation expectations, the reestablishment of price stability would become more difficult and costly to achieve. With the level of resource utilization relatively high and with a sustained moderation in inflation pressures yet to be convincingly demonstrated, the FOMC has consistently stated that upside risks to inflation are its predominant policy concern. In addition to its dual mandate to promote maximum employment and price stability, the Federal Reserve has an important responsibility to help protect consumers in financial services transactions. For nearly 40 years, the Federal Reserve has been active in implementing, interpreting, and enforcing consumer protection laws. I would like to discuss with you this morning some of our recent initiatives and actions, particularly those related to subprime mortgage lending. Promoting access to credit and to homeownership are important objectives, and responsible subprime mortgage lending can help advance both goals. In designing regulations, policymakers should seek to preserve those benefits. That said, the recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards and, in some cases, by abusive lending practices and outright fraud. In addition, some households took on mortgage obligations they could not meet, perhaps in some cases because they did not fully understand the terms. Financial losses have subsequently induced lenders to tighten their underwriting standards. Nevertheless, rising delinquencies and foreclosures are creating personal, economic, and social distress for many homeowners and communities--problems that likely will get worse before they get better. The Federal Reserve is responding to these difficulties at both the national and the local levels. In coordination with the other Federal supervisory agencies, we are encouraging the financial industry to work with borrowers to arrange prudent loan modifications to avoid unnecessary foreclosures. Federal Reserve Banks around the country are cooperating with community and industry groups that work directly with borrowers having trouble meeting their mortgage obligations. We continue to work with organizations that provide counseling about mortgage products to current and potential homeowners. We are also meeting with market participants--including lenders, investors, servicers, and community groups--to discuss their concerns and to gain information about market developments. We are conducting a top-to-bottom review of possible actions we might take to help prevent recurrence of these problems. First, we are committed to providing more-effective disclosures to help consumers defend against improper lending. Three years ago, the Board began a comprehensive review of Regulation Z, which implements the Truth in Lending Act (TILA). The initial focus of our review was on disclosures related to credit cards and other revolving credit accounts. After conducting extensive consumer testing, we issued a proposal in May that would require credit card issuers to provide clearer and easier-to-understand disclosures to customers. In particular, the new disclosures would highlight applicable rates and fees, particularly penalties that might be imposed. The proposed rules would also require card issuers to provide 45 days' advance notice of a rate increase or any other change in account terms so that consumers will not be surprised by unexpected charges and will have time to explore alternatives. We are now engaged in a similar review of the TILA rules for mortgage loans. We began this review last year by holding four public hearings across the country, during which we gathered information on the adequacy of disclosures for mortgages, particularly for nontraditional and adjustable-rate products. As we did with credit card lending, we will conduct extensive consumer testing of proposed disclosures. Because the process of designing and testing disclosures involves many trial runs, especially given today's diverse and sometimes complex credit products, it may take some time to complete our review and propose new disclosures. However, some other actions can be implemented more quickly. By the end of the year, we will propose changes to TILA rules to address concerns about mortgage loan advertisements and solicitations that may be incomplete or misleading and to require lenders to provide mortgage disclosures more quickly so that consumers can get the information they need when it is most useful to them. We already have improved a disclosure that creditors must provide to every applicant for an adjustable-rate mortgage product to explain better the features and risks of these products, such as ``payment shock'' and rising loan balances. We are certainly aware, however, that disclosure alone may not be sufficient to protect consumers. Accordingly, we plan to exercise our authority under the Home Ownership and Equity Protection Act (HOEPA) to address specific practices that are unfair or deceptive. We held a public hearing on June 14 to discuss industry practices, including those pertaining to prepayment penalties, the use of escrow accounts for taxes and insurance, stated-income and low-documentation lending, and the evaluation of a borrower's ability to repay. The discussion and ideas we heard were extremely useful, and we look forward to receiving additional public comments in coming weeks. Based on the information we are gathering, I expect that the Board will propose additional rules under HOEPA later this year. In coordination with the other Federal supervisory agencies, last year we issued principles-based guidance on nontraditional mortgages, and in June of this year we issued supervisory guidance on subprime lending. These statements emphasize the fundamental consumer protection principles of sound underwriting and effective disclosures. In addition, we reviewed our policies related to the examination of nonbank subsidiaries of bank and financial holding companies for compliance with consumer protection laws and guidance. As a result of that review and following discussions with the Office of Thrift Supervision, the Federal Trade Commission, and State regulators, as represented by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators, we are launching a cooperative pilot project aimed at expanding consumer protection compliance reviews at selected nondepository lenders with significant subprime mortgage operations. The reviews will begin in the fourth quarter of this year and will include independent State-licensed mortgage lenders, nondepository mortgage lending subsidiaries of bank and thrift holding companies, and mortgage brokers doing business with or serving as agents of these entities. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations of and improved enforcement for nondepository mortgage lenders. Working together to address jurisdictional issues and to improve information-sharing among agencies, we will seek to prevent abusive and fraudulent lending while ensuring that consumers retain access to beneficial credit. I believe that the actions I have described today will help address the current problems. The Federal Reserve looks forward to working with the Congress on these important issues." FOMC20080805meeting--106 104,MR. FISHER.," Mr. Chairman, I may have to leave the lunch early. So before I start, I do want to bid Rick adieu. Rick, I remember describing you as charming in one of our early meetings. You have charmed me by your intellect and devotion. Anyway, I'm going to miss you. So I wanted to say that in case I do have to leave early. Mr. Chairman, in the intermeeting period, I spent almost as much time in President Rosengren's District as I did in my own--part as vacation but the rest consulting with some advisers and mentors in the People's Republic of Cambridge at my alma mater. [Laughter] I mention this because I want to underscore that, in arguing a perspective, I tend to move away from the rather felicitous circumstances that prevail in my District. Even though things are slowing, we still expect employment growth to come in a little short of 2 percent a year, and our banking situation thus far is holding up rather well. In terms of my national soundings, and you know the list and the group is familiar with it, the anecdotal evidence from everyone--from the bankers to the credit card companies to retailers to fuel producers, food producers, energy companies, shippers, equipment manufacturers, homebuilders, and entertainment companies--confirms reports of progressively higher obstacles to growing their top lines and continued efforts to drive down their cost of goods sold through reducing their head counts, running very tight inventory cycles, tightening their operating expenses, and reexamining and in many cases cutting back significantly on cap-ex. Nationally I expect continued anemia on the growth side. We are, as you know, not at the extreme but at the low end of expectations for economic growth. I would expect zero growth as we approach year-end. As I said earlier, from our perspective we're only about two-thirds through the peak-to-trough correction on housing, and I view that as a continued weak influence. So the summary is that most of my contacts are planning around expectations of a prolonged U.S. and advanced-country slowdown and have a rather woeful outlook as to the growth side. At the same time, there is also a woeful concern with regard to price pressures--intensifying cost pressures affecting their margins at a time when the stock market is most unforgiving of people who miss their mark. Even in the First District, I might note. I want to quote the Beige Book report from Boston: ""Almost all contacted manufacturers voiced concerns about elevated . . . costs. . . . Respondents generally have raised their selling prices in recent months. . . . Over one-half of contacts expect to increase their selling prices further in the second half of 2008 and/or early 2009."" It went on to say that, while some contacts express worry that price increases have led or will lead to loss of market shares, others indicate that--and these are the key operative words--""customers have become more receptive to price increases because they see them as a consequence of generalized cost pressures."" Mr. Chairman, that passage captures the message that I'm receiving from my CEO and CFO contacts around the country. By and large, we appear to be transitioning from vigilance on the price front to acquiescence. Inflation expectations are, I think, becoming unmoored, and I believe they are, if not already adrift, at risk of drifting. On the small business front, I do like to look at Bill Dunkelberg's recent reports from the National Federation of Independent Business. His most recent report indicates that the percentage of small business owners citing inflation as ""the number one problem they face,"" rose to 20 percent in June, the highest rating since 1982, and that 41 percent of his respondents report raising selling prices. At the other extreme of size, to put this in perspective, Wal-Mart's CEO for the United States reported last week--and I quote this: ""My biggest concern is inflation. This month we had an experience that Wal-Mart has never ever""--that's literally what he said--""had before, which is that a major supplier told us we need a 9 percent increase or we will not supply you at all."" Now, he did not mention the name of that supplier. It could have been Unilever, which saw the volume of goods it ships slip 0.5 percent year over year in the second quarter. Yet according to our conversations but also quoted in the Wall Street Journal on August 1, Unilever's CEO reported that he ""raised average prices on his thousands of products 7.4 percent,"" and then added that he ""doesn't plan to reverse any price increases."" Or it could have been one of the largest snack food companies, whose CFO has informed us that, after taking and having stick a 9 percent increase in price in March--I reported this at our last meeting--they will effect another 9� percent increase in October. Here's the pithy quote he gave me: ""Thus far we've been bleeding out price increases to our customers. Now our strategy is to bludgeon them--to broadcast our increases in the expectation that competitors will do the same."" I doubt the supplier to Wal-Mart was Kodak. Last week the New York Times reported that ""hurt by higher manufacturing and materials costs, the company said it will combat these cost pressures by passing on to consumers and raising prices on some products by as much as 20 percent."" I have lots of examples of similar responses. President Evans indicated similar pressures. President Lockhart did too. I'm not going to go through them. I will add, by the way, the one thing that surprised me. Despite Disney's brilliant annual report of record earnings, they, too, plan to raise their single day prices by 5 percent, to $60, in the next quarter. There is also a growing feeling, which I haven't heard before, among semiconductor manufacturers that, after years and years of constant price deflation, they expect that there may--and the operative word is ""may""--be a bottoming out because of the raw materials prices they face and the wage prices and pressures they are receiving in China, which has become a major semiconductor manufacturer. One might take heart from the recent correction in commodity prices. I agree with Steve that we have to be very careful about that. My smartest energy contacts have been expecting a correction in prices. Markets were overshooting. Natural gas prices have reacted to recent developments like the Barnett Shale and, even more important, the so-called Haynesville Play in Louisiana. The ""oilies"" note that increased Saudi supply hit our shores with the normal six-week lag. They were talking about production increases in May and June, and those have just hit our shores recently. So they're not surprised at the price reaction at the pump. But none feels that the basic demand�supply situation has been dramatically altered--much as you argued, Steve--and most expect structural prices to obtain at or near current levels. Now, what does ""at or near current levels"" mean in terms of price impact? I had a long conversation with the CEO of Burlington Northern, and just for data purposes, in terms of what they call their RCAF--an automatic costadjustment contract that covers 25 percent of the goods shipped by their rail--their third-quarter RCAF is 17 percent. The 75 percent of products that are not covered by that automatic contract are subject to a fuel surcharge. That fuel surcharge at $120 a barrel is a 30 percent increase for the third quarter. One might also take comfort in the purported calmness in compensation growth seen so far, along the lines of what I read in the Financial Times by Mark Gertler on July 29. I don't hear confirmation of that benign argument among business operators. First, as President Evans and Mr. Stockton pointed out in our last meeting, labor compensation is not a good predictor of inflation. I remember Dave said that it's not that labor costs, which are a significant chunk of business costs, don't matter but that you can't necessarily take comfort from the well-behaved compensation thus far that you are not going to confront some inflation problems going forward. Now, the last anecdote I want to give you illustrates that point. Yesterday I had a lengthy visit with the CFO of General Mills. Until their fiscal year '08, which ended in May, they priced over many years an average increase of 0 percent. They took 2� percent as the year ended, and they're taking another 5 percent this year. They are having to reexamine their elasticity models, he said. Here is what he said that worried me the most: They are finding those models less predictive because (a) ""everybody is raising prices,"" and (b) consumer perception is that inflation is back. So, again, vigilance is giving way to acquiescence. Mr. Chairman, I do want to comment very briefly on something I mentioned last time, which regards calculating the cost of goods sold. I am hearing more and more from companies that have shifted production to China a verification of the 18 percent number that the ministry gave us. Whether it's a hospital producer whom I talked to in California or a Black & Decker tool assembler in China, they're complaining not only about cost increases of 15 to 20 percent, depending on whether you're operating in the north or south, but also about the employee contract law that was just put into place, which in essence allows for almost an old-fashioned scala mobile Italian/French model, which feeds a wage�price spiral, and it is beginning to infect their wage cost and inject rigidities into their ability to operate in China. So overall, Mr. Chairman, I am concerned, obviously, about economic growth. I think we, as President Lockhart mentioned, are in a very difficult spot. We have three enormously worrisome scenarios facing us. I think we have to be very careful how we word ourselves on inflation. Last night at 6:00 National Public Radio opened their Marketplace report with this headline: ""The Fed Fuels Your Pain."" We have a perception issue that we must address, and there are two ways to do it. One is by being strong in terms of how we argue the case of inflation. The other is to act by raising rates. I'm going to listen very, very carefully because, frankly, I'm undecided here as to what the right approach is. But I think we have to be careful when we state a balance of risks, which are enormous, that we don't understate the fact that inflation is now being accommodated in the minds of the marketplace. Thank you, Mr. Chairman. " CHRG-111shrg54589--149 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM ROBERT G. PICKELQ.1.a. Do you believe the existence of an actively traded cash market is or should be a necessary condition for the creation of a derivative under law and regulation?A.1.a. In general, derivatives markets tend to be more liquid than underlying cash markets. For example, bank loans and many bonds issues tend to be fairly illiquid. There is no good reason to prohibit credit default swaps on such securities because the underlying instruments do not trade in a liquid market. Such a prohibition would only serve to reduce bank lending capacity and the ability and willingness of investors to purchase bonds, which would not be desirable while the economy is in the midst of a credit crunch. Privately negotiated derivatives are built on the fundamental principle of freedom of contract. Two parties can construct a mutually beneficial agreement to address their risk management needs, which may or may not be related to the existence of a cash market. We question whether the creation of such an agreement should be subject to conditions specified by law or regulation, especially since regulators can use powers they already have to limit trading in products that are judged to threaten systemic stability.Q.1.b. If not, what specific objective means besides a cash basis market could or should be used as the underlying relationship for a derivative?A.1.b. We do not believe it would be productive to attempt to legislate or regulate the types of risks traded in derivatives markets. All derivatives reference risks arising from normal economic activity are borne by market participants. Most securities, even the most basic types of securities such as bonds, embody a bundle of risks. The benefit of derivatives is that they permit the unbundling and pricing of specific risks. For example, an investor holding a corporate bond bears both interest rate risk and credit risk. Those individual risks can separately be traded, and valued, using interest rate derivatives and credit default swaps. By allowing investors to unbundle and trade individual risks, derivatives make it possible for investors to tailor the risks they bear. Likewise, hedgers in commercial markets can reduce financial risk while concentrating on managing the business risk associated with their enterprises. The need to manage specific risks can change as economic conditions change. Any a priori restriction on the types of risks that can be referenced by derivatives could easily hamper effective risk management.Q.2. Why should the models to price OTC derivatives not be published? If there is no visible cash basis for a derivative and the model is effectively the basis, why should the models not be public?A.2. As a general matter, prices are determined through trading and not by financial models. Financial models attempt to explain the factors determining values of financial instruments. Many such models lend insight into the factors that influence prices of financial instruments, which is why some traders use financial models to inform their trading decisions. But most existing models cannot predict asset prices accurately enough to be used exclusively for price setting, which is why many more traders do not rely on financial models. In addition to informing trading decisions, models are used for risk management purposes and to value illiquid positions for which market prices are not readily available. Many dealers currently publish newsletters that analyze factors determining the behavior of credit default swap valuation along with insights into how they model the behavior of credit default swap spreads. Moreover, existing regulations require regulated financial intermediaries to disclose to regulators in detail the methods they use to value financial instruments and to measure risk and the controls placed on such processes. This is as it should be. But there has been no demonstrated advantage, yet there would be great expense, associated with a legal mandate requiring every institution to publish the details of their own proprietary models and to explain in detail how they apply those models in practice. We are not suggesting that greater forms of transparency are not desirable. For example, ISDA has recently released the ISDA CDS Standard pricing (originally developed by JPMorgan) as part of an effort to facilitate the central clearing of standardized credit default swap contracts. The ISDA standard CDS model does not determine CDS prices. It merely provides a standardized method for calculating changes in up-front payments for standardized credit default swaps based on changes in credit default swap spreads. Credit default swap spreads are still determined through trading, however, which is the principal method of price discovery in all markets. The ISDA model is freely available to all market participants on a Web site maintained by Markit at www.cdsmodel.com. As a final point, we are not aware of any derivatives market for which there is no cash basis. We are aware that some commentators have leveled this criticism at the credit default swaps market, but we believe the criticism is misplaced. The cash basis for credit default swaps is the difference between the credit default swap spread and observed risk premium paid by bond issuers and borrowers in the loan market. Several good books analyzing and explaining the behavior of the credit default swap basis have been published in recent years. These books are publicly available to all interested parties.Q.3. What is the best way to draw the line between legitimate hedges and purely speculative bets? For example, should we require an insurable interest for purchasers of credit protection, require delivery of the reference asset, or something else?A.3. The dichotomy between ``legitimate'' hedges and ``purely speculative bets'' is a false one because a functioning market requires a seller for every buyer. A person who buys a bond and does not hedge the risk of the bond, for example, could be characterized under an exceedingly narrow definition as engaging in a ``purely speculative bet.'' Few would adopt such a characterization, however, because it would imply that buying bonds without hedging is not legitimate. Similarly, a person who wants to hedge the risk of a bond by buying CDS protection requires that another person be willing to sell protection, which could itself be characterized as a purely speculative bet. Requiring that all hedges be offset by other hedges would result in a ``by appointment only'' market that matches hedges, which would be impossible in the case of credit risk because it is unlikely that a seller of protection would meet the definition of a hedger. Put simply, what is a seller of protection hedging? Further, requiring an insurable interest for purchasers of credit protection, which is meant to apply to insurance products and not to financial derivatives, would effectively make risk transfer impossible. Suppose, for example, that a bondholder buys CDS protection from a bank; the bank that sells protection will normally want to hedge the credit risk it takes on from the bondholder by buying protection. But if only bond owners can buy protection, the bank will not be able to hedge its risk. In the presence of such restrictions, few firms will be willing to act as protection sellers. Finally, requiring delivery of the reference asset, which was the standard means of settlement prior to 2005, would be counterproductive and harmful to bond market liquidity in light of the large number of index CDS transactions found in today's market.Q.4. Is the concern that increased regulation of derivatives contracts in the United States will just move the business overseas a real issue? It seems to me that regulating the contracts written in the U.S. and allowing American firms to only buy or sell such regulated contracts would solve the problem. What else would need to be done?A.4. Derivatives markets are fluid and global. Any increased regulation must take into account that certain trades will not be done or will be done elsewhere. A recent article shows that the concern about business moving overseas is real: According to Euractiv.com, the European Commission's proposed rules for derivative dealers, which appear to be more flexible than those discussed in the U.S., might be intended to ``court'' U.S. dealers faced with a choice of where to conduct business. More broadly, companies need the risk management tools that only derivatives can supply and will respond to arbitrary restrictions on their ability to enter into risk-shifting contracts by seeking out venues where they can enter into such agreements. For example, an American company with foreign subsidiaries routinely needs to enter into a variety of contracts with local parties as part of the conduct of business, and these business dealings will produce risks that they will wish to hedge. The assumption that a U.S. company could always find a market in derivatives for any type of risk in the United States is unfounded. Derivatives contracts are not universal. Interest rate derivatives referencing foreign interest rates, for example, are typically actively traded in the home country of the currency. The demand for such contracts inside the United States might be so limited that a U.S. market for such contracts does not exist. Thus, restricting a U.S. company to trade only U.S.-regulated derivatives will have the effect of prohibiting the hedging of interest rate risks borne by overseas subsidiaries. At the very least, such a prohibition would effectively make it impossible for U.S. banks to offer through overseas subsidiaries a full complement of financial services to U.S. firms operating outside the U.S., which would thereby hamper the competitiveness of any U.S. company with overseas operations.Q.5. Do over-the-counter or custom derivatives have any favorable accounting or tax treatments versus exchange-traded derivatives?A.5. Over-the-counter derivatives may enjoy favorable accounting treatment when they are used to hedge an existing risk. U.S. GAAP hedge accounting guidelines are extremely rigid. Unless a company can demonstrate that a hedge employing a derivative instrument is a nearly perfect hedge, it is required to report the mark-to-market gains and losses from the hedge instrument as a profit or loss, even if it does not report changes in the value of the underlying exposure. By their nature, standardized derivatives contracts almost never qualify as a perfect hedge. Thus, if a company hedges the interest rate risk using interest rate futures it must report any gains or losses on the hedging position in its income statement. But if the underlying instrument is held in the investment portfolio, changes in the market value of the instrument do not affect reported income. Such a regime creates artificial volatility in reported earnings. Similarly, a multinational company that wishes to use standardized foreign exchange futures to hedge against changes in exchange rates might find that the exercise exacerbates the volatility of its reported income. Thus, requiring all companies to use only standardized derivatives may have the unintended effect of making reported income more volatile than it really is. The ultimate result would be to discourage legitimate hedging activity, placing U.S. companies at a competitive disadvantage. Over-the-counter derivatives do not necessarily enjoy favorable tax treatment relative to exchange-traded derivatives. To the extent that the tax treatment may differ, it is because gains and losses on exchange-traded derivatives are recorded daily. Whether this difference benefits the user depends on the nature of the transaction and the ultimate change in the value of the contract, which may be positive or negative. As a general rule, it all depends on the type of transaction, the terms of the contract, and what happens to market prices and rates over the term of the contract.Q.6. In addition to the Administration's proposed changes to gain on sale accounting for derivatives, what other changes need to be made to accounting and tax rules to reflect the actual risks and benefits of derivatives?A.6. ISDA is actively engaged with tax authorities and accounting standard setters on rules governing derivatives. The FASB has an active agenda, and we would encourage policy makers to engage them in consideration of their views. ISDA is concerned about preserving the ability of commercial end users to customize derivatives in order to meet their particular risk management needs. Without the ability to precisely hedge risks in accordance with FASB 133 through customized OTC derivatives, companies would experience increased volatility, reduced liquidity, and higher financing costs.Q.7. Is there any reason standardized derivatives should not be traded on an exchange?A.7. Standardization is a necessary but not sufficient condition for trading on an exchange: Standardized derivatives can be traded on an exchange only when a product has sufficient volume and liquidity to support reliable price discovery for the product. If sufficient volume and liquidity do not exist, it would be preferable to trade the products over-the-counter, that is, execute trades privately, and then manage the risk in other ways, such as through a clearinghouse. Policy discussions frequently confound exchange trading--which means that all trades must be negotiated and executed through a central venue--with clearing--which means that trades must be booked with a central counterparty that serves as the counterparty to all cleared transactions. Exchange trading is possible without clearing, although most exchanges involve clearing as well; and clearing is compatible with both exchange trading and over-the-counter trading. Exchanges and clearinghouses both make use of standardization, but for different reasons. Exchange trading involves extensive standardization because it makes a product easier to trade, which leads to higher liquidity. But as a product becomes more standardized, it may attract a narrower range of traders, leading to lower liquidity. As a result of these conflicting effects, only products that inherently appeal to a large number of traders are likely to succeed on an exchange; more specialized products generally lack liquidity and consequently do not trade successfully on an exchange. Clearinghouses also rely on standardization: not to facilitate trading but to facilitate valuation for the purposes of margin setting. Although cleared products need to be substantially standardized, they need not be as liquid as exchange-traded instruments. What matters is that the clearinghouse can calculate contract values and required margin in a timely manner and can unwind a position in the event of clearing member default.Q.8. How do we take away the incentive for credit default swap holders to force debtors into bankruptcy to trigger a credit event rather than renegotiate the debt?A.8. It is debatable whether such an incentive exists at all. It is more likely that bankruptcy and credit default swap protection are independent of each other. Claims that bought credit default swap protection somehow ``caused'' a bankruptcy filing appear to be based on misunderstanding of how credit default swaps work. One misunderstanding is that buyers of credit default swap protection can profit only if the reference entity actually goes bankrupt. But if the credit quality of a borrower deteriorates, a protection buyer need not wait for bankruptcy, but can instead take its profit by closing out the contract that presumably has appreciated in value. It is even possible that the protection buyer might prefer that the reference entity continue as a going concern instead of fail. Consider an investor that believes that credit default swaps are underpriced relative to the underlying bond. The investor can buy the bond and buy credit protection, thereby locking in a profit. If the reference entity fails, the investor will be compensated and can then seek recovery on the bond. But if the reference entity survives, the investor can continue to collect the difference between the bond's interest and the fee paid for the credit protection. Another misunderstanding is that it is possible to game the bankruptcy system by buying protection on distressed firms and then somehow ``forcing'' the firms into bankruptcy. This misunderstanding appears to be based on the assumption that the cost of protection is independent of the likelihood of a credit event so one can buy protection on distressed firms at a low cost. But the price paid for credit default swap protection is in fact related directly to the expected loss on the reference credit. Indeed, protection on a distressed credit--one widely expected to declare bankruptcy--requires that the protection buyer pay a substantial amount up-front. And if the reference entity does not declare bankruptcy, the protection buyer will in fact incur a substantial loss. A final misunderstanding is that, because a protection buyer is ``made whole'' after a reference entity fails, a protection buyer that cash settles their CDS position and remains in possession of the underlying bond has no incentive to maximize the recovery on the underlying bond. It is not clear why this should be the case: A bond holder that has been compensated and fails to pursue further recovery is in effect ``leaving money on the table,'' which does not seem in the bond holder's interest. The way the credit default swap market works, after settlement of a credit event, someone ends up holding the underlying bond, and that party has an interest in maximizing recovery.Q.9. How do we reduce the disincentive for creditors to perform strong credit research when they can just buy credit protection instead?A.9. The presumption that creditors lack incentives to perform strong credit research belies an understanding of how hedging works. As a general matter, it is necessary to take on risk in order to earn a profit. Because hedging involves giving up risk, it also generally means giving up the potential profit from taking risk, usually by paying the cost of the hedge. Further, routinely entering into hedged transactions is seldom profitable unless one has knowledge superior to that of the rest of the market, which is unlikely to be the case on a systematic basis. Hedging loans with credit default swaps affects profitability as follows. A bank hopes to profit by making a loan; its profit is based on the difference between the bank's cost of funding and the interest charged the borrower. Before making the loan, the bank should perform strong credit research in order to avoid losses from default. But if the bank decides to hedge against losses on the loan by buying credit protection, the bank will have to pay a periodic fee for protection, which will offset some or all of the profit from the loan. A bank that routinely lends and then buys protection on the loans will almost certainly run a loss-making business; the bank has incentive to hedge only if the borrower's condition deteriorates unexpectedly. So the bank can either choose not to hedge and possibly profit, or to hedge but give up the opportunity to profit, but generally cannot both hedge and profit simultaneously.Q.10. Do net sellers of credit protection carry that exposure on their balance sheet as an asset? If not, why shouldn't they?A.10. Because the value of a credit default swap is zero at inception and the parties to the contract do not exchange a consideration at the time the contract is initiated, as typically happens when an asset is purchased or sold, the potential exposure is not recorded on the balance sheet at the time the contract is first settled. Under long-standing accounting conventions, there is no way to record a contract as an asset or liability when no consideration is paid or received and the contract has a zero value. For analogous reasons, banks do not report on their balance sheets the notional amount of loan commitments, stand-by letters of credit and unused amounts on revolving credit lines, which all create a similar type of credit exposure as a credit default swap. This is why such commitments are classified as ``off-balance sheet.'' This is not to say that financial companies are not required to report the amount of their potential credit exposure arising from credit default swaps, however. First, companies must report the mark-to-market value of their derivatives exposures as either a ``derivatives receivable'' or a ``derivatives payable'' when the value of the contract changes. To illustrate, if a bank sells protection on company XYZ and the credit spreads on that company subsequently widen, then the protection seller must record the mark-to-market loss on the contract as a derivatives liability. Similarly, the protection seller's counterparty will record the mark-to-market gain as a derivatives receivable. Second, financial companies are required to report as a supplementary item the notional amount of any financial guarantees they have assumed. Thus, the financial reports of banks and other financial companies contain tables detailing the amount of ``financial guarantees'' the entity has written, including protection sold using credit default swaps, exposures created through written options, and the amount of other financial guarantees that include loan commitments, revolving credit lines and stand-by letters of credit. AIG, for example, did report to investors, credit-rating agencies, and to regulators in its public financial statements that it wrote protection on $125 billion of securities in its 2002 10k. The table below, which draws on data reported in subsequent annual reports, documents the growth in AIG's exposure to $527 billion by year-end 2007, the year when AIG first began reporting losses related to its credit default swap portfolio. ------------------------------------------------------------------------ Amount ($ in Date Reported (at December 31) billions)------------------------------------------------------------------------2002................................................ 125.72003................................................ 203.02004................................................ 290.32005................................................ 387.22006................................................ 483.62007................................................ 527.0------------------------------------------------------------------------ Moreover, AIG's financial reports discuss explicitly the risk the company faced of margin calls stemming from its credit default swap exposure. In short, investors, credit-rating agencies and regulators all had ample prior knowledge of AIG's credit derivatives related potential risk exposure. Like AIG's management, however, all involved parties failed to appreciate the impact a collapsing housing market would have on that exposure. Opaque financial reporting was not the reason why AIG was permitted to amass such a large risk exposure using credit default swaps.Q.11. In her testimony Chairman Schapiro mentioned synthetic exposure. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.11. ``Synthetic exposure'' refers to the ability to take on a risk by means of derivatives or a combination of derivatives and cash instruments. Synthetic exposure is not necessarily equivalent to leverage. For example, many investors use equity swaps to gain synthetic exposure to foreign equities. They do not do this to leverage their exposure. Purchasing foreign equities can be very expensive. In many countries, it can only be done from within the country and ownership is limited to residents. A U.S. investor can enter into an equity swap to gain equivalent economic, or ``synthetic,'' exposure to foreign equities, thereby gaining diversification while holding cash in the form of Treasury bills or other liquid investments. More generally, equity swaps can be used to gain exposure to baskets of equities while avoiding the brokerage fees and other transactions costs associated with buying and selling the cash instruments. Another form of synthetic exposure is exemplified by selling credit default swap protection on asset backed securities. The motivation for doing so is to attain access to investments that are limited in supply, but does not necessarily constitute leverage. This form of synthetic exposure will be discussed in the next question.Q.12. Regarding synthetic exposure, if there is greater demand for an asset than there are available assets, why shouldn't the economic benefit of that demand--higher value--flow to the creators or owners of that asset instead of allowing a dealer to create and profit from a synthetic version of that asset?A.12. Financial assets such as bonds represent a bundle of risks. For a bond, that bundle of risks comprises credit risk, interest rate risk, funding risk, and possibly foreign exchange risk. Derivatives facilitate the unbundling of the different types of risks embodied by securities such as bonds. Because derivatives are not funding transactions, the act of selling protection on a reference entity is not equivalent to buying a bond issued by that entity and does not drain away the benefit of access to credit from the bond issuer. Finance is not a zero-sum game. The benefit that one party derives from being able to trade an unbundled risk does not necessarily diminish the benefit of access to credit by borrowers. In the case of synthetic exposure such as credit default swaps on securitized products, it is doubtful that synthetic exposure occurs at the expense of the ``creators or owners'' of the underlying assets. If access to synthetic exposure is restricted, investors will not necessarily continue to bid up the price of the underlying asset but will likely turn to other, lower priced investments instead. And in many cases, creators or owners of assets will benefit from the existence of synthetic exposure. For instance, a bond issuer may benefit from such activity because it indirectly promotes the liquidity of its bonds, thereby lowering funding costs. Also, after an investor takes on synthetic exposure on an asset by selling protection to a dealer, the dealer will in many cases buy the underlying asset to hedge its own position. The economic benefit in these cases will flow to the owners.Q.13. One of the arguments for credit default swaps is that they are more liquid than the reference asset. That may well be true, but if there is greater demand for exposure to the asset than there is supply, and synthetic exposure was not allowed, why wouldn't that demand lead to a greater supply and thus more liquidity?A.13. Financial assets are not homogeneous--that is, infinitely interchangeable with each other--nor are they completely elastic in supply. Instead, assets are heterogeneous and can generally be issued only in limited amounts. Particularly in the case of fixed income (bond) markets, many individual issues tend to be illiquid. There is therefore demand for access to certain assets that have attractive properties but cannot easily be increased in supply. Restricting access to synthetic exposure would make it more difficult for investors to benefit from exposure to these assets. As noted earlier, financial assets embody a bundle of different risks. Derivatives facilitate the unbundling of risks so that they can be managed individually. Thus, a bond incorporates both interest rate risk and credit risk. What derivatives cannot do is to confer the benefit of funding to the contract's counterparties. Therefore, the act of selling credit protection does not divert the benefit of receiving credit from the borrower. To the contrary, the availability to creditors of a means of hedging and trading the borrower's credit risk in more liquid markets should facilitate the availability of credit, thereby benefiting the bond issuer. In general, market liquidity tends to reduce borrowing costs, which is why interest rates paid by bond issuers tend to be lower than interest rates on loans.Q.14. Is there any justification for allowing more credit protection to be sold on a reference asset than the value of the asset?A.14. For every buyer of protection, there is a seller of protection. Prior to default, the terms of a credit default swap is determined by market sentiment regarding a firm's prospects, but has no causal influence that we are aware of on the underlying bond's price. After default, recent experience has shown that the vast majority of the offsetting bought and sold protection net down to a comparatively small proportion of the market. Harrah's, for example, has $17 billion of outstanding debt compared with $30 billion of outstanding CDS protection. But according to the Depository Trust Clearing Corporation, this $30 billion of CDS protection nets down to $1.86 billion, which is far less than the amount of outstanding debt. Given the ISDA Credit Event Auction Mechanism, most protection buyers need not deliver the underlying asset, so there is little if any liquidity pressure on the underlying asset.Q.15. Besides the level of regulation and trading on an exchange, there seems to be little difference in swaps and futures. What is the need for both? In other words, what can swaps do that forward contracts cannot?A.15. A swap is a bundle of forward contracts with different maturity dates. In the early days of trading in interest rate futures, the exchanges listed contracts with maturities extending only 2 years into the future. Swaps and other OTC derivatives originally were created in part to address the needs of market participants who wished to hedge longer-dated exposures. While market participants currently have a broader choice of standardized contracts, they typically turn to OTC markets for longer-dated contracts and, more generally, when available standardized products do not meet their needs. Only highly standardized contracts can be traded on exchanges because contract standardization facilitates liquidity by limiting trading to just a few contracts. The Eurodollar futures contract, for example, specifies a $1 million notional principal. These contracts are listed for quarterly expiration (in March, June, September, and December) on the second London business day preceding the third Wednesday of the expiration month. Such standardized contracts are well suited for speculation on changes in the general level of interest rates, but are ill-suited to hedge the unique risk exposures borne by most market participants. In the parlance of derivatives markets, using exchange traded derivatives requires hedgers to take on significant basis risk, the risk that changes in the value of the exposure being hedged and changes in the value of the hedging instrument might not fully offset each other. For example, a company may have floating-rate bonds outstanding for which the interest rate resets on the 15th of February, May, August, and November. As noted above, however, the only available interest rate contracts mature in the third week of March, June, September, and December. In such circumstances, the company would find it impossible to hedge perfectly its interest exposure. Each interest payment would be unhedged for over a month of the quarter. Instead of taking on the basis risk, the company could enter into an OTC interest rate swap, thereby effectively passing on the basis risk to an OTC derivatives dealer. OTC dealers have a natural advantage in managing such risks because they trade continuously with a large number of counterparties and have the skilled personnel and order flow necessary to manage interest rate risk arising from mismatched contracts and exposures. For these reasons, futures markets tend to be professional markets while the OTC markets serve the needs of customers such as corporates and smaller, less-sophisticated banks. There is no easy way around this obstacle. The range of listed contracts cannot be extended to include all contracts because most individual contracts arising from commercial trade are so unique as to be inherently illiquid. Simply listing a contract on an exchange does not guarantee liquidity, and may actually reduce the liquidity of existing contracts. Every derivatives exchange has had experience listing new contracts that subsequently had to be withdrawn because the contract never acquired sufficient interest to become viable. If a contract is illiquid, it cannot be marked to market reliably and the exchange clearinghouse cannot manage the associated risk as effectively as with a liquid instrument. Thus, a blanket requirement that all derivatives be exchange traded would have the practical effect of prohibiting most contracts for deferred delivery, including such straightforward transactions as the purchase or sale of fuel oil or wheat at a negotiated price for delivery at a chosen future date. Mandating that all risk management solutions be standard does not reflect the hedging needs driven by the unique risks that businesses encounter.Q.16. One of the arguments for keeping over-the-counter derivatives is the need for customization. What are specific examples of terms that need to be customized because there are no adequate substitutes in the standardized market? Also, what are the actual increased costs of buying those standard contracts?A.16. As noted in the above response to Question 15, standardized contracts list standard delivery dates, maturities and deliverable grades that do not necessarily correspond to the delivery dates and types of exposures market participants need to hedge. Bank loans, for example, are illiquid by their very nature. A creditor bank might wish to reduce its exposure to a particular borrower so as to expand its lending capacity. But if the company in question is relatively small, exchanges will not find it worthwhile to list standardized credit default swaps against that company's loans. At the same time, there might be some investors interested in diversifying their portfolios by taking on an exposure to bank debt. They can do this by buying a portion of the loan, but because bank loans are illiquid trading loans is much more expensive than entering into an over-the-counter credit default swap. More than any other group, restricting trading to standardized derivatives would hurt small businesses. In the area of equity derivatives, investors often use equity swaps to gain exposure to foreign equities because the direct purchase of foreign equities can be very expensive--and in some cases impossible--for an institution without foreign offices (and foreign broking licenses). Thus, restricting trading to standardized contracts traded only in the United States would make it much more difficult and much more costly for U.S. investors to diversify into foreign stocks. The problem would be even more severe in commodity markets. Airlines wishing to hedge jet fuel costs, for example, are often forced to use heating oil futures because the market for jet fuel derivatives is relatively illiquid. Substituting heating oil futures for jet fuel forwards or jet fuel swaps exposes the airline to basis risk. As noted earlier, managing basis risk is a difficult task that typically requires the expertise of professional traders. Simply banning trading in OTC instruments does not guarantee that a liquid market in jet fuel futures would emerge. Moreover, futures markets are typically only liquid for short-term contracts, so that companies such as airlines would find themselves without a way to secure long-term, fixed-price delivery contracts. By offering to provide such custom-tailored contracts, banks supply risk management services to their corporate customers more effectively and at a lower cost than those organizations could do if they had to hire the staff necessary to manage those risks themselves. Managing risks using standardized contracts would require companies to replicate the types of trading and risk management systems typically found only in commodity dealers and banks, and at a very steep cost. More generally, the ability to enter freely into a variety of long-term contracts facilitates the conduct of business. No one can anticipate in advance the terms of all the long-term contracts U.S. companies will find necessary to conduct business, which makes it impossible to list standardized contracts that will address all the needs of all businesses.Q.17. Who is a natural seller of credit protection?A.17. A ``natural'' seller of protection is any entity seeking to profit from being exposed to credit risk of a company, region or industry. Examples of natural sellers include: Institutional investors, pension funds, and insurers, which also invest in corporate bonds. Banks seeking to diversify their sources of income in order to reduce credit concentration. Hedge funds and other investors seeking to profit from perceived overpricing of credit. A seller of credit protection is in an analogous position to a bond holder who has hedged the interest rate risk and, in some cases, exchange rate risk bundled in the bond. The advantage to doing so using credit default swaps instead of buying the bond is that transactions costs typically are smaller and credit default swaps tend to be more liquid than the underlying debt. Credit default swaps may also be available for maturities that would be otherwise unavailable to investors.Q.18. There seems to be agreement that all derivatives trades need to be reported to someone. Who should the trades be reported to, and what information should be reported? And is there any information that should not be made available to the public?A.18. Trades across all derivative asset classes will be reported to various trade information repositories. A repository is accessible in full detail to anyone who regulates the entities who have provided such information to allow the regulator to properly access the risk inherent in the transactions. Aggregated data on open positions and trading volumes will be available to the public. We would direct your attention to http://www.newyorkfed.org/newsevents/news/markets/2009/ma090602.html, which contains a link to the most recent industry letter outlining its commitments to the Federal Reserve Bank of New York, which included commitments regarding trade reporting.Q.19. What is insufficient about the clearinghouse proposed by the dealers and New York Fed?A.19. Please review the ``Report to the Supervisors of the Major OTC Derivatives Dealers on the Proposals on Centralized CDS Clearing Solutions for the Segregation and Portability of Customer CDS Positions and Related Margin'' for a detailed analyses of the relevant clearinghouses. The report can be accessed at http://www.isda.org/credit/docs/Full-Report.pdf. The report highlights some legislative changes that would be desirable to facilitate buy-side access to clearing.Q.20. How do we prevent a clearinghouse or exchange from being too big to fail? And should they have access to Fed borrowing?A.20. These questions are matters of pubic policy that are appropriately decided by legislative and regulatory bodies and not by ISDA or other industry groups. Nonetheless, we respectfully suggest that the possibility of failure is an important element of the market process and that protecting firms from failure can have the paradoxical effect of making individual firms safer while making the financial system less safe. Congress might consider the precedent of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), which placed limitations on the ability of regulators to rescue failing banks, subject to a systemic risk exception. Such limitations put the industry on notice that they will have to bear the consequences of unsound practices. But in order for such a policy to be effective, the limitations must be credible; in other words, the industry must know that regulators will not routinely invoke a systemic risk exception when faced with an actual failure. If such a credible policy cannot be achieved, it is difficult to envision circumstances in which the government would not find it necessary to rescue a large central clearinghouse if it ever experienced financial distress. Access to Fed borrowing by the clearinghouse might be necessary to cope with temporary liquidity crises but should not be used as a bailout tool. In order to address the moral hazard issue, policy makers could require that any lending by the Fed could be repaid out of guarantee funds as well as loss sharing arrangements among surviving firms so the losses would ultimately be borne by the industry. The result would be greater incentives for clearinghouse participants to monitor the risks associated with the clearinghouse.Q.21. What price discovery information do credit default swaps provide, when the market is functioning properly, that cannot be found somewhere else?A.21. Credit default swaps have made credit pricing more transparent by means of their price discovery function. First, credit default swaps on diversified credit indexes such as CDX in North America and iTraxx in Europe provide virtually the only price discovery information on credit markets overall, similar to the price discovery information for U.S. equity markets provided by the ability to enter into contracts on such indexes as the S&P 500 and Dow Jones indexes. Second, both single-name credit default swaps and corporate bond markets provide price discovery for individual corporate debt issues, and the two are linked by means of asset swap pricing. Credit default swaps are arguably more liquid than the underlying bond issues, however, and are therefore likely to provide more informative credit pricing than the underlying cash markets. Finally, the uneven liquidity of corporate bonds is a primary reason not only for widespread reliance on credit default swaps for price discovery, but for early warning about impending credit problems as well. While it is true that corporate bond credit spreads also provide early warning, most corporate bonds tend to trade infrequently so the information dispersal is generally less timely than with credit default swaps.Q.22. Selling credit default swaps is often said to be the same as being long in bonds. However, when buying bonds, you have to provide real capital up front and there is a limit to the lending. So it sounds like selling swaps may be a bet in the same direction as buying bonds, but is essentially a highly leveraged bet. Is that the case, and if so, should it be treated that way for accounting purposes?A.22. First, it should be noted that while it is true that an investor who holds a bond bears the same credit risk as the seller of credit default swap protection, the protection seller does not bear the same bundle of risks as a lender or bond investor. In addition to credit risk, a bond investor faces interest rate risk, possibly foreign exchange risk (in the case of a bond denominated in a foreign currency), funding risk (it is worth remembering that many bond investors such as banks and insurance companies are leveraged: they must borrow the funds they use to buy bonds), and liquidity risk (bonds tend to be much less liquid than derivatives referencing those bonds). Therefore, there is no compelling conceptual reason to apply the same accounting treatment to credit default swaps and bonds based on an equivalence of risks. Moreover, as discussed in response to Question 10 above, it is simply infeasible to apply the same accounting treatment to off-balance-sheet instruments such as credit default swaps as to transactions involving cash securities. Companies can and do report their off-balance-sheet exposures; existing bank regulatory capital requirements already limit the effective leverage that can be created using derivatives. To the extent that existing regulations have not always been applied effectively in the past, or to the extent that they have not been applied uniformly to financial companies in all industries, this is an issue best addressed through more uniform and effective regulation and supervision and more effective risk management. Mandating changes to accounting standards is not a solution. Existing accounting standards were originally devised as expense tracking systems and are not a substitute for capital requirements. Therefore, mandating changes to accounting standards in contravention of conventions established by existing professional rulemaking bodies would likely prove an ineffective method of improving risk management practices.Q.23. Why should we have two regulators of derivatives, with two interpretations of the laws and regulations? Doesn't that just lead to regulation shopping and avoidance?A.23. Regulation of the derivatives markets is a part of the broader public policy debate over the financial regulatory reform. Federal regulation of securities, commodities, exchanges, and derivatives has developed over time and reflects the evolution of the capital markets. In its white paper released last month, the Administration supports the harmonization of futures and securities regulation, proposing the CFTC and the SEC make recommendations to Congress for changes to statutes and regulations that would harmonize regulation of futures and securities. The SEC and CFTC are expected to complete a report to Congress on this issue by the end of September. As Congress considers these recommendations, we submit that inconsistency between regulatory requirements and enforcement of those requirements, for generally equivalent instruments or activities leads to costly uncertainties. Reporting requirements, filing requirements, and approval standards should be harmonized as much as possible. Harmonized standards are necessary to enhance the quality of regulation by the primary Federal regulators and any systemic risk regulator. Finally, the derivatives markets are global and require cooperation among the international markets' regulators. Coordination among regulators at the Federal Government level is critical to successful coordination on the international level. Toward this end, any regulatory reform restructuring that will be passed by Congress should include provisions to preempt State initiatives on the regulation of derivatives instruments, users, and markets.Q.24. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.24. Please see the response to Question 11.Q.25. What is good about the Administration proposal?A.25. The Administration's proposal is an important step toward much-needed reform of financial industry regulation. ISDA and the industry welcome the Administration's recognition of industry measures to safeguard smooth functioning of our markets and its support of the customized OTC derivatives as tools needed by companies to meet their specific needs. ISDA supports appropriate regulation of financial and other institutions that have such a large presence in the financial system that their failure could cause systemic concerns. For nearly 4 years, the industry has been engaged in a dialogue with the Federal Reserve that has resulted in ISDA and the industry committing to strengthening the resilience and robustness of the OTC derivatives markets through the implementation of changes to risk management, processing and transparency that will significantly transform the risk profile of these important financial markets. Specifically, the industry has undertaken to increase standardization of trading terms, improve the trade settlement process, bring more clarity to the settlement of defaults, move toward central counterparty clearing where appropriate, enhance transparency, and enhance openness in the industry's governance structure. All of these initiatives are consistent with the Administration's proposals. We would direct your attention to http://www.newyorkfed.org/newsevents/news/markets/2009/ma090602.html, which contains a link to the most recent industry letter outlining its commitments to the Federal Reserve Bank of New York.Q.26. Is the Administration proposal enough?A.26. Please see answer to 25 above.Q.27. Mr. Whalen suggests that Congress should subject all derivatives to the Commodity Exchange Act, at least as an interim step. Is there any reason we should not do it?A.27. Here is an extract from Mr. Whalen's testimony: ``Congress should subject all OTC contracts to The Commodity Exchange Act (CEA) and instruct the CFTC to begin the systematic review and rule making process to either conform OTC markets to minimum standards of disclosure, collateral and transparency, or require that the contracts be migrated onto organized, bilateral exchanges.'' ISDA disagrees with Mr. Whalen's suggestion, which would turn the clock back almost two decades by reintroducing substantial legal and regulatory uncertainty into derivatives activity and to financial markets in general. The problem is that the CEA is unclear about which financial instruments are and are not futures as defined in the CEA, so extensive discretion is left to the Commodity Futures Trading Commission (CFTC) to decide. The extreme possibility is that an over-the-counter derivatives will be found to be an off-exchange futures contract and therefore illegal. Although the CFTC has the authority to carve out exceptions to the exchange trading requirement, the exceptions themselves are subject to uncertainty because they can be subsequently narrowed and possibly even revoked. The result is that parties seeking to manage their risk with OTC derivatives are forced to do so under the cloud that their transaction could at a later date be declared null and void, which can have potentially disastrous consequences for the firms involved. We submit instead that the Commodity Futures Modernization Act appropriately cleared up much of the legal and regulatory uncertainty surrounding the CEA while leaving CFTC with sufficient authority to address fraud and market manipulation concerns. Returning to an earlier era of legal uncertainty would unnecessarily increase the risks faced by market participants. Further, forcing useful but relatively less liquid products onto exchanges might in many cases doom such products to failure because they cannot generate sufficient volume to support continuous trading.Q.28. Is there anything else you would like to say for the record?A.28. ISDA and the OTC derivatives industry are committed to engaging with Congress to build upon the substantial improvements that have been made in our business since 2005. We will continue to support efforts of Congress, the regulators and the Administration to determine the most effective prudential regulation of this important industry. Changes to the OTC derivatives industry should be informed by an understanding of how the OTC derivatives market functions as well as a recognition that OTC derivatives play an important role in the U.S. economy. OTC derivatives offer significant value to the customers who use them, to the dealers who provide them, and to the financial system in general by enabling the transfer of risk between counterparties. Ultimately, it is important to maintain the continued availability and affordability of these important tools. ------ FOMC20060328meeting--138 136,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Like all of you, we think the underlying trajectory of demand and inflation seems quite favorable, perhaps a bit more so than it did in January. We expect real GDP to grow at a rate slightly above the rate of increasing potential in ’06 and to slow to the range of potential in ’07. We expect the core PCE to rise at a rate in the neighborhood of 2 percent over the forecast period. Differences between our forecast and the Greenbook’s are minor. In our forecast, we assume that inflation expectations remain anchored and the term premium remains low and that we are now at a point where little or no resource slack is left in the domestic economy. The monetary policy assumption we adopt is the path currently priced into the futures markets. The major sources of uncertainty in our forecast are the size of the wealth effect we might see accompanying any slowdown of housing, the flexibility of profit margins, and the sustainability of this present configuration of low risk premiums. We view the risk to the growth forecast as roughly balanced, although the usual suspects provide a source of concern. The risk to our inflation forecast, in contrast, still seems slightly tilted to the upside. On the growth front, as I said, we think the underlying pace of demand growth is pretty strong, and we don’t see any signs yet that would point to evidence of a significant slowdown relative to potential in prospect. We think productivity growth is likely to remain quite high, rising perhaps a bit faster this year than in ’05. With the labor market growing on trend and some increase in labor’s share of national income, we expect consumption growth to remain reasonably strong. Stronger income growth offsets the expected deceleration in housing-price appreciation and the effect that might have on consumption. We expect a slight increase in the contribution of business fixed investment to demand growth, due principally to a rise in spending on equipment and software. We expect, of course, the contribution of residential investment to slow with the forecast period. World GDP growth seems stronger and more broadly based. We expect net exports to be a persistent drag, shaving about ½ percentage point off growth for each of the next two years. Despite this forecast of pretty strong spending growth and high levels of resource utilization, we believe core inflation is likely to remain moderate. Under the assumption of a relatively stable dollar and with the energy-price assumption taken from the futures curve, we expect headline inflation to slow to a rate closer to the core over the forecast period. But this forecast rests on three important foundations. The first is that we succeed in keeping inflation expectations reasonably well anchored. The second is that demand growth not only does not accelerate to a rate substantially above trend but also slows to potential over the forecast period. And the third is that the expected rise in compensation and unit labor costs results in a rise in labor share of income—in other words, that compensation growth accelerates but the increase is absorbed by some compression of profit margins and does not lead to a significant acceleration in core inflation. Now, the sources of potential upside risk to the inflation forecast are several. One, of course, comes from the interaction between our views about productivity growth, compensation, and profit margins. If the pace of productivity growth slows significantly relative to our assumption and if, at the same time, conditions in labor markets continue to improve, unit labor costs are then likely to accelerate. A rise in compensation, however, would not by itself portend a troubling increase in core inflation. The extent of this risk, as I said, depends on the degree to which rising unit labor costs are absorbed in shrinking profit margins rather than triggering output price increases as firms attempt to defend existing margins. And because the labor share of income seems somewhat low and, as historical averages suggest, there’s room for unit labor cost growth to be absorbed in profit margins rather than causing price increases, we need to be attentive to the risk that this process may produce a short-term increase in core inflation, perhaps also in inflation expectations. A second potential risk comes from what we think we know about the pace of demand relative to potential supply globally. A continued increase in commodity prices around the globe and, more recently, some modest increase in capital goods prices may suggest that global pressures on resource constraints are pushing up prices. This raises the risk that the recent weakness in core goods prices in the United States may not be sustained. Service price inflation in the United States has shown signs of slowing. Our central forecast, as I said, is conditioned on little movement in the dollar over the forecast period, but any sizable depreciation of the dollar would still carry the risk of some acceleration in core goods prices. For nearly two years, overall inflation, as what is measured by the PCE or the CPI would suggest, has been running substantially above core, and this is true for a range of alternative measures of underlying inflation. If the underlying inflation rate were closer to 1.5 percent than to 2 percent, we might view these potential sources of upward pressure with more equanimity. Although the probability seems low that these forces will act to produce a significant acceleration of core inflation or a significant deterioration in inflation expectations, we need to be careful about those risks. So with underlying inflation at the upper end of the inferred inflation preference of the Committee, we need to be more attentive to these risks. On the growth side, the most obvious sources of downside risk to growth are a substantial rise in energy prices from current levels, a slowdown in productivity growth, a sharp rise in risk premiums, and a more-adverse effect on saving and consumption from the expected adjustment in housing markets and prices. Like the staff forecast, we think it’s reasonable to expect household saving to rise a bit and consumption growth to slow, in part because of changing expectations about the pace of future appreciation in the value of home equity. But we believe that, absent some large, negative shock to perceptions about employment and earned income, the effects of the expected cooling in housing prices are going to be modest. Of course, this view may prove optimistic. We take some reassurance from the fact that the average growth forecast in the private sector probably anticipates a significant cooling in housing and a significant effect of that cooling on saving and consumption. Developments in asset prices and risk premiums over the past several months seem to support this picture of stronger confidence in the growth and inflation outlook because real rates seem to have risen. Equity prices and credit spreads suggest considerable confidence in the prospect for growth. Implied volatilities remain quite low. We don’t know how much of this is fundamental and how much will prove ephemeral. At the moment, though, overall financial conditions seem pretty supportive of the expansion. So with this forecast of growth in the vicinity of potential, core inflation at around 2 percent, and the risk somewhat to the upside for inflation, we think the principal responsibility of monetary policy remains to preserve the sense that we will act to keep long-term inflation expectations contained at levels consistent with price stability." FinancialCrisisReport--20 By 2003, many lenders began using higher risk lending strategies involving the origination and sale of complex mortgages that differed substantially from the traditional 30-year fixed rate home loan. The following describes some of the securitization practices and higher risk mortgage products that came to dominate the mortgage market in the years leading up to the financial crisis. Securitization. To make home loans sales more efficient and profitable, banks began making increasing use of a mechanism now called “securitization.” In a securitization, a financial institution bundles a large number of home loans into a loan pool, and calculates the amount of mortgage payments that will be paid into that pool by the borrowers. The securitizer then forms a shell corporation or trust, often offshore, to hold the loan pool and use the mortgage revenue stream to support the creation of bonds that make payments to investors over time. Those bonds, which are registered with the SEC, are called residential mortgage backed securities (RMBS) and are typically sold in a public offering to investors. Investors typically make a payment up front, and then hold onto the RMBS securities which repay the principal plus interest over time. The amount of money paid periodically to the RMBS holders is often referred to as the RMBS “coupon rate.” For years, securitization worked well. Borrowers paid their 30-year, fixed rate mortgages with few defaults, and mortgage backed securities built up a reputation as a safe investment. Lenders earned fees for bundling the home loans into pools and either selling the pools or securitizing them into mortgage backed securities. Investment banks also earned fees from working with the lenders to assemble the pools, design the mortgage backed securities, obtain credit ratings for them, and sell the resulting securities to investors. Investors like pension funds, insurance companies, municipalities, university endowments, and hedge funds earned a reasonable rate of return on the RMBS securities they purchased. Due to the 2002 Treasury rule that reduced capital reserves for securitized mortgages, RMBS holdings also became increasingly attractive to banks, which could determine how much capital they needed to hold based on the credit ratings their RMBS securities received from the credit ratings agencies. According to economist Arnold Kling, among other problems, the 2002 rule “created opportunities for banks to lower their ratio of capital to assets through structured financing” and “created the incentive for rating agencies to provide overly optimistic assessment of the risk in mortgage pools.” 15 High Risk Mortgages. The resulting increased demand for mortgage backed securities, joined with Wall Street’s growing appetite for securitization fees, prompted lenders to issue mortgages not only to well qualified borrowers, but also higher risk borrowers. Higher risk borrowers were often referred to as “subprime” borrowers to distinguish them from the more creditworthy “prime” borrowers who traditionally qualified for home loans. Some lenders began 15 “Not What They Had In Mind: A History of Policies that Produced the Financial Crisis of 2008,” September 2009, Mercatus Center, http://mercatus.org/sites/default/files/publication/NotWhatTheyHadInMind(1).pdf. to specialize in issuing loans to subprime borrowers and became known as subprime lenders. 16 FOMC20080130meeting--184 182,MR. FISHER.," First, Mr. Chairman, I want to say a good word about President Poole. I have sat next to him since I got here. I would give him hyperbolic praise if he hadn't handed me the IT Oversight Committee; otherwise, I think he is a wonderful human being. [Laughter] Much of what I was going to say has been said. I think President Plosser, President Lacker, and others have summarized what I would have said about my own District. We continue to grow, but at a decelerated pace, and our current forecast is for employment growth of 2 percent for our District for 2008. That is relatively healthy, and I really am not going to take more time on that subject. I am delighted to hear all this anecdotal evidence. We were talking, Governor Mishkin and I, about Woody Allen earlier. If I remember correctly, he had a wonderful quip--that he cheated on his metaphysics exam by looking into another boy's soul. [Laughter] Basically, what we are doing at this time of transition is almost cheating on the data by looking at the anecdotal evidence. My broader CEO soundings indicate pretty much the same as what we are seeing in our District and what others have mentioned--shipping, rail, express delivery, manufacturing, and other activities are much slower. Retail sales are soft. As President Poole and others pointed out, truckers are suffering. Receivables are being stretched out. Delinquencies are rising. I could bore you with specifics company by company, as I am tempted to do, but I will not unless you wish me to. The point is that, while there are tales of woe, none of the 30 CEOs to whom I talked, outside of housing, see the economy trending into negative territory. They see slower growth. Some of them see much slower growth. None of them at this juncture--the cover of Newsweek notwithstanding, a great contra-indicator, which by the way shows ""the road to recession"" on the issue that is about to come out--see us going into recession. I will just give you two indicators there. If you look at MasterCard and dig into their data, their December retail sales ex-auto, ex-gas, were up 5 percent and in January to date were up 4 percent. President Poole mentioned UPS, and President Lockhart has the incoming CEO of UPS on his board. Year over year to January, they are up 2 percent. So it is anemic. It is not negative. The expectation is not to be negative. My CEO soundings indicate pretty much what we have forecast as a group--much slower growth, not necessarily a recession. Where the difference comes, Mr. Chairman, is on the inflation front. Others have spoken eloquently about inflation. I just want to make a couple of comments here. It is uncanny in the charts that we show in exhibit 5, for example, that we have food PCE prices and energy PCE prices peaking almost as we speak. That may be true in the spot markets. That is not the way it works in reality. AT&T has 100,000 trucks. Southwest Airlines has I don't know how many airplanes. They contract and hedge out forward their energy costs, and the kick-in of any turndown does not occur immediately but rather is stretched out over a time period. I would ask our staff, as we go forward, to try to get a better feeling for that. We are certainly struggling with that in Dallas. As far as food prices are concerned, which again I remind you are twice the weight of energy prices in the headline PCE and the CPI, I heard some very disturbing news. Frito-Lay, for example, which when we last met I reported was going to increase prices 3 percent, has inched them up another 3 percent, to 6 percent, and that is their planning for the year. This is the first time in memory, according to my contacts, that grocery prices are rising faster than restaurant food. Yet it is not simply food where we are seeing this kind of pressure, and I want to come back to the lag effect that occurs. This morning the CEO of Burlington Northern told me that the so-called rail adjustment factor, which captures fuel, labor, supply, and other costs from the previous quarter and is contractually input into contracts for the coming quarter, rose at the highest rate in history--11 percent. That means that even if you are shipping lumber, even if you are shipping whatever goes into housing, by contract--of course, that can be negotiated, I am sure--for the coming quarter the price rise from the shippers, the railers, will be 11 percent. Finally, going back to food and other items bought by consumers--when you drill down deep into Wal-Mart, which has 127 million customers, and you talk about the specifics of their sales, their expansion is not coming from unit sales, it is coming from price inflation. A senior official there tells me that they are budgeting a 2 to 3 percent increase for nonfood items for '08, 6 to 7 percent for food items. It is the first time in his fifteen-year history at the company that they are going to use their price leadership strategy on the plus side of the inflation ledger. So I do worry about inflation expectations, Mr. Chairman. I will summarize with the statement that was in today's New York Times by the CEO of Tyson Foods, who said, ""Because of the unanticipated high corn and soybean meal costs, we have no choice but to raise prices substantially."" That is my major concern besides the additional weakness we are seeing in the economy. Thank you, Mr. Chairman. " FOMC20070509meeting--89 87,CHAIRMAN BERNANKE.," Thank you. Let me try to summarize the discussion around the table and take any comments on the summary, and then I would like to add just a few thoughts. Broadly speaking, the outlook of most participants has not substantially changed since March. Housing remains weak, and it is the greatest source of downside risk. Whether the demand for housing has stabilized remains difficult to judge, in part because of subprime issues. It is also unclear whether builders will seek to return inventories to historical levels, and if so, at what rate. There is yet no indication of significant spillover from housing to other sectors, although that remains a risk. The downside risks to investment have moderated since the last meeting, although investment seems unlikely to be a strong driver of growth. The inventory cycle is now well advanced, and production is strengthening. Consumption growth seems likely to moderate, reflecting factors such as weakness in house prices and high energy prices. However, the labor market remains strong, particularly in the market for highly skilled workers. Incomes generated by the labor market, together with gains in the stock market and generally accommodative financial conditions, should provide some support for consumption going forward. Financial markets are priced for perfection, which implies some risks on that score. Foreign economies remain strong and should be a source of support, although some are undertaking monetary tightening. Overall, the economy is in a soft patch and will likely grow below trend for a while. Growth should return to potential later this year or in 2008, depending on the evolution of the housing market. The rate of potential growth remains hard to pin down. Several participants seem a bit more optimistic than the Greenbook on potential growth and the NAIRU, although there are risks. Inflation has improved a bit, and most see continued but very slow moderation. However, there are upside risks to inflation, including compensation, the dollar, energy prices, and a slowing in productivity. Moreover, a rise in inflation from current levels would be costly, particularly if it involved unhinging inflation expectations. Vigilance on inflation must, therefore, be maintained. Overall the risks and uncertainties seem a bit less pronounced than at the last meeting, and participants seemed relatively comfortable with the outlook. Although there are some potentially significant downside risks to output, arising particularly from the housing sector and the possible spillover to consumption, the group still appears to view a failure of inflation to moderate as expected to be the predominant risk to longer-term stability. Are there any comments or questions? Hearing none, I will just add a few points. First, following President Yellen, I think that the tension between slow growth and a strong labor market remains central to understanding what’s going on. Okun’s law is supposed to work better than this. [Laughter] I looked at recent history. Over the past twenty years or so, there has been no exact parallel to what we are seeing now. There was a jobless recovery in ’91-’93 in which unemployment remained high even though growth was picking up, and we had a midcycle slowdown in ’95 and ’96, which was relatively short and not very severe, in which the unemployment rate got temporarily ahead of growth. So there have been some deviations. Interestingly, after the 2001 recession, despite lots of talk about jobless recoveries, Okun’s law worked pretty well. So we are in an unusual situation—instead of a jobless recovery, we have growthless job growth. [Laughter] Interpreting this correctly is very important. The staff forecast essentially assumes that Okun’s law will revert to historical tendency. I think that assumption is reasonable, particularly since the staff is not exceptionally optimistic about potential growth and, therefore, that particular source of error is moderated. That would suggest that labor hoarding is probably a good part of what is happening here. If there is one area in which labor hoarding appears to be significant, it would be construction, as President Yellen mentioned. I asked the staff to do a simple study of this relationship, to which Dave Stockton referred. Andrew Figura and Adam Looney of the Board’s staff performed a regression analysis in which they regressed all construction employment against all investment in structures quarterly with lags going back to 1985. The reason to look at all construction in terms of both employment and production is that there is a lot of substitutability between those two categories. That regression approach should also account for unmeasured labor, including undocumented workers and the like. In this analysis they found that employment is roughly proportional to construction activity, but with substantial lags, which again is somewhat surprising. Indeed, the model fits well through the fourth quarter of ’06 but then begins to underpredict significantly in the first quarter of ’07. If this model is correct, then given what is already in the pipeline in terms of reduced construction activity and then going on with the forecast in the Greenbook, we should begin to see fairly significant declines in construction employment on the order of 30,000 per month over the next year, which would be sufficient in itself, with all else being equal, to add 0.2 to 0.3 to the unemployment rate. So if labor hoarding explains the failure of Okun’s law, then we may soon see some gradual rise in the unemployment rate, which would also be consistent with the view that the staff has taken that a good bit of the slowdown in productivity is cyclical. It is actually fairly difficult to calculate the contribution of the construction sector to productivity because it involves not just construction workers but also upstream production of various kinds. But one estimate, which comes from discussions with the Council of Economic Advisers, had the implication of employment hoarding in construction being about ½ percentage point on productivity growth. We will see how that develops. Even though I believe, as does the staff, that we will see some softening in the labor market, I should say that the evidence is still quite tentative. We saw a bit of weakness in the last labor report, but unemployment insurance claims remain low, and we do not really see a significant indication. The other major issue is the housing market. Again, as a number of people pointed out, this is an inventory-cycle problem. The two main determinants of an inventory cycle are (1) what the level of final demand is and (2) how quickly you move to bring inventories back to normal. There does seem to have been some step-down in final demand over the past few months. Assuming that homebuilders would like to get not all the way to but significantly toward their last ten years’ inventories by the end of 2008 implies fairly weak construction, not only in the second quarter but going into the third quarter as well. Only in the fourth quarter will we see a relatively minor subtraction from GDP. That’s also relatively speculative, but residential construction does seem fairly likely to me to be more of a drag than we previously thought and to continue to be a problem into the third quarter. There will also be a slowdown in consumption. We have been having rates near 4 percent, which is certainly not sustainable. We already see indications that consumption may be closer to 2 percent in the second quarter. I think the house-price effects are going to show up. Gasoline prices will have an effect. The labor market is strong, but it is going to slow a bit. So it looks to me as though underlying growth is roughly 2 percent and will be so for a couple of quarters to come. Notice in the thinking about the underlying case that there has been quite an asynchronicity between private domestic final demand and production lately. For example, for the second quarter we expect to see weaker private domestic final demand but probably a stronger GDP number because of rebounds in net exports and the like. But we should look past that—those are just quarter-to-quarter variations—and observe that growth is moderate, an observation that is supported by the sense that industrial production and manufacturing seem to be picking up. To summarize, I think that the notion of moderate growth with some uncertainty and with return toward potential later in the year or early next year is still probably about the right forecast. On inflation, there’s the famous stock market prediction that prices will fluctuate. That seems to be true also for inflation. I mentioned at the last meeting that the monthly standard deviation in inflation numbers is about 0.08, and so between 0.1 and 0.3 there is not necessarily a whole lot of information. We have a few pieces of good news. I think vacancy rates are rising for both apartments and single-family homes. At some point we will begin to see better progress on owners’ equivalent rent and shelter costs. Also, the quarterly average of medical cost increases was much more moderate than in the first two months, which suggests that maybe this risk is not as serious as it may have looked. However, as many people pointed out, there are a number of negatives, including the dollar, energy, food prices, commodity prices, and most importantly, the labor market. The compensation data remain quite mixed—in particular, the ECI, which was a very soft headline number. The 1.1 percent quarterly wage and salary number, or 3.6 percent for twelve months, is now more or less consistent with what we’re seeing in average hourly earnings. If productivity falls below 2 percent, then we are beginning to get to a range in which unit labor costs will be putting pressure on inflation. So I am quite comfortable with the view expressed around the table that, although inflation looks to be stabilizing and perhaps falling slowly, there are significant risks to inflation and we should take those very seriously. Very much a side point—I did have some interesting discussions with the staff about the role of the stock market in the forecast. This is not the staff’s fault, but there is a sort of tension in how the stock market is treated. On the one hand, the stock market is assumed to grow at 6½ percent from the current level. On the other hand, the forecast has profit growth going essentially to zero by the third quarter but interest rates coming up. Those two things are a little hard to reconcile. The difficult problem is which way you should go to reconcile it. On the one hand, it could be that the forecast is right, and therefore the stock market will in fact be weaker; that will have implications for stability, for consumption, and so on. On the other hand, perhaps we should be taking information from the stock market in making our forecast. So it is a very difficult problem, and I just wanted to point out the tension that we will have to see resolved over the next few quarters. One partial resolution is that, as has been noted, the stock market and the economy as a whole can be decoupled to some extent because of overseas profits. This is an interesting example of how financial globalization is creating stability for domestic consumption—you know, decoupling domestic consumption from domestic production. Again, we had a very good discussion with the staff about this issue, and I think it is just something we will need to think about going forward. In summary, in the last meeting we felt that uncertainty had risen. There has been perhaps a slight moderation of those concerns at this point—a little less inflation risk, a little less growth risk. Nevertheless, the balance of risks with inflation being the greater still seems to me to be a reasonable approach. Let me now turn to Vincent to begin the policy go-round." FOMC20060808meeting--150 148,CHAIRMAN BERNANKE.," I know some people have flights and so on, so why don’t we continue eating here. If you’re still eating, we can just reconvene. Before we get going, I just want to recognize Barbara Driggins over here. Barbara is retiring. [Applause] Thank you, Barbara, for thirty-six years of service, and we hope this display of affection will cause you to reconsider. [Laughter]" FOMC20050630meeting--110 108,MR. LEHNERT.," Then I beg your pardon. Of course, the stock differences are enormous. As for the flow difference, on net, GSE guaranteed mortgages in both pools and to a small extent on the balance sheet hardly grew at all in 2004, while it was an explosive year for growth for the RMBS sector." FOMC20060510meeting--220 218,MR. POOLE.," Obviously this is something that is very hard to gather any evidence on in advance. I am just telling you my gut feeling for what’s going to happen is that this will reduce the market’s expectation about action in June, and I would be surprised if that were just simply switched out later in the year." FOMC20060629meeting--161 159,MR. HOENIG.," That’s a generous word, but thank you. [Laughter]" CHRG-111hhrg49968--14 Chairman Spratt," Has the Fed done any work to determine what the likely pool of savings available for borrowing may be--foreign markets, world markets, global credit markets--and to what extent we will have to borrow substantially from those savings pools, capital pools, in order to meet our debt requirements in the foreseeable future? " FOMC20081029meeting--165 163,MR. MADIGAN.," 5 I will be referring to the separate package labeled ""Material for Briefing on FOMC Participants' Economic Projections."" Exhibit 1 shows the central tendencies and ranges of your current forecasts for 2008; corresponding information about the Committee's most recent projections, those from June, is shown in italics, and Greenbook projections are included as a memo item. Your June projections regarding GDP growth and inflation for the first half of 2008 turned out to be quite close to subsequent BEA data releases; therefore, the revisions in your 5 The materials used by Mr. Madigan are appended to this transcript (appendix 5). projections for the year as a whole are almost entirely due to the changes in your implicit projections for the second half of 2008. As shown in the right column of the top panel, your GDP growth forecasts for 2008:H2 now range from minus 2� percent to minus � percent; compared with June, each of you has marked down your projection for second-half growth by at least 2 percentage points. As shown in the second panel, your forecasts of the fourthquarter average unemployment rate fall in a range of 6.3 to 6.6 percent, more than � percentage point higher than in June. In accounting for the sharp deterioration in the near-term outlook for activity, your narratives point to the intensification of the financial crisis and its impact on credit conditions and stock market wealth as well as the weakness of incoming data on consumer spending and labor market conditions. Your assessments of inflation in 2008 have also shifted significantly since June. The central tendency of your forecasts for overall PCE inflation during 2008:H2 (the right column of the third panel) is now about 1� to 2� percent, a drop of about 2 percentage points from June. In this regard, a number of you noted the implications of recent sharp declines in energy and commodity prices that were apparently triggered by the worldwide slowdown in economic activity. In contrast, your projections for core PCE inflation in 2008:H2 (the right column of the bottom panel) are a notch higher than in June. Exhibit 2 reports your projections for the next three calendar years. Most of you anticipate little or no GDP growth during 2009; as with your implicit forecasts for the second half of 2008, these projections are about 2 percentage points lower than in June. A few of you are projecting even weaker outcomes, with output declining about 1 percent, whereas a few others are projecting stronger economic growth of about 1� to 1� percent. The width of both the ranges and the central tendencies of your projections for real GDP growth for 2009 and 2010 has increased noticeably. Still, all of you anticipate that economic expansion will resume by 2010, and most of you expect a further pickup in growth during 2011. In the narratives accompanying these projections, a number of you said that you expect the pace of recovery to be damped by persistent credit market strains, ongoing adjustment in the housing market, and economic weakness abroad. Apparently, only a few of you assumed that additional fiscal stimulus would be enacted. Most of you project that the unemployment rate will peak at around 7 to 7� percent in 2009 and decline gradually over the subsequent two years. However, you generally expect that, even by the end of 2011, the unemployment rate will still be at or above 5� percent. Moreover, most of you anticipate that the unemployment rate in 2011 will remain well above your own projections of the longer-run unemployment rate that were provided in your trial-run submissions. The central tendency of your projections for overall PCE inflation is about 1� to 2 percent for 2009 and about 1� to 1� percent for 2010 and 2011--roughly the same as for your forecasts of core PCE inflation. About half of you projected inflation rates in 2011 close or identical to your own individual assessments of the rate of inflation consistent with Federal Reserve's dual mandate for promoting price stability and maximum employment, where we have again judged the latter from your longerterm trial-run submissions. But half of you are projecting that inflation in 2011 will be below your own individual assessments of the mandate-consistent inflation rate by about � to � percentage point, and in one case, by more than 1 percentage point, mainly reflecting the lagged effects of weak economic activity and the relatively sluggish pace of recovery. In your forecast submissions, several of you indicated that the appropriate path of monetary policy would involve less near-term easing than assumed in the Greenbook, and more than half of you expressed the view that policy tightening would need to occur several quarters earlier and at a substantially more rapid pace than in the Greenbook. Exhibit 3 presents your views on the risks and uncertainties in the outlook. As shown in the top left-hand panel, all of you now see uncertainty about growth as elevated relative to historical norms. As shown to the right, most of you continue to perceive the risks to growth as weighted to the downside even with the downward revision in your modal projections. Several of you pointed to the possibility that financial market turmoil might not subside as quickly as anticipated and to significant risks of an increasingly negative feedback loop between credit markets and economic activity. As shown in the bottom left-hand panel, most of you also continue to see an elevated degree of uncertainty about inflation. In June, most of you judged the risks to the inflation outlook as skewed to the upside, but as shown to the right, nearly all of you now see the risks to the inflation outlook as either balanced or tilted to the downside. Exhibit 4 summarizes the results of the trial run on longer-term projections. These projections were intended to represent values to which variables would converge over time, say five to six years ahead, under the assumption of appropriate monetary policy and in the absence of any further shocks. For real GDP growth, your longer-term projections have a central tendency of 2� to 2� percent and a range of about 2 to 3 percent. For the unemployment rate, your longer-run projections have a central tendency of 4� to 5 percent and a range of about 4� to 5� percent. For both variables, the central tendencies are very similar to those of the projections for 2010 that you made in October 2007, shown in the bottom panel, a point at which many of you viewed the modal outlook for 2010 as being fairly close to the balanced growth path of the economy. For PCE inflation, your longer-run projections have a central tendency of about 1� percent and a range of 1� to 2 percent. The range of these projections is identical to the range of two-year-ahead inflation projections that you made last October; the minutes from that meeting indicated that those projections were influenced importantly by your judgments about the measured rates of inflation consistent with the Federal Reserve's dual mandate of promoting price stability and maximum employment. The request for the trial-run projections suggested that convergence might typically occur over a period of five to six years. One of you noted that the convergence process this time will likely occur over an even longer period because of the severity of the economic crisis. However, apparently most of you thought that convergence would occur sooner than that, suggesting that the configuration of this trial run produces a good representation of FOMC participants' views of the steady state values of GDP growth, unemployment, and inflation. As usual, the staff will be preparing a summary of economic projections (SEP) and will be circulating drafts to you over the next few weeks along with drafts of the minutes. The published SEP, and hence the drafts, will not incorporate the longerterm projections from the trial run. The staff will provide to you separately a version of the SEP that has been modified to incorporate the longer-term projections generated by the trial run. The subcommittee will consult with the Chairman about next steps. One possibility would be for the Committee to discuss experience with the trial run at its December meeting and make a provisional decision at that time as to whether to proceed in January with regular longer-term projections; a final decision could be made in January. Thank you. That concludes our presentation. " FOMC20070628meeting--126 124,MR. LOCKHART.," Thank you, Mr. Chairman. I would like to speak earlier next time, so I don’t have to give credit to so many of the previous speakers—[laughter] including President Poole, who really said a lot of what I have to say. There wasn’t much change in the Sixth District economic picture during the intermeeting period, particularly regarding things that are relevant to the national outlook. So I am not going to devote a lot of time to discussing across-the-board conditions in the District. My staff’s outlook— and my outlook—for the national economy doesn’t differ much from the Greenbook analysis and forecast, so I also won’t detail small differences between those two forecasts. The Greenbook outlook reflects the baseline expectation of a diminishing drag on real growth from residential investment. Since our forecast largely agrees with the Greenbook, we obviously see the most likely playout of the housing correction similarly. However, as suggested in the Greenbook’s first alternative simulation, we may be too sanguine. I think this is really President Poole’s message about a recovery in the housing sector. That is to say, the downturn in residential investment will be deeper and more prolonged and possibly involve spillovers. So I would like to devote my comments, in a cautionary tone, to this particular concern. Credit available for residential real estate purchases is contracting, and the credit contraction, specifically in the subprime mortgage market, has the potential to lengthen the transition period required to reduce housing inventories to normal levels. This tightening of credit availability, along with higher rates, may affect the timeline of the recovery. One market of concern is the starter home market. The subprime mortgage market has been a major credit source for first-time homebuyers—although, as has been mentioned earlier, subprime mortgages are a small portion of the aggregate stock of mortgages. Subprimes were 20 percent of originations in 2005 and 2006, and if you added alt-A nonprime mortgages, you would get 33 percent of originations in the past two years. In many suburban areas, like those around Atlanta and Nashville in my District, much home construction was targeted at first-time buyers. We have heard anecdotal reports from banking and real estate contacts in our region that tighter credit conditions have aggravated the already sluggish demand for homes. The country’s largest homebuilder—there may be a debate with President Fisher—[laughter] so one of the country’s largest homebuilders, headquartered in Miami, reported on Tuesday a 29 percent drop in homes delivered and a 7.5 percent drop in average prices. But that is combined with a 77 percent increase in sales incentives. They attribute their negative sales experience to rising defaults among subprime borrowers and higher rates. That company’s CEO said that he sees no sign of a recovery, and he provided guidance of a loss position in the third quarter. Because of the major role that homebuilding—and, I might add, construction materials, particularly in forest products—plays in the Sixth District economy and because of some tentative signs of spillover, we will continue to monitor these developments in our District very carefully. As I stated at the outset, we share the basic outlook described in the Greenbook, but observation of the housing sector dynamics in the Sixth District has raised our level of concern that the national housing correction process may cause greater-than-forecasted weakness in real activity. If that is the case and inflation gains prove transitory, as suggested in the Greenbook commentary, we may be dealing with a far more challenging policy tradeoff than we are today. Thank you, Mr. Chairman." CHRG-111hhrg58044--302 Mr. Wilson," Sure. One of the key considerations is the target that is being modeled. A credit score for financial purposes is generally targeting the likelihood or the odds of someone going delinquent on a loan payment in the next 2 years. The bank has a pool of loans. They know who has gone delinquent and who has not gone delinquent. They model for that. The credit characteristics that are most correlated with loan delinquency come into that model. By contrast, an insurance company is going to look at loss ratio for a pool of policyholders. They will use the correlation between the credit factors and the observed loss ratio to produce a rank ordering. Because the target is different, the credit characteristics and their weights are different. Ms. Kilroy. What kind of-- " CHRG-111hhrg51585--286 Mr. Hullinghorst," The amount of investment in commercial paper by governments is probably less than 10 percent, maybe 20 percent of our entire portfolio. I would have to be speculating on that. But there is at least $200 billion to $300 billion invested in pools, pooled investment funds. And so that is roughly $30 billion. It is not going to kill the commercial paper market, but we are in the commercial paper market because there are specific maturity dates that we need to meet. Sometimes those maturity dates aren't available in other paper, and commercial paper that is A1/P1 rated is supposed to have a maturity that you can count on. There are two things that are going to happen if we continue down this road and don't support municipal governments. One is already happening, and that is that people are pulling out of the pooled investment funds all over the country. One in Colorado has already failed because of its Lehman investments because it broke the buck. It wasn't a bad investment pool; it is just that, by the rules of the game, if you have more than a $1 loss in a pooled investment fund, you close the doors and you liquidate. There is another pool in Colorado that-- " FOMC20071211meeting--159 157,CHAIRMAN BERNANKE.," Thank you. Thank you, everyone. Oh, sorry. Vice Chairman. [Laughter]" FOMC20050809meeting--157 155,MR. POOLE.," Thank you, Mr. Chairman. My contacts led off almost universally with comments such as: “Things look great;” “Everything is steady-as-she-goes;” and “All business areas are strong.” And I’d just like to fill in a few observations here. My Wal-Mart contact—and as I think you know, Wal-Mart has been very concerned about the drain on purchasing power because of gasoline prices—said that they now believe that August 9, 2005 60 of 110 product mix that was too skewed toward the low end, and the part of the income distribution that buys the low end merchandise is still struggling with gasoline prices. So, to some extent, their overall sales performance last year was simply a consequence of the mix of goods that they had on their shelves. They have changed that mix of goods. He used as an example the fact that 22 percent of the TVs they’re selling now are high definition digital TVs. That’s a rather big percentage for a company like Wal-Mart. An interesting comment from my UPS contact was that they are now struggling to obtain enough aircraft, in good part because of their expansion in China. That expansion is not just in the import/export business—they’re entering the internal Chinese market. He said that they have no aircraft available either for purchase or lease until 2008. UPS and FedEx both have filled out their fleets to a very considerable extent by taking aging passenger aircraft and converting them. But the converters are all working at capacity. So, UPS will keep in service aircraft that are 30 to 40 years old. Obviously, those planes are much more expensive to operate, and UPS would like to replace them with new aircraft but will make do with these older ones. Both UPS and FedEx said that they’re expecting a very good holiday season, but they anticipate having plenty of capacity. A contact with a major software company said that they’re a little skittish—“very cautious” was the term he used—about the large enterprise business but that other sectors of their business are doing quite well. It seems to me clear that the economy has a very good head of steam. I would argue that monetary policy is not highly expansionary at this point. Rates have gone up a lot, and the market anticipates that rates will continue to go up. I’m one of the few people, I guess, who look August 9, 2005 61 of 110 [laughter] MZM is up by slightly more than 1 percent in the last year and has been about flat in the last six months. M2 is up a bit less than 4 percent. That’s not consistent with highly expansionary monetary policy. I would say, however, that there is a disconnect arising between the anecdotal reports and the econometric estimates and analysis on the state of the labor market. When I talk to contacts in my District, they say over and over again that they have no problem with labor availability and that there is no wage pressure, except in isolated cases. For example, my UPS friend said that they are having ongoing negotiations with the Teamsters and are seeing some job actions. So there may be some issue there. But except for a few scattered examples—such as truck drivers, as I’ve mentioned before—my contacts say that they just don’t see any problem with labor availability. And that’s not just at the low end, but at all skill levels, though there may still be some problems hiring accountants. But even that’s not something that they bring up voluntarily when I talk with them. Again, they see no significant wage pressures. So I think there’s a disconnect here between the anecdotal information and the econometric information. I don’t know what to do about it, but I’d make note of it. [Laughter] Thank you." FOMC20060920meeting--132 130,CHAIRMAN BERNANKE.," Thank you, President Pianalto, for the new leading indicator of religious statues. [Laughter] I recently gave a speech in South Carolina, where they always have an invocation, and the pastor called for God’s blessing on monetary and credit policy. [Laughter] President Guynn." FOMC20080130meeting--4 2,CHAIRMAN BERNANKE.," We'll let Bill have the last word on that. [Laughter] Okay. Today is the first regular meeting of the year. This is our organizational meeting, so we have some housekeeping things. Item one, nomination of the Chairman. Governor Kohn. " FOMC20060510meeting--62 60,MR. POOLE.," Thank you, Mr. Chairman. I have several questions that I will ask quickly here. First of all, I do want to commend the Board staff and the staff of the Reserve Banks on the special survey. I thought the information on nonresidential construction was very useful. Here are my questions. First, is there a way we can reconcile the ECI and the compensation data? They seem to be further apart than typical. I don’t know technically whether doing so is possible or the extent to which it’s possible. Second, you note in the Greenbook, but without any real explanation, that federal tax revenues are coming in extraordinarily strong—stronger than anticipated. What do we know about why that might be the case? I would also ask about your expected narrowing of profit margins. My question is, why? There are lots and lots of economic incentives for corporate managers to keep those margins high and to expand them if they can. A lot of people have compensation linked to profits, the stock market, and so forth. So it seems to me that the economics would say that there’s no reason particularly to expect a reversion. I gather that your explanation was that it’s sort of outside what we have typically observed and, in a time series sense, you expect it to go back. But I’m worried about the economics underlying that view. I think it’s quite important for the inflation outlook because, even if wages are well contained, it could well be that companies will just take price increases whenever they can and enjoy the benefits of the profits. So I’ll let you deal with those in any way you want. [Laughter]" FOMC20070321meeting--126 124,MR. REINHART., Thank you. That will be noted in the transcript. [Laughter] CHRG-111shrg55117--7 Mr. Bernanke," Thank you. Chairman Dodd, Ranking Member Shelby, and other Members of the Committee, I am pleased to present the Federal Reserve's semiannual Monetary Policy Report to the Congress. Aggressive policy actions taken around the world last fall may well have averted the collapse of the global financial system, an event that would have had extremely adverse and protracted consequences for the world economy. Even so, the financial shocks that hit the global economy in September and October were the worst since the 1930s, and they helped push the global economy into the deepest recession since World War II. The U.S. economy contracted sharply in the fourth quarter of last year and the first quarter of this year. More recently, the pace of decline appears to have slowed significantly, and final demand and production have shown tentative signs of stabilization. The labor market, however, has continued to weaken. Consumer price inflation, which fell to low levels late last year, remained subdued in the first 6 months of 2009. To promote economic recovery and foster price stability, the Federal Open Market Committee last year brought its target for the Federal funds rate to a historically low range of 0 to \1/4\ percent, where it remains today. The FOMC anticipates that economic conditions are likely to warrant maintaining the Federal funds rate at exceptionally low levels for an extended period. At the time of our February report, financial markets at home and abroad were under intense strains, with equity prices at multiyear lows, risk spreads for private borrowers at very elevated levels, and some important financial markets essentially shut. Today, financial conditions remain stressed, and many households and businesses are finding credit difficult to obtain. Nevertheless, on net, the past few months have seen some notable improvements. For example, interest rate spreads in short-term money markets, such as the interbank market and the commercial paper market, have continued to narrow. The extreme risk aversion of last fall has eased somewhat, and investors are returning to private credit markets. Reflecting this greater investor receptivity, corporate bond issuance has been strong. Many markets are functioning more normally, with increased liquidity and lower bid-asked spreads. Equity prices, which hit a low point in March, have recovered to roughly their levels at the end of last year, and banks have raised a significant amount of new capital. Many of the improvements in financial conditions can be traced, in part, to policy actions taken by the Federal Reserve to encourage the flow of credit. For example, the decline in interbank lending rates and spreads was facilitated by the actions of the Federal Reserve and other central banks to ensure that financial institutions have access to adequate amounts of short-term liquidity, which in turn has increased the stability of the banking system and the ability of banks to lend. Interest rates and spreads on commercial paper dropped significantly as a result of the backstop liquidity facilities that the Federal Reserve introduced last fall for that market. Our purchases of agency mortgage-backed securities and other longer-term assets have helped lower conforming fixed mortgage rates. And the Term Asset-Backed Securities Loan Facility, or TALF, which was implemented this year, has helped to restart the securitization markets for various classes of consumer and small business credit. Earlier this year, the Federal Reserve and other Federal banking regulatory agencies undertook the Supervisory Capital Assessment Program, popularly known as the ``stress test,'' to determine the capital needs of the largest financial institutions. The results of the SCAP were reported in May, and they appeared to increase investor confidence in the U.S. banking system. Subsequently, the great majority of institutions that underwent the assessment have raised equity in public markets. And, on June 17, 10 of the largest U.S. bank holding companies--all but one of which participated in the SCAP--repaid a total of nearly $70 billion to the Treasury. Better conditions in financial markets have been accompanied by some improvement in economic prospects. Consumer spending has been relatively stable so far this year, and the decline in housing activity appears to have moderated. Businesses have continued to cut capital spending and liquidate inventories, but the likely slowdown in the pace of inventory liquidation in coming quarters represents another factor that may support a turnaround in activity. Although the recession in the rest of the world led to a steep drop in the demand for U.S. exports, this drag on our economy also appears to be waning, as many of our trading partners are also seeing signs of stabilization. Despite these positive signs, the rate of job loss remains high and the unemployment rate has continued its steep rise. Job insecurity, together with declines in home values and tight credit, is likely to limit gains in consumer spending. The possibility that the recent stabilization in household spending will prove transient is an important downside risk to the outlook. In conjunction with the June FOMC meeting, Board members and Reserve Bank presidents prepared economic projections covering the years 2009 through 2011. FOMC participants generally expect that, after declining in the first half of this year, output will increase slightly over the remainder of 2009. The recovery is expected to be gradual in 2010, with some acceleration in activity in 2011. Although the unemployment rate is projected to peak at the end of this year, the projected declines in 2010 and 2011 would still leave unemployment well above FOMC participants' views of the longer-run sustainable rate. All participants expect that inflation will be somewhat lower this year than in recent years, and most expect it to remain subdued over the next 2 years. In light of the substantial economic slack and limited inflation pressures, monetary policy remains focused on fostering economic recovery. Accordingly, as I mentioned earlier, the FOMC believes that a highly accommodative stance of monetary policy will be appropriate for an extended period. However, we also believe that it is important to assure the public and the markets that the extraordinary policy measures we have taken in response to the financial crisis and the recession can be withdrawn in a smooth and timely manner as needed, thereby avoiding the risk that policy stimulus could lead to a future rise in inflation. The FOMC has been devoting considerable attention to issues relating to its exit strategy, and we are confident that we have the necessary tools to implement that strategy when appropriate. To some extent, our policy measures will unwind automatically as the economy recovers and financial strains ease, because most of our extraordinary liquidity facilities are priced at a premium over normal interest rate spreads. Indeed, total Federal Reserve credit extended to banks and other market participants has declined from roughly $1.5 trillion at the end of 2008 to less than $600 billion, reflecting the improvement in financial conditions that has already occurred. In addition, bank reserves held at the Fed will decline as the longer-term assets that we own are maturing or are prepaid. Nevertheless, should economic conditions warrant a tightening of monetary policy before this process of unwinding is complete, we have a number of tools that will enable us to raise market interest rates as needed. Perhaps the most important such tool is the authority that the Congress granted the Federal Reserve last fall to pay interest on balances held at the Fed by depository institutions. Raising the rate of interest paid on reserve balances will give us substantial leverage over the Federal funds rate and other short-term market interest rates, because banks generally will not supply funds to the market at an interest rate significantly lower than they can earn risk free by holding balances at the Federal Reserve. Indeed, many foreign central banks use the ability to pay interest on reserves to help set a floor on market interest rates. The attractiveness to banks of leaving their excess reserve balances with the Federal Reserve can be further increased by offering banks a choice of maturities for their deposits. But interest on reserves is by no means the only tool we have to influence market interest rates. For example, we can drain liquidity from the system by conducting reverse repurchase agreements, in which we sell securities from our portfolio with an agreement to buy them back at a later date. Reverse repurchase agreements, which can be executed with primary dealers, Government-sponsored enterprises, and a range of other counterparties, are a traditional and well-understood method of managing the level of bank reserves. If necessary, another means of tightening policy is outright sales of our holdings of longer-term securities. Not only would such sales drain reserves and raise short-term interest rates, but they also could put upward pressure on longer-term interest rates by expanding the supply of longer-term assets. In sum, we are confident that we have the tools to raise interest rates when that becomes necessary to achieve our objectives of maximum employment and price stability. Our economy and financial markets have faced extraordinary near-term challenges, and strong and timely actions to respond to those challenges have been necessary and appropriate. I have discussed some of the measures taken by the Federal Reserve to promote economic growth and financial stability. The Congress also has taken substantial actions, including the passage of a fiscal stimulus package. Nevertheless, even as important steps have been taken to address the recession and the intense threats to financial stability, maintaining the confidence of the public and financial markets requires that policy makers begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and the continued increases in the costs of Medicare and Medicaid. Addressing the country's fiscal problems will require difficult choices, but postponing those choices will only make them more difficult. Moreover, agreeing on a sustainable long-run fiscal path now could yield considerable near-term economic benefits in the form of lower long-term interest rates and increased consumer and business confidence. Unless we demonstrate a strong commitment to fiscal sustainability, we risk having neither financial stability nor durable economic growth. A clear lesson of the recent financial turmoil is that we must make our system of financial supervision and regulation more effective, both in the United States and abroad. In my view, comprehensive reform should include at least the following key elements: A prudential approach that focuses on the stability of the financial system as a whole, not just the safety and soundness of individual institutions, and that includes formal mechanisms for identifying and dealing with emerging systemic risks; Stronger capital and liquidity standards for financial firms, with more stringent standards for large, complex, and financially interconnected firms; The extension and enhancement of supervisory oversight, including effective consolidated supervision, to all financial organizations that could pose a significant risk to the overall financial system; An enhanced bankruptcy or resolution regime, modeled on the current system for depository institutions, that would allow financially troubled, systemically important nonbank financial institutions to be wound down without broad disruption to the financial system and the economy; Enhanced protections for consumers and investors in their financial dealings; Measures to ensure that critical payment, clearing, and settlement arrangements are resilient to financial shocks, and that practices related to the trading and clearing of derivatives and other financial instruments do not pose risks to the financial system as a whole; And, finally, improved coordination across countries in the development of regulations and in the supervision of internationally active firms. The Federal Reserve has taken and will continue to take important steps to strengthen supervision, improve the resiliency of the financial system, and to increase the macroprudential orientation of our oversight. For example, we are expanding our use of horizontal reviews of financial firms to provide a more comprehensive understanding of practices and risks in the financial system. The Federal Reserve also remains strongly committed to effectively carrying out our responsibilities for consumer protection. Over the past 3 years, the Federal Reserve has written rules providing strong protections for mortgage borrowers and credit card users, among many other substantive actions. Later this week, the Board will issue a proposal using our authority under the Truth in Lending Act, which will include new, consumer-tested disclosures as well as rule changes applying to mortgages and home equity lines of credit; in addition, the proposal includes new rules governing the compensation of mortgage originators. We are expanding our supervisory activities to include risk-focused reviews of consumer compliance in nonbank subsidiaries of holding companies. Our community affairs and research areas have provided support and assistance for organizations specializing in foreclosure mitigation, and we have worked with nonprofit groups on strategies for neighborhood stabilization. The Federal Reserve's combination of expertise in financial markets, payment systems, and supervision positions us well to protect the interests of consumers in their financial transactions. We look forward to discussing with the Congress ways to further formalize our institution's strong commitment to consumer protection. Finally, the Congress and the American people have a right to know how the Federal Reserve is carrying out its responsibilities and how we are using taxpayers' resources. The Federal Reserve is committed to transparency and accountability in its operations. We report on our activities in a variety of ways, including reports like the one I am presenting to the Congress today, other testimonies, and speeches. The FOMC releases a statement immediately after each regularly scheduled meeting and detailed minutes of each meeting on a timely basis. We have increased the frequency and scope of the published economic forecasts of FOMC participants. We provide the public with detailed annual reports on the financial activities of the Federal Reserve System that are audited by an independent public accounting firm, and we publish a complete balance sheet each week. We have recently taken additional steps to better inform the public about the programs we have instituted to combat the financial crisis. We expanded our Web site this year to bring together already available information as well as considerable new information on our policy programs and financial activities. In June, we initiated a monthly report to the Congress that provides even more information on Federal Reserve liquidity programs, including breakdowns of our lending, the associated collateral, and other facets of programs established to address the financial crisis. These steps should help the public understand the efforts that we have taken to protect the taxpayer as we supply liquidity to the financial system and support the functioning of key credit markets. The Congress has recently discussed proposals to expand the audit authority of the GAO over the Federal Reserve. As you know, the Federal Reserve is already subject to frequent reviews by the GAO. The GAO has broad authority to audit our operations and functions. The Congress recently granted the GAO new authority to conduct audits of the credit facilities extended by the Federal Reserve to ``single and specific'' companies under the authority provided by section 13(3) of the Federal Reserve Act, including the loan facilities provided to, or created for, AIG and Bear Stearns. The GAO and the Special Inspector General have the right to audit our TALF program, which uses funds from the Troubled Assets Relief Program. The Congress, however, purposefully--and for good reason--excluded from the scope of potential GAO reviews some highly sensitive areas, notably monetary policy deliberations and operations, including open market and discount window operations. In doing so, the Congress carefully balanced the need for public accountability with the strong public policy benefits that flow from maintaining an appropriate degree of independence for the central bank in making and executing monetary policy. Financial markets, in particular, likely would see a grant of review authority in these areas to the GAO as a serious weakening of monetary policy independence. Because GAO reviews may be initiated at the request of Members of Congress, reviews or the threat of reviews in these areas could be seen as efforts to try to influence monetary policy decisions. A perceived loss of monetary policy independence could raise fears about future inflation, leading to higher long-term interest rates and reduced economic and financial stability. We will continue to work with the Congress to provide the information it needs to oversee our activities effectively, yet in a way that does not compromise monetary policy independence. Thank you, Mr. Chairman. " FOMC20071031meeting--39 37,MR. PLOSSER.," Thank you, Mr. Chairman. There has been little change in the District economic conditions since our September meeting. Except for housing, activity is expanding at a modest pace, somewhat below trend. Our business contacts are cautious, generally expecting slow growth to continue over the next quarter, but they remain fairly optimistic for business conditions six to twelve months out. Payroll employment continues to expand at a slow pace in our three states, which partially reflects slow population growth, and so the unemployment rate remains slightly below that of the nation. Retail sales have generally held up, but there are divergent views among retailers regarding holiday sales. High-end stores expect a very strong finish to the year; lower-end merchants are more cautious. Housing construction and sales continue to decline, but the pace of that decline is in line with the expectations at our last meeting. The value of nonresidential building contracts has declined more sharply in our region than in the nation as a whole. Nevertheless, I would characterize nonresidential real estate markets as firm. That office vacancy rates are declining and commercial rents are rising suggests a positive outlook for commercial construction going forward. According to our business outlook survey, manufacturing activity in the District has been increasing at a modest pace for the past several months. The general index of economic activity moved down slightly, from 10.9 in September to 6.9. Shipments and new orders also weakened slightly. Staff analysis suggests that our manufacturing index, which precedes the release of national industrial production numbers, provides useful information in forecasting monthly manufacturing IP and total IP. That forecasting model is predicting a rise in both manufacturing IP and total IP in October. About two-thirds of the District manufacturers and service-sector firms we have polled said that recent changes in financial conditions have not prompted any change in their capital spending plans, and the other firms are about evenly split as expecting a slight decrease or a slight increase over the next six to twelve months compared with the past six to twelve months. However, in speaking with my business contacts, I do hear a sense of continuing caution among businesses in their capital spending plans. The manufacturers seem to be a bit stronger than the service firms, perhaps reflecting a more robust export market, which many of them are participating in. District bankers, in general, continue to express concern over housing and mortgage lending but see commercial and industrial lending as fairly stable and proceeding about as they had expected. There has been little change in the District’s inflation picture since our last meeting. Firms continue to report higher benefit costs, but other wage pressures have moderated. Our manufacturers reported having to pay higher prices for many inputs, particularly energy-related inputs and petroleum-based products as well as agricultural commodities. They have passed on many of those increases in terms of higher prices to their consumers. While retailers report only modest price increases for many products, food prices are generally higher. In summary, since our last meeting, there has been little change in the economic conditions in the District or in the outlook for the region. Overall, business activity in the region is advancing at a fairly modest pace, and most of our contacts expect that pace to continue for the next quarter or so. But in general, firms in the District remain optimistic about business six to twelve months from now. Turning to the nation, the economy appears less vulnerable to me than it did at the time of our last meeting. Financial markets have improved somewhat, as Bill Dudley was telling us. Conditions are not back to normal yet in all segments of the market, but the markets that are still under stress are the same ones that were under stress last month. Subprime and jumbo mortgages and asset-backed commercial paper are the ones that still are struggling. Price discovery still plagues many of these markets, and I suspect it will take some time before the markets can sort things out and trading returns to normal. That does not mean that the ultimate agreed-upon market prices for some of these assets will bear any resemblance to what they looked like before August. Indeed, they probably won’t, but that’s not necessarily a bad sign or a cause for concern; it may even be a healthy development. We haven’t seen disruption spread to other asset classes for the most part, and the level of stress in financial markets seems to have fallen even as volatility remains high. The spread of jumbo over conventional mortgage rates remains elevated, reflecting some concern, I think, about the risk that expensive homes may face greater price declines than other homes, but the premium is less than it was in September. Both investment-grade and non-investment-grade corporate bond issues have increased. Financial institutions have begun to write off some of their investments and take the losses. This has weighed heavily on equity markets, but I view the write-downs as a necessary part of the process toward stabilization in the markets. Earnings reports from nonfinancial firms have actually been pretty favorable. I’m not saying that we are out of the woods yet, but in my view the risks for a serious meltdown in financial markets have lessened somewhat since our last meeting. The news on general economic activity has improved somewhat since our last meeting as well. Indeed, some of the data have come in better than expected. Employment was revised up, and retail sales data suggest that consumer spending remains resilient, despite the downturn in housing. Like the Greenbook, my outlook for the economy has changed little since our last meeting, when we acted preemptively and lowered rates to “forestall some of the potential adverse effects of financial market disruptions and the expected intensification of the housing correction on the broader economy.” Housing investment and sales continue to decline but about as expected in our forecast. After all, the rapid reduction in subprime lending is exacerbating the decline in housing demand and thus home sales, contributing to the slower recovery of that sector. Other sectors of the economy have performed about as I expected, with little evidence as yet of any major spillovers from housing. Oil prices have moved higher than expected since our last meeting, as has been discussed, but it is unclear to me yet how permanent that increase will be or how much of a drag it might be on activity. The oil price rise is likely to show through to headline inflation in the coming months. Although core inflation measures have improved since the beginning of the year, the rise in energy prices has the potential to put upward pressure on core inflation. Thus, while inflation and inflationary expectations have been stable to date, I suspect that inflation risks are now more to the upside than they were in September. The forecast is an important context for our policy, in my view. We have stressed in the past year that we are data driven and respond to the evolution of our forecast. In general, like the Greenbook, as I said, my forecast of the economy going forward is little changed from my September view. I see that growth returns to trend, which I estimate to be about 2.7—a little higher than the Greenbook—late in 2008 as the housing correction runs its course and the financial market turbulence unwinds. Core PCE inflation remains slightly below 2 percent next year and moderates toward my goal of 1½ percent by 2010. I built in a 25 basis point easing sometime in early 2008 to bring the funds rate back down to a more neutral level, and in my baseline forecast I assume a constant funds rate thereafter. That forecast, however, is contingent on inflation and inflationary expectations remaining well behaved. Having said that, I repeat my caution that inflationary pressures are somewhat elevated at this point, and we run the risk that inflationary expectations may become unhinged if the markets suspect that we have lessened our commitment to keep inflation contained. Thus, I don’t rule out the possibility that we may have to reverse course and tighten policy sometime in 2008 or 2009 in order to achieve consistency between my target rate of inflation of 1½ and inflationary expectations. Thank you, Mr. Chairman." FOMC20061025meeting--158 156,MR. POOLE.," The rate that we would be proud of is really a way of stating the objective or loss function. Okay. Thank you. Thank you, Mr. Chairman." FinancialCrisisReport--30 Structured Finance. In recent years, Wall Street firms have devised increasingly complex financial instruments for sale to investors. These instruments are often referred to as structured finance. Because structured finance products are so complicated and opaque, investors often place particular reliance on credit ratings to determine whether they should buy them. Among the oldest types of structured finance products are RMBS securities. To create these securities, issuers – often working with investment banks – bundle large numbers of home loans into a loan pool, and calculate the revenue stream coming into the loan pool from the individual mortgages. They then design a “waterfall” that delivers a stream of revenues in sequential order to specified “tranches.” The first tranche is at the top of the waterfall and is typically the first to receive revenues from the mortgage pool. Since that tranche is guaranteed to be paid first, it is the safest investment in the pool. The issuer creates a security, often called a bond, linked to that first tranche. That security typically receives a AAA credit rating since its revenue stream is the most secure. The security created from the next tranche receives the same or a lower credit rating and so on until the waterfall reaches the “equity” tranche at the bottom. The equity tranche typically receives no rating since it is the last to be paid, and therefore the first to incur losses if mortgages in the loan pool default. Since virtually every mortgage pool has at least some mortgages that default, equity tranches are intended to provide loss protection for the tranches above it. Because equity tranches are riskier, however, they are often assigned and receive a higher rate of interest and can be profitable if losses are minimal. One mortgage pool might produce five to a dozen or more tranches, each of which is used to create a residential mortgage backed security that is rated and then sold to investors. Cash CDOs. Collateralized debt obligations (CDOs) are another type of structured finance product whose securities receive credit ratings and are sold to investors. CDOs are a more complex financial product that involves the re-securitization of existing income-producing assets. From 2004 through 2007, many CDOs included RMBS securities from multiple mortgage pools. For example, a CDO might contain BBB rated securities from 100 different RMBS securitizations. CDOs can also contain other types of assets, such as commercial mortgage backed securities, corporate bonds, or other CDO securities. These CDOs are often called “cash CDOs,” because they receive cash revenues from the underlying RMBS bonds and other assets. If a CDO is designed so that it contains a specific list of assets that do not change, it is often called a “static” CDO; if the CDO’s assets are allowed to change over time, it is often referred to as a “managed” CDO. Like an RMBS securitization, the CDO arranger calculates the revenue stream coming into the pool of assets, designs a waterfall to divide those incoming revenues among a hierarchy of tranches, and uses each tranche to issue securities that can then be marketed to investors. The most senior tranches of a CDO may receive AAA ratings, even if all of its underlying assets have BBB ratings. FOMC20070131meeting--30 28,MR. REINHART., So it will not say “laughter” in the margins. [Laughter] FOMC20060328meeting--183 181,MR. POOLE.," Thank you, Mr. Chairman. I take it that you would like us to give the policy recommendation that we would favor at this point?" FOMC20071211meeting--11 9,CHAIRMAN BERNANKE., Thank you. Are there questions for Bill on financial conditions or for Bill or me on the TAF proposal? President Poole. CHRG-111hhrg53244--13 Mr. Bernanke," Thank you, Mr. Chairman. Chairman Frank, Ranking Member Bachus, and other members of the committee, I am pleased to present the Federal Reserve's semiannual Monetary Policy Report to the Congress. Aggressive policy actions taken around the world last fall may well have averted the collapse of the global financial system, an event that would have had extremely adverse and protracted consequences for the world economy. Even so, the financial shocks that hit the global economy in September and October were the worst since the 1930's; and they helped push the global economy into the deepest recession since World War II. The U.S. economy contracted sharply in the fourth quarter of last year and the first quarter of this year. More recently, the pace of decline appears to have slowed significantly; and final demand and production have shown tentative signs of stabilization. The labor market, however, has continued to weaken. Consumer price inflation, which fell to low levels late last year, remain subdued in the first 6 months of 2009. To promote economic recovery and foster price stability, the Federal Open Market Committee last year brought its target for the Federal funds rate to a historically low range of zero to one-quarter percent, where it remains today. The FOMC anticipates that economic conditions are likely to warrant maintaining the Federal funds rate at exceptionally low levels for an extended period. At the time of our February report, financial markets at home and abroad were under intense strains, with equity prices at multiyear lows, risk spreads for private borrowers at very elevated levels, and some important financial markets essentially shut. Today, financial conditions remain stressed, and many households and businesses are finding credit difficult to obtain. Nonetheless, on net, the past few months have seen some notable improvements. For example, interest rate spreads and short-term money markets, such as the interbank market and the commercial paper market, have continued to narrow. The extreme risk aversion of last fall has eased somewhat, and investors are returning to private credit markets. Reflecting this greater investor receptivity, corporate bond issuance has been strong. Many markets are functioning more normally, with increased liquidity and lower bid-asked spreads. Equity prices, which hit a low point in March, have recovered to roughly their levels at the end of last year; and banks have raised significant amounts of new capital. Many of the improvements in financial conditions can be traced in part to policy actions taken by the Federal Reserve to encourage the flow of credit. For example, the decline in interbank lending rates and spreads was facilitated by the actions of the Federal Reserve and other central banks to ensure that financial institutions have adequate access to short-term liquidity, which in turn has increased the stability of the banking system and the ability of banks to lend. Interest rates and spreads on commercial paper dropped significantly as a result of the backstop liquidity facilities that the Federal Reserve introduced last fall for that market. Our purchases of agency mortgage-backed securities and other longer-term assets have helped to lower conforming fixed mortgage rates. And the Term Asset-Backed Securities Loan Facility, or TALF, which was implemented this year, has helped to restart the securitization markets for various classes of consumer and small business credit. Earlier this year, the Federal Reserve and other Federal banking regulatory agencies undertook the Supervisory Capital Assessment Program (SCARP), popularly known as the stress test, to determine the capital needs of our largest financial institutions. The results of the SCAP were reported in May, and they appear to increase investor confidence in the U.S. banking system. Subsequently, the great majority of institutions that underwent the assessment have raised equity in public markets; and, on June 17th, 10 of the largest U.S. bank holding companies, all but one of which participated in the SCAP, repaid a total of nearly $70 billion to the Treasury. Better conditions in financial markets have been accompanied by some improvements in economic prospects. Consumer spending has been relatively stable so far this year, and the decline in housing activity appears to have moderated. Businesses have continued to cut capital spending and liquidate inventories, but the likely slowdown in the pace of inventory liquidation in coming quarters represents another factor that may support a turnaround in activity. Although the recession in the rest of the world led to a steep drop in the demand for U.S. exports, this drag on our economy also appears to be waning as many of our trading partners are also seeing signs of stabilization. Despite these positive signs, the rate of job loss remains high, and the unemployment rate has continued its steep rise. Job insecurity, together with declines in home values and tight credit, is likely to limit gains in consumer spending. The possibility that the recent stabilization in household spending will prove transient is an important downside risk to the outlook. In conjunction with the June FOMC meeting, Board members and Reserve Bank presidents prepared economic projections covering the years 2009 through 2011. FOMC participants generally expect that, after declining in the first half of this year, output will increase slightly over the remainder of 2009. The recovery is expected to be gradual in 2010, with some acceleration in activity in 2011. Although the unemployment rate is projected to peak at the end of this year, the projected declines in 2010 and 2011 would still leave unemployment well above FOMC participants' views of the longer-run sustainable rate. All participants expect that inflation will be somewhat lower than recent years, and most expect it to remain subdued over the next 2 years. In light of the substantial economic slack and limited inflation pressures, monetary policy remains focused on fostering economic recovery. Accordingly, as I mentioned earlier, the FOMC believes that a highly accommodative stance of monetary policy will be appropriate for an extended period. However, we also believe that it is important to assure the public and the markets that the extraordinary policy measures we have taken in response to the financial crisis and the recession can be withdrawn in a smooth and timely manner as needed, thereby avoiding the risk that policy stimulus could lead to a future rise in inflation. The FOMC has been devoting considerable attention to issues relating to its exit strategy, and we are confident that we have the necessary tools to implement that strategy when appropriate. To some extent, our policy measures will unwind automatically as the economy recovers and financial strains ease, because most of our extraordinary liquidity facilities are priced at a premium over normal interest rate spreads. Indeed, total Federal Reserve credit extended to banks and other market participants has declined from roughly $1.5 trillion at the end of 2008 to less than $600 billion, reflecting the improvement in financial conditions that has already occurred. In addition, bank reserves held at the Fed will decline as the longer-term assets that we own mature or are prepaid. Nevertheless, should economic conditions warrant a tightening of monetary policy before this process of unwinding is complete, we have a number of tools that will enable us to raise market interest rates as needed. Perhaps the most important such tool is the authority that the Congress granted the Federal Reserve last fall to pay interest on balances held at the Fed by depository institutions. Raising the rate of interest paid on reserve balances will give us substantial leverage over the Federal funds rate and other short-term market interest rates, because banks generally will not supply funds to the market at an interest rate significantly lower than they can earn risk-free by holding balances at the Federal Reserve. Indeed, many foreign central banks use the ability to pay interest on reserves to help set a floor on market interest rates. The attraction of this to banks of leaving their excess reserve balances with the Federal Reserve can be further increased by offering banks a choice of maturities for their deposits. But interest on reserves is by no means the only tool we have to influence market rates. For example, we can drain liquidity from the system by conducting reverse repurchase agreements, in which we sell securities from our portfolio with an agreement to buy them back at later dates. Reverse repurchase agreements, which can be executed with primary dealers, Government-Sponsored Enterprises, and a range of other counterparties, are a traditional and well-understood method of managing the level of bank reserves. If necessary, another means of tightening policy is outright sales of our holdings of longer term securities. Not only would such sales drain reserves and raise short-term interest rates, but they could also put upward pressure on longer-term rates by expanding the supply of longer-term assets. In sum, we are confident that we have the tools to raise interest rates when that becomes necessary to achieve our objectives of maximum employment and price stability. Our economy and financial markets have faced extraordinary near-term challenges, and strong and timely actions to respond to those challenges have been necessary and appropriate. I have discussed some of the measures taken by the Federal Reserve to promote economic growth and financial stability. The Congress also has taken substantial actions, including the passage of a fiscal stimulus package. Nevertheless, even as important steps have been taken to address the recession and the intense threats to financial stability, maintaining the confidence of the public and financial markets requires that policymakers begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby boom generation and the continued increases in the costs of Medicare and Medicaid. Addressing the country's fiscal problems will require difficult choices, but postponing those choices will only make them more difficult. Moreover, agreeing on a sustainable long-run fiscal path now could yield considerable near-term economic benefits in the form of lower long-term interest rates and increased consumer and business confidence. Unless we demonstrate a strong commitment to fiscal sustainability, we risk having neither financial stability nor durable economic growth. A clear lesson of the recent financial turmoil is that we must make our system of financial supervision and regulation more effective, both in the United States and abroad. In my view, comprehensive reform should include at least the following key elements: a prudential approach that focuses on the stability of the financial system as a whole and not just the safety and soundness of individual institutions, and that includes formal mechanisms for identifying and dealing with emerging systemic risks; stronger capital and liquidity standards for financial firms, with more stringent standards for large, complex, and financially interconnected firms; the extension and enhancement of supervisory oversight, including effective consolidated supervision to all financial organizations that could pose a significant risk to the overall financial system; an enhanced bankruptcy or resolution regime, modeled on the current system for depository institutions, that would allow financially troubled, systemically important nonbank financial institutions to be wound down without broad disruption to the financial institution's system and to the economy; enhanced protections for consumers and investors in their financial dealings; measures to ensure that critical payment, clearing, and settlement arrangements are resilient to financial shocks, and that practices related to the trading and clearing of derivatives and other financial instruments do not pose risk to the financial system as a whole; and, finally, improved coordination across countries in the development of regulations and in the supervision of internationally active firms. The Federal Reserve has taken and will continue to take important steps to strengthen supervision, improve the resiliency of the financial system, and to increase the macroprudential orientation of our oversight. For example, we are expanding our use of horizontal reviews of financial firms to provide more comprehensive understanding of practices and risks in the financial system. The Federal Reserve also remains strongly committed to effectively carrying out our responsibilities for consumer protection. Over the past 3 years, the Federal Reserve has written rules providing strong protections for mortgage borrowers and credit card users, among many other substantive actions. Later this week, the Board will issue a proposal using our authority under the Truth in Lending Act, which will include new, consumer-tested disclosures as well as rule changes applying to mortgages and home equity lines of credit. In addition, the proposal includes new rules governing the compensation of mortgage originators. We are expanding our supervisory activities to include risk-focused reviews of consumer compliance in nonbank subsidiaries of holding companies. Our community affairs and research areas have provided support and assistance for organizations specializing in foreclosure mitigation, and we have worked with nonprofit groups on strategies for neighborhood stabilization. The Federal Reserve's combination of expertise in financial markets, payment systems, and supervision positions us well to protect the interests of consumers and their financial transactions. We look forward to discussing with the Congress ways to formalize our institution's strong commitment to consumer protection. The Congress and the American people have a right to know how the Federal Reserve is carrying out its responsibilities and how we are using taxpayer resources. The Federal Reserve is committed to transparency and accountability in its operations. We report on our activities in a variety of ways, including reports like the one I am presenting to Congress today, other testimonies, and speeches. The FOMC releases a statement immediately after each regularly scheduled meeting and detailed minutes of each meeting on a timely basis. We have increased the frequency and scope of the published economic forecast of FOMC participants. We provide the public with detailed annual reports on the financial activities of the Federal Reserve System that are audited by an independent public accounting firm. We also publish a complete balance sheet each week. We have recently taken additional steps to better inform the public about the programs we have instituted to combat the financial crisis. We expanded our Web site this year to bring together already available information as well as considerable new information on our policy programs and financial activities. In June, we initiated a monthly report to the Congress that provides even more information on Federal Reserve liquidity programs, including breakdowns of our lending, the associated collateral, and other facets of programs established to address the financial crisis. These steps should help the public understand the efforts that we have taken to protect the taxpayer as we supply liquidity to the financial system and support the functioning of key credit markets. The Congress has recently discussed proposals to expand the audit authority of the GAO over the Federal Reserve. As you know, the Federal Reserve is already subject to frequent reviews by the GAO. The GAO has broad authority to audit our operations and functions. The Congress recently granted the GAO new authority to conduct audits of the credit facilities extended by the Federal Reserve to ``single and specific'' companies under the authority provided by section 13(3) of the Federal Reserve Act, including the loan facilities provided to, or created for, AIG or Bear Stearns. The GAO and the Special Inspector General have the right to audit our TALF program, which uses funds from the Troubled Asset Relief Program. The Congress, however, purposefully--and for good reason--excluded from the scope of potential GAO reviews some highly sensitive areas, notably monetary policy deliberations and operations, including open market and discount window operations. In doing so, the Congress carefully balanced the need for public accountability with the strong public policy benefits that flow from maintaining an appropriate degree of independence for the central bank in the making and execution of monetary policy. Financial markets, in particular, likely would see a grant of review authority in these areas to the GAO as a serious weakening of monetary policy independence. Because GAO reviews may be initiated at the request of Members of Congress, reviews or the threat of reviews in these areas could be seen as efforts to try to influence monetary policy decisions. A perceived loss of monetary policy independence could raise fears about future inflation and lead to higher long-term interest rates and reduced economic and financial stability. We will continue to work with the Congress to provide the information it needs to oversee our activities effectively, yet in a way that does not compromise monetary policy independence. Thank you, Mr. Chairman. [The prepared statement of Chairman Bernanke can be found on page 68 of the appendix.] " FOMC20080805meeting--137 135,CHAIRMAN BERNANKE.," Thank you. Governor Mishkin, your swan song. [Laughter] " FOMC20060920meeting--141 139,CHAIRMAN BERNANKE., Thank you. Vice Chairman … Governor Kohn. [Laughter] FOMC20071211meeting--143 141,CHAIRMAN BERNANKE., Rules versus discretion. [Laughter] Thank you. President Plosser. FOMC20070918meeting--94 92,CHAIRMAN BERNANKE., Thank you. The news about the Italian strike is concerning me considerably. [Laughter] FOMC20070131meeting--183 181,MR. STOCKTON.," And I will provide it. [Laughter]. Whether it’s worth anything or not, I don’t know. [Laughter]" CHRG-110hhrg46593--200 Mr. Findlay," Thank you, Congressman Kanjorski. I am Cameron Findlay, the executive vice president and general counsel of Aon, and I appreciate the opportunity to testify today on behalf of the Council of Insurance Agents and Brokers. My written testimony provides the details of an innovative proposal for the Department of the Treasury to exercise the authority you have granted under Section 102 of TARP, so please permit me here just to summarize the high points. We start with the premise that the insurance industry has a lot to offer in the efforts to stabilize the economy, because insurance is a critical but sometimes overlooked part of the financial services industry. Put simply, we believe that the Department of the Treasury should use its statutory authority, the authority you have granted it, to establish a program to insure a portion of the expected payment of principal and interest from troubled and illiquid financial instruments. While Treasury's efforts to inject capital in financial institutions is important--and has succeeded in some respects--this effort doesn't address a primary cause of the liquidity problem, the hundreds of billions of dollars of illiquid assets that are on the books of America's financial institutions. Our proposed approach is an insurance program that would combine risk pooling, risk retention by the financial institutions themselves, and potential government backstop liquidity. In our view, such an approach would benefit all the stakeholders here, taxpayers, financial institutions, and homeowners. The plan involves, first, the sharing of risk by participants in an asset stabilization pool. Participants in the pool would pay risk-based premiums, and the pool would insure a portion of the principal and the interest from illiquid assets on their books. Thus, the program would insulate an asset holder from having to immediately recognize the decline in value resulting from the nonpayment or expected nonpayment of principal and interest. Second, our plan requires financial institutions to retain some risk. Just as holders of insurance policies retain risk through deductibles, asset holders would be required to retain a percentage of the shortfall of principal and interest. Asset holders would be reimbursed from the pool for a shortfall, only when the shortfall exceeds their retained amount in a single year. It is just like a deductible in your home insurance policy. Third, our plan involves the potential of government loans as a backstop. That is, in the event that in the early years, payments from the pool exceeded premium collections, the government could loan the pool funds needed to make good on the guarantees. The government would then be reimbursed by premium collections in subsequent years. Let me illustrate the proposal by using a very simple example. Suppose an institution holds $1 million in mortgage-backed assets. Assume that the current lack of confidence in the liquidity of these assets has dropped the market value to, say, $600,000. Now, this $400,000 drop is not necessarily the result of a true decrease in the asset's intrinsic value. It may simply be the result, at best, of a lack of information about the value of the asset or, at worst, in the current environment, to sheer panic. Let's assume in our example that the actual intrinsic value of the asset is $800,000. Without our proposed insurance program, the institution might have to mark the asset to market, resulting in an immediate loss of $400,000 in value or, even worse, the institution might have to sell the asset into a panicked market. But an insurance pool that guarantees the repayment of the principal and interest from these assets would, under proper accounting treatment, result in the institution holding assets worth $800,000, not $600,000. The insurance industry knows how to do this. Actuaries can set initial premiums based on the law of large numbers, and then after experience working with the proposed pool, actuaries could use the accumulated data about the performance of the assets to develop ever-more-accurate premium pricing models, reflecting the actual value of the underlying securities. In our view, this program will have significant benefits for all stakeholders: Taxpayers; financial institutions; and homeowners. For taxpayers, an insurance program would have significantly less short-term cash requirements and capital infusions. Also, because it would be funded by its direct beneficiaries, it would restore liquidity without requiring massive immediate outlays of government funds. The insurance solution would also assist financial institutions. As an insurance program, it would provide asset holders the option to hold assets until maturity or until economic conditions permit the recognition of the assets' real value. It wouldn't flood the market with distressed assets, which could have the effect of further depressing asset values. An insurance program would also prevent opportunistic purchases of depressed assets by predatory investors. Finally, our plan helps homeowners as well, homeowners facing foreclosure, by proposing that participating companies have to agree to a plan to restructure individual mortgages as a condition of participation. On behalf of Aon and the CIAB, I want to thank you again for the opportunity to testify today. We stand ready to work with you on our proposal, and we would be pleased to take any questions that you may have. [The prepared statement of Mr. Findlay can be found on page 185 of the appendix.] " FOMC20070131meeting--21 19,MR. POOLE., Okay. So the alternate would serve until the next president was in office. That has certainly been the practice; my question was about the wording. Thank you. FinancialCrisisReport--251 Arrangers. For RMBS, the “arranger” – typically an investment bank – initiated the rating process by sending to the credit rating agency information about a prospective RMBS and data about the mortgage loans included in the prospective pool. The data typically identified the characteristics of each mortgage in the pool including: the principal amount, geographic location of the property, FICO score, loan to value ratio of the property, and type of loan. In the case of a CDO, the process also included a review of the underlying assets, but was based primarily on the ratings those assets had already received. In addition to data on the assets, the arranger provided a proposed capital structure for the financial instrument, identifying, for example, how many tranches would be created, how the revenues being paid into the RMBS or CDO would be divided up among those tranches, and how many of the tranches were designed to receive investment grade ratings. The arranger also identified one or more “credit enhancements” for the pool to create a financial cushion that would protect the designated investment grade tranches from expected losses. 973 Credit Enhancements. Arrangers used a variety of credit enhancements. The most common was “subordination” in which the arranger “creates a hierarchy of loss absorption among the tranche securities.” 974 To create that hierarchy, the arranger placed the pool’s tranches in an order, with the lowest tranche required to absorb any losses first, before the next highest tranche. Losses might occur, for example, if borrowers defaulted on their mortgages and stopped making mortgage payments into the pool. Lower level tranches most at risk of having to absorb losses typically received noninvestment grade ratings from the credit rating agencies, while the higher level tranches that were protected from loss typically received investment grade ratings. One key task for both the arrangers and the credit rating agencies was to calculate the amount of “subordination” required to ensure that the higher tranches in a pool were protected from loss and could be given AAA or other investment grade ratings. A second common form of credit enhancement was “over-collateralization.” In this credit enhancement, the arranger ensured that the revenues expected to be produced by the assets in a pool exceeded the revenues designated to be paid out to each of the tranches. That excess amount provided a financial cushion for the pool and was used to create an “equity” tranche, which was the first tranche in the pool to absorb losses if the expected payments into the pool were reduced. This equity tranche was subordinate to all the other tranches in the pool and did not receive any credit rating. The larger the excess, the larger the equity tranche, and the larger the cushion created to absorb losses and protect the more senior tranches in the pool. In some pools, the equity tranche was also designed to pay a relatively higher rate of return to the party or parties who held that tranche due to its higher risk. Still another common form of credit enhancement was the creation of “excess spread,” which involved designating an amount of revenue to pay the pool’s monthly expenses and other liabilities, but ensuring that the amount was slightly more than what was likely needed for that 973 See, e.g., 7/2008 “Summary Report of Issues Identified in the Commission Staff’s Examination of Select Credit Rating Agencies,” report prepared by the SEC, at 6-10. 974 Id. at 6. purpose. Any funds not actually spent on expenses would provide an additional financial cushion to absorb losses, if necessary.